IRS Hearing Transcript on Microcaptive Transactions Is Available

UNITED STATES DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE

TELECONFERENCE PUBLIC HEARING ON PROPOSED REGULATIONS

“MICROCAPTIVE LISTED TRANSACTIONS AND MICROCAPTIVE TRANSACTIONS OF INTEREST"

[REG-109309-22]

Washington, D.C.

Wednesday, July 19, 2023

PARTICIPANTS:

For IRS:

ELIZABETH M. HILL,
Attorney (FIP)

KATHRYN SNEADE,
Branch Reviewer (FIP)

ALEXIS MACIVOR,
Deputy Associate Chief Counsel (FIP)

For U.S. Department of Treasury:

ANGELA WALITT
Attorney-Advisor
Office of Tax Policy

Speakers:

JAMES F. PERNA
James F. Perna,
Attorney at Law

ADAM R. WEBBER
Webber Law Group

J. MATTHEW QUEEN
The Queen Firm, LLC

DAVID M. FINDLAY
Lake City Bank

JOE MAGYAR
Crowe LLP

STEVE KINION
Oklahoma Insurance Department

* * * * *

PROCEEDINGS

(10:00 a.m.)

MS. HILL: Thank you very much, and good morning, everyone. My name is Elizabeth Hill. I'm a docket attorney in the insurance branch of the Financial Institutions & Products Division of the IRS Office of Chief Counsel, or FIP.

First, let me confirm my audio with the operator. Is my sound okay?

OPERATOR: Yes.

MS. HILL: Thank you very much. And again, good morning, everyone. This is the public hearing for the notice of proposed rulemaking, or NPRM, designating certain microcaptive transactions of listed transactions and certain other transactions as transactions of interest. Our office's identifying number for this NPRM is Reg-109309-22.

Let's start today's hearing by introducing our panelists. As I noted, I am Elizabeth Hill, docket attorney in the insurance branch of FIP. Next, Katie, can you introduce yourself?

MS. SNEADE: Hi, this is Kathryn Sneade. I am the branch chief of Branch Foreign Financial Institutions & Products.

MS. HILL: Thank you, Katie. Alexis, can you introduce yourself?

MS. MACIVOR: Hi. I am Alexis MacIvor. I'm the deputy associate chief counsel in Financial Institutions & Products.

MS. HILL: Thank you, Alexis. And last but not least, Angela.

MS. WALITT: Hi. This is Angela Wallet. I'm an attorney-adviser in the Treasury Department Office of Tax Policy.

MS. HILL: Thank you very much to our panelists today. First, let me thank everyone on the call, listeners and speakers alike, and everyone else who submitted public comments on this NPRM.

We are in the process of carefully considering each comment submitted, and we are of course going to carefully consider all of your remarks today. As we are still in that process, we may not be able to respond substantively to questions in today's hearing, but we are very grateful to the captive industry and its stakeholders for their thoughtful comments and candor.

Let's turn now to the six speakers who requested to testify at this hearing. Speakers, you will have 10 minutes for your remarks. Our operator will notify you at the nine-minute mark that you have one minute left to speak. We are going to be conducting this as we would an in-person hearing. So if, for whatever reason, a panelist interrupts a speaker, the speaker's time will be paused during that interruption, and we'll let you know when the clock starts running again.

Now, I'm going to go ahead and introduce each speaker in turn. And our first speaker who was designated to speak today was James F. Perna, attorney at law. James, are you on the call?

OPERATOR: If you're on the call, please press star, then zero, because all lines are closed except for the speakers.

MS. HILL: We'll give Mr. Perna a moment to see if he can join us.

In the interest of time, I will move to our next speaker, and I understand that Mr. Steve Kinion from the Oklahoma Insurance Department had requested to speak and is on the call. Mr. Kinion?

MR. KINION: Ms. Hill, good morning. MS. HILL: Good morning.

MR. KINION: Should I — is that my cue to proceed with my comments?

MS. HILL: That is your cue.

MR. KINION: Thank you very much, Ms. Hill. I appreciate that. On behalf of Oklahoma Insurance Commissioner Glen Mulready and the staff of the Oklahoma Insurance Department, I thank you for the opportunity to present these verbal comments, in addition to the written comments that the Oklahoma Insurance Department previously submitted last month.

My comments will not address the specifics of the notice of approved rulemaking, such as the 65 percent loss ratio policy holder dividends or the IRS's authority to present the proposed rules. The written comments submitted, of which there are more than 100, more than adequately address these issues, as well as other issues.

Instead, this morning, I will address the consequences of the notice of proposed rulemaking, which I will refer to simply as the proposal in these verbal comments. I will do so in terms of what it means for Oklahoma businesses insured by captive insurers and how it negatively affects Oklahoma's regime for funding the pensions for retired firefighters and police officers.

At 9:02 a.m. on Wednesday, April 19th, 1995, the largest act of U.S. domestic terrorism struck Oklahoma City. A bomb exploded in front of the Alfred P. Murrah Federal Building, killing 168 men, women, and children and causing hundreds of millions of dollars in property damage. At the time of the blast, the Murrah Building housed some 600 federal and contract workers, as well as an estimated 250 visitors.

