Judge Grants Injunction Against IRS in Micro-Captive Reporting Case

A federal judge has granted a preliminary injunction barring the US Internal Revenue Service (IRS) from enforcing its micro-captive reporting requirement on CIC Services.

The September 21, 2021, ruling comes after the US Supreme Court earlier this year overturned a federal district court ruling and remanded the case to the lower court for consideration of CIC's effort to stop the IRS from enforcing its micro-captive reporting requirement set out in Notice 2016-66. The IRS contended that micro-captives are "transactions of interest" that should be reported to the IRS.

The IRS had contended that CIC was barred from seeking its injunction by the Anti-Injunction Act, a measure preventing courts from issuing injunctions that restrain the assessment or collection of a tax. However, in CIC Servs., LLC v. Internal Revenue Serv., No. 19-930, 2021 U.S. LEXIS 2585 (May 17, 2021), the Supreme Court determined that the Anti-Injunction Act didn't apply in the case of CIC's suit.

Though the lower court had initially denied CIC's injunction motion in 2017 on the basis of the Anti-Injunction Act, following the Supreme Court's May ruling, CIC filed a renewed motion in July, seeking to enjoin the IRS's enforcement of Notice 2016-66.

In seeking the injunction, CIC argued that the notice was a legislative rule under the federal Administrative Procedures Act (APA) and that in issuing Notice 2016-66 the IRS had failed to comply with the APA's notice and comment rulemaking requirements. CIC also noted that complying with the IRS rule had cost it hundreds of hours of employee labor and thousands of dollars per year.

Ultimately, the US District Court for the Eastern District of Tennessee at Knoxville ruled that "CIC has demonstrated that it is likely to succeed on its claim that Notice 2016-66 constitutes a legislative rule and that it is invalid because the Secretary failed to comply with required notice-and-comment procedures under the APA."

The court also took issue with the IRS's definition of a "transaction of interest" as "a transaction that is the same or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest."

"Such a circular definition amounts to a catch-all that seemingly grants the IRS unlimited discretion to label any transaction a 'transaction of interest,' and, thus, a 'reportable transaction,' if it believes the transaction has the potential for tax avoidance or evasion," the court's ruling said.

So-called micro-captives, small captive insurance companies that elect to be taxed under section 831(b) of the Internal Revenue Code, which allows small insurance companies to be taxed only on their investment income, have been the target of IRS scrutiny in recent years.

The IRS has noted that in the past several years, it has intensified its efforts to combat abusive micro-captive insurance arrangements.

In 2020, the agency deployed 12 new micro-captive examination teams to substantially increase its examinations of micro-captive insurance transactions, while in April, it warned participants in abusive micro-captive arrangements to exit those arrangements as soon as possible. Days later, the IRS announced that it had formed an office to coordinate the agency's focus on abusive tax avoidance transactions, including abusive micro-captive insurance arrangements.