The bomb was located within the confines of a 24-foot Ryder rental truck. The explosive mixture had been prepared to charge with a detonation cord and prepositioned parked parallel in a loading lane on the north side of the Murrah Building, near the intersection of Northwest Fifth Street and Robinson Avenue in Downtown Oklahoma City.

The force of the explosion was of such magnitude that it destroyed approximately one-third of the Murrah Building. The entire North Phase of the structure was reduced to rubble, and each of the nine floors, plus the roof, received extensive damage. Contents of the first and second floors were blown against the second portion of the building, while the third through ninth floors were initially raised by the blast and proceeded to pancake one atop the other at street level.

When the dust cleared, approximately one-third of the structure was located in a pile of debris, measuring in some places 35 feet in height and running the length of the building. More than 300 nearby buildings were destroyed or damaged, and shattered glass covered a 10-block radius.

To comply with the conditions of the declaration of major disaster, then-Governor Frank Keating established a Governor's taskforce for damage assessment.

MR. PERNA: I kept on talking, but all of a sudden, they're now listening to this guy from Oklahoma.

MR. KINION: Ms. Hill, may the guy from Oklahoma proceed?

MS. HILL: Yes. Operator, if you could give a few moments back. We'll get to another speaker as soon as Mr. Kinion is done with his comments.

OPERATOR: Not a problem. I'll add a minute back.

MR. KINION: Thank you very much. As I was saying, to comply with the conditions of the declaration of a major disaster —

MR. PERNA: Okay, yes. Okay.

MS. HILL: This is Elizabeth Hill. I would ask that everybody put themselves on mute if they're not actively commenting.

MR. KINION: Is this included?

MS. HILL: We'll give you time back on this, as well. Operator, if you can add another 30 seconds.

MR. KINION: Thank you. This total included $426,594,000 in nonfederal losses, such as losses to buildings and property, medical services, lost income, sales, and taxes. In 2023, the 1995 nonfederal losses equal $851 million — or more than $851 million.

In 1995, what we know of today as the Terrorism Risk Insurance Act, otherwise known as TRIA, T-R-I-A, did not exist. Following 9/11, Congress recognized the unique challenges of insuring commercial enterprises against terrorism attacks and passed TRIA in November of 2002.

What's important is this: TRIA established a risk-sharing mechanism for certain commercial lines that allows the federal government and the insurance industry to share losses in the event of a major terrorist attack. As recently as March 2, 2023, the U.S. General Accountability Office reported that domestic terrorism is on the rise. If such a horrific event of the magnitude that's occurred in Oklahoma City occurred again today in another US city, it would trigger TRIA coverage. If they have a business in Oklahoma City and anywhere else in the United States desires to form a captive insurer to insure terrorism and risk, it could do so in those states that have adopted the act, such as the Oklahoma Captive Insurance Company Act.

Unfortunately, it would also be penalized by the operation of the IRS's proposal provisions, due to this being a low frequency — terrorism being a low-frequency and high-severity event. It would be negatively affected because of the 65 percent loss ratio that the proposal presents. Terrorism insurance is a coverage that regrettably is a modern-day necessity. Thankfully, it is a very low-frequency and, in best case, no-frequency occurrence, but unfortunately, a high-severity event in terms of losses when it occurs.

In spite of this reality, an Oklahoma-domiciled captive insurer formed in 2013 that insures property risks in Oklahoma City for terrorism or finances the TRIA deductible automatically becomes a listed transaction or transaction of interest under the proposal for failing the 65 percent loss ratio. It becomes so because of a celebrated fact — and I stress this point — a celebrated fact. There were no terrorist acts, which means there were no losses. The fact that there are no terrorism acts should be celebrated; however, this would be an unwelcome celebration for this Oklahoma captive insurer because under the proposal, a lack of claims suggests an engagement in tax evasion or tax avoidance.

The proposal is contrary to the Terrorism Risk Insurance Act, TRIA. One of TRIA's purposes is to encourage the coverage of terrorist risks by private insurance, so that businesses do not need to rely upon federal assistance, as was the case following the 1995 bombing. The proposal is simply a disincentive to ensure terrorism risks through a captive insurer.

Oklahoma partially funds its firefighter employees' pensions and taxes paid by captive insurers domiciled in the state. The consequence of the proposal's adoptions would be the formation of fewer captive insurers, and those that exist today — some will dissolve in order to avoid becoming reportable transactions. This results in fewer taxes paid to pension systems.

You know, an irony of the proposal is that many of the first responders present at the Murrah Building in 1995 are now retired. It would be an unfortunate legacy of this proposal for it to discourage the use of captive insurers to ensure terrorism coverage — the terrorist acts to which they responded — and, at the same time, reduce revenue for the pensions caring for them.

Commissioner Mulready knows that no one at the IRS desires this kind of result — so-called shortchanging of the pension systems for retired first responders. That is why he extends the invitation to IRS leadership to work together to identify the IRS's concerns, as well as to address the unforeseen consequences, which I have just described that this proposal can present. The Oklahoma Insurance Department is willing to take the lead to formalize this process, which can take a number of forms of working together. It can be in the form of an NAIC — National Association of Insurance Commissioners — working group or other format.

The message I send is this: Commissioner Mulready is willing to put forth a time and effort to work together with the Internal Revenue Service, as well as the other states that have an interest in captive insurance, and the captive insurance industry to hear its voice, as well, so that we can collaboratively work together to address the IRS's concerns, the concerns of the state, and the concerns of the industry.

In closing, Commissioner Mulready asks IRS leadership to accept the invitation so that it results in good public policy. Ms. Hill, thank you very much for the opportunity this morning to present comments.

MS. HILL: Thank you very much, Mr. Kinion, for your comments. Operator, is there any time left of Mr. Kinion's allotted 10 minutes?

OPERATOR: He has about two — a little less than two.

MS. HILL: So I'll now ask my panelists if they have any questions for Mr. Kinion.

Okay, hearing none, I will turn to our next speaker. We had Mr. James F. Perna, attorney at law, designated as a speaker on today's hearing. Mr. Perna, are you available to speak?

MR. PERNA: Yes, I am.

MS. HILL: Thank you, Mr. Perna. Please proceed.

MR. PERNA: Thank you. I will leave addressing the particularities of the proposed regulation to the other commentators that follow. I will instead go to the intention of Treasury and IRS in concocting these proposed regulations, which were preceded by their "Dirty Dozen" campaign known as 2016-66 and other artifices.

Captive insurance companies are a proven value and are widely appreciated and utilized by virtually every Standard & Poor's 500 company and Russell 1000 company in the United States using section 831(a). These companies recognize that a substantial portion of insurance company expenses go to the payment of commissions and other sales-related expenses. Their captive insurance companies afford them the opportunities to avoid such expenses. Further, whatever profits are derived from a captive insurance company are returnable to the stockholders as dividends.

Code section 831(b) simply takes these concepts, which large, successful companies understand and utilize, and make them available to small businesses. All businesses, both large and small, have a need to maximize their risk management needs. Transitional domestic insurance companies often are unable to optimize such risk management needs, or they are required to do so at unreasonable cost; however, there does not have to be an either/or choice between not insuring a particular need or insuring one at unreasonable cost.

Instead, a third alternative, the utilization of a captive insurance company, is available to help businesses optimize risk insurance needs, while avoiding unduly burdensome expenses. This need for flexibility has become even more pressing in our post-COVID climate-sensitive business world. The owners of a captive insurance company are also the owners of the particular business being insured. Small insurance companies which are organized and operated in accordance with section 831(b) can provide a broad array of benefits to owners: cost reduction, access to reinsurance, cash flow benefits, customization of insurance benefits, appropriate creation of insurance gains, and the ability to control and direct investment options.

Finally, just obtaining commercial insurance is not assured at a time when The Wall Street Journal headlines just this past week stated that home insurers curb new policies in risky areas naturally. The pullback goes beyond California and Florida as insurers face inflation and climate change. The article notes that AIG is curbing home insurance sales to customers in some 200 zip codes, including New York, Delaware, Florida, Colorado, Montana, Idaho, and Wyoming. AIG had already cut its new business in California. Farmers Group earlier stopped offering home insurance policies in Florida. State Farm and Allstate are withdrawing from California's home insurance market.

And although homeowner insurance is getting the most publicity, small- and medium-size businesses, which own factories, and offices, and other real property where their employees and their contractors work, will suffer the same absence of property and casualty insurance.

The Treasury and the IRS are harming the American economy by their misguided efforts to eradicate microcaptives. Consider if the IRS had been around when biblical Joseph was advising the Pharaoh about his dream of seven fat cows, followed by seven lean cows, and seven good heads of grain, followed by seven worthless heads of grain, meaning that Egypt would have seven years of plentiful food, followed by seven years of famine — and that Egypt should store up the food for the good years to get them through the famine years. The IRS would have advised the Pharaoh not to do so, because the loss ratio for five years was zero.

Just last week, The Wall Street Journal published an AM Best graph showing the loss ratios of large commercial home insurance companies for the period of 2010 to 2022 for the U.S. nationally and for California. The U.S. nationally fluctuated from about 50 percent to 70 percent, and California fluctuated from about 40 percent to 200 percent property and casualty loss ratio caused by acts of God, war, weather, accident, and chance cannot be as stable as the medical loss ratios that the IRS referenced in formulating its proposed regulatory loss ratio test. Small captives have even more variability and loss ratios because they often have a single insured.

In making a comparison, the IRS is making a fundamental error, comparing apples to oranges to justify its presumptive biases. By some estimates, as many as 1,000 captive cases are pending in the U.S. tax court. But the IRS has completed litigation with respect to only a handful of cases involving the most obviously egregious fact patterns. Only a smidgeon of these cases under audit have been permitted access to good-faith administrative appeal sessions for possible resolution.

Pursuant to a directive from a former IRS commissioner, IRS examining agents will consider opening settlement discussions only if the taxpayer agrees upfront to accept a resolution of 80 percent to 90 percent in favor of the IRS and to shut down the captive. IRS agents have threatened taxpayers and their advisers with double and triple taxation and penalties that continue to accumulate while the taxpayers wait years for resolution of their claims.

Even for the IRS, this sort of behavior is shameful. The current commissioner, Mr. Werfel, I understand, has still not responded to questions for the record on a microcaptive enforcement made by Senator Cornyn and Representative Blake Moore during the Congressional Oversight hearings held in April 2023.

Three decades ago, the IRS conceded its battle against big business captives qualifying under section 831(a). After losing in half a dozen federal circuit courts, the IRS then acquiesced to the big captives, which have deep pockets and are easily able to defend themselves, and shifted its crosshairs to small captives owned by small- and medium-size businesses less able to put up with a struggle with a bureaucratic behemoth like the IRS.

The IRS may ultimately win, at least in the short term. It is commonplace that too often might prevails over right. The cost of a taxpayer litigating a captive case is very expensive. It may range from $500,000 to over $1 million. The IRS uses this together with penalties and interest to extract punitive, asymmetric settlements from the engine of our economy, small- and medium-size businesses.

The private bar has suggested that a few higher-up individuals at Treasury and IRS are trying to accomplish by administrative devices what they were unable to convince Congress to do legislatively in 2015, namely to repeal section 831(b) and to shut down the small captive industry, which has been in existence for over 35 years and for which Congress has since continued to demonstrate bipartisan support. It is readily apparent that the IRS is trying to repeal by pretextual regulation what Congress has authorized, accepted, and approved. The IRS would throw out the baby with the bathwater rather than develop reasonable standards in cooperation with the small captive insurance industry.

No doubt there are some bad actors in this small captive industry, just as there are bad priests, bad ministers, bad doctors, and bad lawyers. But that does not mean that such professions or all small captives should be eradicated. The Treasury and the IRS have had over 35 years to consult with industry experts, academics, lawyers, actuaries, underwriters, and accountants to develop safe harbors and best practices. The IRS has totally failed in this regard.

Instead, the IRS has resorted to every conceivable impediment to semblance, regulatory hindrance, and bureaucratic obstacle to strangle the economic life out of the small captive industry in contravention to the expressed will of Congress. For over 10 years, the IRS has tried to make toxic a congressionally enacted and reenacted, as recent as the PATH Act, user-friendly incentive that encouraged small- and medium-size businesses to establish a small captive by means of its Dirty Dozen dragnet audits, its bad-faith industry litigation, and now these proposed regulations, which are as arbitrary and capricious as the federal district court found Notice 2016-66 to be.

Without significant changes, the proposed regulation will result in protracted and expensive litigation, which is not in the interest of the IRS, the small captive industry, and the American economy. Many suspect —

OPERATOR: Excuse the interruption. You have one minute left.

MR. PERNA: Many suspect that the comments submitted for record and the testimonies offered today are just a theatrical charade, because Treasury and IRS have already decided to promulgate the proposed regulation as is; however, truth be told, proposed regulations should be withdrawn. Thank you.

MS. HILL: Thank you very much for your comments, Mr. Kerner — Perna. I'm sorry. Our next speaker for today's agenda is Mr. Adam Webber, with the Webber Law Group. Mr. Weber, are you available to speak?

OPERATOR: Mr. Webber, if you're online, please press star, then zero. One moment while I —

MR. WEBBER: Good morning. This is Adam Webber.

MS. HILL: Good morning, Mr. Webber. Pleased to see you.

MR. WEBBER: Well, good morning, and thank you for permitting me to speak. My name is Adam Webber, and I'm an attorney in Dayton, Ohio. Unlike perhaps the other speakers today, I'm not heavily involved in the captive insurance business, but I care about administrative law. And like all citizens, I hope, I'm concerned about proper governance.

My primary qualification to provide testimony to you today is that I was lead counsel in tax litigation against the IRS in CIC Services versus the IRS. That litigation challenged this proposed regulation's illegal predecessor, Notice 2016-66.

When that notice was issued, my co-counsel and I filed on behalf of our client for injunctive relief to prevent that notice's enforcement. Initially, the IRS tried to avoid judicial scrutiny of its conduct in issuing the notice, asserting that a Civil War-era law prevented review of its actions. The IRS lost that argument 9 to 0 before the U.S. Supreme Court. Along the way, the Sixth Circuit Court of Appeals repeatedly heaped scorn upon the IRS for its improper administrative rulemaking history, of which Notice 2016-66 was the then latest example.

Once the IRS's conduct with respect to Notice 2016 was reviewed by the federal court, the results were startling. Not only did the Court find that the notice was void due to the IRS's failure to comply with notice and comment rulemaking, but the Court also found that Notice 2016 was arbitrary — Notice 2016-66 — excuse me — was arbitrary and capricious. As a result, the Court vacated the notice in its entirety on a nationwide basis.

In proposing this new regulation, the IRS is finally complying with the Administrative Procedure Act and doing what Congress clearly commanded it to do in the statute, which is to identify reportable transactions via regulation. It's unfortunate that the IRS wasted taxpayer dollars fighting for over six years to avoid this notice and comment process. But I'm hopeful that the IRS will complete this rulemaking process in good faith and with due consideration of the public comments submitted by myself and other concerned citizens.

I have significant concerns, however, that this proposed regulation, if finalized in its current form, will be found again to be arbitrary and capricious by the courts. My position is informed by several lessons gleaned from the prior litigation over Notice 2016-66.

First, it's clear that this regulatory push by the IRS to tar brush all small captives was a top-down decision that was begun without any evidence to support the IRS's fundamental contention that small captive insurance is prone to abuse. The IRS's assertion that small captives were worthy of reportable transaction designation was a claim without a warrant.

In Notice 2016-66 itself, the IRS stated that it only believed that microcaptive transactions had a potential for tax avoidance or evasion, and that the IRS lacked sufficient information to identify which 831(b) arrangements would be identified as tax avoidance transactions, and that it might lack sufficient information to define the characteristics that distinguish tax avoidance transactions from other 831(b) transactions.

Now, this stated concern about tax avoidance is notable because tax avoidance is legal. Congress clearly wished to incentivize small captive formation. As the Sixth Circuit has said, the commissioner cannot fault taxpayers for making the most of tax-minimizing opportunities that Congress creates.

Now, via Notice 2066 and this proposed regulation, the IRS tries to criminalize and excessively fine those who engage in legal activity; that is, engaging in tax avoidance transactions.

When we get on into the administrative records from Notice 2016-66, we uncovered the IRS was not honest in professing ignorance about small captives. Rather, internal memos revealed that persons inside the IRS were far more concerned about targeting microcaptives before courts had a chance to rule on the merits of certain cases and focused on dissuading the formation of new captives. There appears to be nothing in this newly proposed regulation that would evidence that the IRS has now become sincere in its stated policy objectives. Second, once the IRS was forced to disclose its administrative record for Notice 2016-66, it shocked everyone including the court. There were no facts, no memoranda, no studies, no research, and no data in the IRS's record that would quantify or substantiate the IRS's asserted belief that microcaptives have a potential for tax avoidance or evasion. One would think that the IRS, presumably more so than any other Federal agency, ought to be able to marshal an incredible amount of data regarding any past issue. But the administrative record for Notice 2016-66 was bare. There was simply nothing in that record to justify its existence. Instead, the record contained inane documents like hundreds of pages which make up the instructions for filing a Form 1040 and printouts of decades-old legal cases that had nothing to do with small captives. With respect to this newly proposed regulation, there similarly is nothing in this proposal that would suggest that the IRS has actually digested and formed reasonable conclusions from all the data that it must have about small captives. Where are these studies? What is this data? The IRS has not shown us any. Third, this proposed regulation appears to be another misguided attempt by the IRS to legislate against congressional directives. When Notice 2016 was issued, it drew criticism from three U.S. senators, all of whom criticized its effect on small businesses, and its overbreadth. The IRS admitted that it had performed no studies on the effect of the notice on small businesses and had done no analysis of its cost to citizens versus its benefits to the agency. This proposed regulation is even worse. It makes broad legislative pronouncements about the business of insurance and what can legally be considered insurance. These are questions that have the potential to disrupt the entire insurance industry, not just small captives. These are questions for Congress, not the IRS. There are also excellent arguments submitted in other comments to this proposed regulation.

OPERATOR: One-minute warning.

MR. WEBBER: Thank you. The IRS is encroaching on the regulation of the insurance industry, which is specifically delegated to state governments under the McCarren-Ferguson Act in principles of federalism. What's more, the U.S. Supreme Court appears ready to rewrite the rules of proper administrative agency rulemaking. Not only does this proposed regulation exceed the current scope of IRS authority, but that authority is likely to be significantly curtailed in the future. This is what I know. Every tax break for deduction contained within the Internal Revenue Code has the potential abuse, but the IRS has shown us no empirical evidence that warrants small captives being targeted in this extreme and heavy-handed way. Instead, this proposed regulation, like its illegal predecessor, appears designed to threaten thousands of law-abiding citizens with criminal sanctions and crippling fines unless they comply with an unnecessary and arbitrary regulation. This proposed regulation should be retracted in its entirety and the IRS's efforts redirected to issuing thoughtful guidance to this industry and prosecuting the truly abusive practitioners. Thank you for your time and attention this morning.

MRS. HILL: Thank you very much for your comments, Mr. Webber. Our next designated speaker is Mr. J. Matthew Queen from The Queen Firm LLC. Mr. Queen, are you available to speak?

MR. QUEEN:

OPERATOR: Mr. Queen. Just one moment. He signaled, so I'll open his line. One moment. Mr. Queen, your line is now unmuted.

MR. QUEEN: Hi. Can everyone hear me?

MRS. HILL: Yes.

MR. QUEEN: Hi, good morning. Thank you very much for this opportunity. My name is Matthew Queen. I run The Queen Firm. I manage a middle-market captive insurance company. I'd like to open up by demonstrating what I'm seeing. It is increasingly evident to me that the reinsurance markets are as hard as I've ever seen in my career, probably the hardest of the 21st century, and with the explosion of Best2 earlier this week, we've seen that a billion-dollar partnership between a front-end carrier called Clear Blue and Best2 has now gone down in flames, affecting a number of programs including large (inaudible) brokers with like Tiger risk (phonetic). The reason this is important is because it demonstrates that there's no new capacity, or at least not a material amount of capacity, entering the reinsurance market. But the consequence of that, the horror stories that you're seeing in property insurance like in Florida are likely to continue. I don't think I need to explain to everyone just how expensive other lines of insurance are like B&O and medical malpractice, skilled nursing facilities, they all are under heavy pressure right now. As a consequence of that, captive formation is high and there is no foreseeable end to this hard market. As a result, well, IRS is walking into a real problem. At the time when the industry is lacking capacity it's entering into a regime that is blatantly unconstitutional and is just not going to align within the market. Let's start from the very beginning. American Jobs Creation Act grants the IRS the authority to identify affordable transaction. This does not bestow upon it the power to govern the business of insurance or to define it for federal income tax purposes. Congress delegated the power to govern the business of insurance to the state. Congress declined to define insurance for federal income tax purposes. Consequently, the proposed vested transaction is unconstitutional for at least two grounds. First, it violates federalism because an attempt to govern the business of insurance conflicts with the McCarren-Ferguson Act, which established that the business of insurance is state law. Second, this violates the intent of Congress and effectively strikes a whole section of the law passed pursuant to bicameral legislation. So, let's just explore what 831-B is. 831-B is not a captive insurance statute. It's passed by — it was passed by Congress a long time ago. In fact, if you trace the legislative history, it goes back to 1916. And the reason that it existed was because the insurance tax scheme back in the early part of the 20th century was complicated and very difficult. Payments were taxed as ordinary income. So as a consequence, insurance companies which have to maintain minimum sovereignty standards, in other words, a certain amount of surplus, these insurance carriers were paying income tax on their premiums and losses. As a result, a lot of mutuals in particular in smaller, rural areas, which is unable to accumulate a surplus, you had receiverships and farmers were left without insurance. So Congress passed, at that time it was called section 11-A, and that provided the income tax exemption which was then reaffirmed in 1918, 1924, '26, '28, '34, and 1942. Notably, in 1942 the House report stated that the exemption was designed to facilitate growth for small insurance companies. Skip ahead to the Tax Reform Act of 1986. We see that the income tax exemption was then re-categorized into section 831-B. It was then expanded to include stock insurance companies, not just mutual, and then it introduced a qualification requirement requiring that the company be an insurance company. Now, the IRC does not define what insurance is, but it does define an insurance company for historical reasons related to life insurance. Congressional intent was clarified again in 2015 in deliberation of the Tax Act. The act again expanded the election. This time it raised the gross written premium by almost double, and it conducts (phonetic) to inflation and then there was a diversification requirement introduced to curb perceived abuses of the estate tax. It is worth noting that during these deliberations Senator Chuck Grassley stressed the vital role of small insurance carriers for rural communities and the need for this income tax exclusion to generate surplus for small insurance companies. So I want to be very clear. 831-B is not a (inaudible) statute. Rather, this has been around for well over a hundred years as part of Congress's desire to assist small insurance companies to be able to accumulate enough surplus to be able to write more business and join in in the risk-financing game. Along with the McCarren-Ferguson Act, Section 831-A and B constitutes a large part of Congress's vision, and the net effect of this (inaudible) transaction proposal will basically eliminate 831-B for captive insurance companies, and you just can't do that. That is a clear violation of the intent of this law. I believe that that raises some issues with major questions doctrine because the enabling statute under the AJCA does not permit the IRS to unilaterally remove 831-B for captive insurance companies just because of perceived abuses or some troublesome litigation. That is an overstep of the authority granted in AJCA, and I think that with over a century's worth of increasing influence of section 831-B within the grand insurance economy, it's very difficult to argue that Congress doesn't want section 831-B in particular for captive insurance companies. But remember that by the time the PATH Act was passed the Internal Revenue Service would actively trying to lobby to get rid of 831-B, presented its arguments to Congress. The Abrahani case was known to the IRS at that time, probably deliberately expressed to Congress, at least behind the scenes. We don't know that to be true, but we do know that Siria Clarke's investigation started in 2010, so it's reasonable to assume that Congress is completely aware and has been made aware of whatever perceived issues there are and in spite of that voted to expand the PATH Act. As a consequence, we have to go look at what congressional intent is with 831-B in light of the McCarren-Ferguson Act. So since the Second World War the business of insurance has been state law. That means that state law supersedes federal law when the state law relates to the business of insurance. Consequently, if IRS's proposed transaction violates McCarren-Ferguson, then it's unconstitutional as regulating the business of insurance. So I believe that the IRS's proposed transaction constitutes an attempt to regular the business of insurance in a number of ways. The most obvious way is this 65 percent loss ratio, and then whatever the combined ratio ends up being. The way that you get to a loss ratio is very clear. It's basically just your losses in relation to the premiums. But the IRS has effectively a loophole built in to say that, well, if you just issue dividends then, you know,

OPERATOR: One minute warning.

MR. QUEEN: Long story short, by the inclusion of dividends what you're doing is you're now moving the boards of directors with the soft hand of accusing them of committing tax abuse in a way that now governs the direction of how these small companies are governing not only their surplus but their business strategy. That is 100 percent governing the business of insurance and that's something that's (inaudible) for the state departments of insurance. Consequently, the IRS is setting itself up for just at least two arguments I broadly outlined here, and then a number of other legitimate constitutional challenges that will come down the line. This list of (phonetic) transaction, the proposed rules under this list of transaction are not nuanced enough to be able to avoid very obvious challenges from a wide variety of taxpayers (inaudible) including tax managers, captive insurance company owners, and possibly other stakeholders along the way. Thank you very much.

MS. HILL: Thank you very much for your comments, Mr. Queen. I will turn now to our next commentor, David Findlay from Lake City Bank. David, are you available to speak?

MR. FINDLAY: I'm on the line. Am I connected now?

MS. HILL: Yes, you are.

MR. FINDLAY: Good morning. I'm David Findlay and I'm the least qualified person to provide testimony of today, but the most impacted, as I'm the CEO of Lake City Bank — it's based in Warsaw, Indiana — that has had a captive insurance subsidiary in place for over 10 years. We are a traditional community bank. We're $6.5 billion in assets. We have 54 locations located in Northern Central Indiana, and we really do define, as do many of the thousands of banks in the country, what a true community bank is, and its ability to take care of clients and take care of communities. Our locations are spread around 14 counties in Indiana, and many of them are in rural areas that Lake City Bank or another community bank are the only bank in the community, and they're not communities served by the larger regional and national banks. The recently proposed IRS regulation 109309-22 is really a problematic change in IRS code for banks like Lake City Bank that use the captive insurance subsidiary in a very effective way to protect the bank, protect the bank's shareholders, and protect our interests. This change would have a significant negative impact on community banks throughout the country, as this is a heavily used tool in tax management by the community banking sector. You all know this has been reinforced by several of the speakers, that lines of coverage in the insurance world have increased significantly, and in many cases doubled and tripled over the past several years. We've also seen limitations on capacity, and increased deductibles, as well as increasing premiums.

The study that we did over 10 years ago, utilizing a national accounting firm, to complete a feasibility study to analyze the banks' insured and uninsured risk, determined that we would benefit significantly from a captive insurance subsidiary.

As a result of that study, we did form a captive insurance company, LCB Risk Management, to manage and mitigate the rising cost of our commercial insurance program, and our banks' increased exposure to unfunded risk, that continues to expand, day in and day out.

They are low-frequency events, but potentially very high-severity risk, but cybersecurity and certain crime coverages, like wire and check fraud, that are taking place every single day in the banking community.

When we accredited, worked with the accredited actuarial firm to review these coverages, the actuary also supported the study by the national accounting firm. And the actuary can calculate the premium for the various insurance policies issued by our captive, to insure these risks, that are uninsured in other ways at Lake City Bank.

It's all based on market-driven, commercial insurance rate tables, our bank's historical rate claims, industry claims experience and our bank's significant exposures. Lake City Bank Risk Management, our regulators in the (inaudible) division of insurance, requires to provide dispassionate analysis to validate the premiums paid to LCB Risk Management at the captive inception, that any suspect changes to the captive coverage.

This is real insurance to banks like ours. This is not designed to do anything other than support the bank in covering uninsured claims and activities that our primary insurance coverage does not provide for. There is no doubt that this has been a beneficial impact to the bank, the bank's shareholders, and our clients. We utilize this captive as a crucial to mitigate, distribute our risk, and protect against these catastrophic losses that could occur on uninsured activity.

The captive also helps us remain competitive with large national banks, most of which utilize captive insurance structures to build efficient and cost effective insurance programs, outside of the traditional commercial marketplace. When I started in banking in 1984, there were nearly 15,000 banks in this country. Today, there are almost 4,100 banks. Community banking is critical, and our ability to compete with these large regional and national banks is also critical. Since we launched our captive in 2012, KeyState, the Manager of the bank captive program, has processed over 4,400 claims, totaling approximately $93.5 million for bank program participants.

Of those 185 claims, totaling $20 million have benefited from the insurance, reinsurance arrangement. The captive and the reinsurance arrangement have had a significant impact here at Lake City Bank. Our risk management, LCB Risk Management, was greatly beneficial as our bank navigated the challenges of COVID-19, when most commercial carriers denied coverage.

In total participants in the bank capital program submitted $5 million in claims, and approved the process that, by the professional license claims administrators of this program.

Speaking directly about Lake City Bank, since we've formed this captive in 2012, we've submitted 63 claims. We've received payment of $1.5 million in claims not covered by other insurance lines. We've recouped approximately $300,000 in COVID-19 expenses which our commercial carrier denied coverage on. We recovered $456,000 in claims from the reinsurance arrangement with our peer bank captives. Without the captive and reinsurance arrangement, the bank would have recognized those losses directly, reducing our earnings and reducing our critical regulatory capital levels.

In addition to our claims insurance, we can share with you what we know from being part of the captive world, that banks throughout the country have benefited from these types of coverages. A community bank in Kansas with total assets of $900 million formed its captive in 2017. In the first year of the captive's operation, the bank suffered a $14 million loss, with the check-kiting fraud not covered by insurance. The bank's captive covered the loss of the captive policy limit of $1 million. Clearly, not in the significant loss, but partial loss came back.

There are so many claims that we know from having been doing this for 11 years, community banks experience claims. I could go on and on with the listed that captives have benefited banks, but I think you understand how this is a real insurance product to us.

When we decided to do this, we carefully evaluated, and ultimately decided to make the 831-B tax election. In doing so, we consulted with our tax advisers to ensure that LCB Risk Management and its fact pattern adhered to the revenue rolling to 2002 to 89 were by risk nanagement insurance over 30, I'm sorry, over 50 percent of our third-party risk.

Our captive has not entered into any intercompany loan backs or guarantees. And our insurance premiums are calculated annually, by an independent actuary. This proposed regulation would take away a critical tool in risk management and insurance protection that we, or hundreds or thousands of other banks, use in the country today. There are others that simply (inaudible) objections we have. I'm not going to go in detail on them, because the experts have already spoken. But the loss ratio in the 10-year lookback is unfair to those organizations like ours, who have put this in place with all the right reasons, and all the right support. The retroactivity of the post resolution, again, it's unfair to those of us who have done this the right way, the honest way, the appropriate way, from day 1.

The punitive double taxation that others have spoken about, of historical premiums and captive income for a list of transactions, again, punitive to organizations like ours, who have done the right thing here. Captive insurance companies are legitimate and meaningful risk management tools for community banks. That's the simple fact. They are important options for our community banks to manage risk and obtains coverages that were not available or not affordable in the commercial market.

Bank regulators appreciate this extra layer of protection. Your peers, over at the Federal Reserve Bank, the Office of the Comptroller, the currency, the FDIC, they appreciate this layer of protection. Because the FDIC-insured institutions ultimately are stronger because of them. We've benefit from low-frequency, high-severity losses, such as financial institutions bonds, wire fraud, check-cutting fraud and various cyber-related fraud.

I appreciate the opportunity to bring a simpleton's mind-set into this, because at the end of the day, we are only doing what protects the bank, the bank's shareholders, and makes us a stronger organization, to provide banking services to our communities.

So thanks again for letting me testify today.

MS. HILL: Thank you very much for your comments, Mr. Findlay.

Our last, and final, speaker on today's hearing is Joseph Magyar, from Crowe LLP. Joseph, are you available to speak?

MR. MAGYAR: I am available.

MS. HILL: All right, please proceed.

MR. MAGYAR: Thank you for the opportunity to speak today. My name is Joe Magyar, and I'm a CPA and partner with Crowe LLP. I'm speaking on behalf of the National Automobile Dealer's Association. NADA represents over 16,000 franchise dealers, located in all 50 states that sell, finance and service new and used vehicles. The members of the NADA employ over 1 million people nationwide, most of whom are small businesses.

These oral comments supplement our written comments and response to the Department of Treasury's proposed regulations under section 6011. NADA and its members understand, and fully support, the need to limit the potential purviews of micro captive arrangements. At the same time, NADA and its members appreciate Treasury's, and the IRS's need to provide an exception for consumer coverage arrangements that do not represent this concern, including consumer coverage arrangements that are common to automobile dealers.

OPERATOR: Excuse the interruption. One-minute warning.

MS. HILL: Oh no. This is a different speaker. Please proceed.

MR. MAGYAR: However, we request consideration of certain modifications that will better align this exception to the actual circumstances of the automobile dealer arrangements, and thereby facilitate compliance without creating undue reporting hardships, where there is low risk of abuse.

The IRS examined these types of captives in the past and determined there was no need to characterize them as listed transactions. Without the recommended changes, a number of legitimate captives will be subject to unnecessary and very burdensome information gathering, testing, and recording requirements.

Our specific recommendations with regard to consumer coverage arrangements are as follows: In circumstances where the dealership is, technically, a transitory, a residual obliger under the contract due to various factors, including state regulatory, or other requirements, we request that, where the customer is the ultimate beneficiary, the dealer not be considered an insured, within the meaning of the proposed regulations.

If Treasury and the IRS believe a total removal of such products from the definition isn't prudent, we urge Treasury and the IRS to consider modifying the definition of captive under the proposed regulations and provide a 25 percent exemption for gap, and other products where the ultimate beneficiaries are unrelated customers.

We believe modifying the definition of seller is necessary to prevent the occasional sale of an automobile and insurance contract to a related party from disqualifying a reinsurance captive from the exemption. This might be further clarified as a (inaudible) exception for related-party sales by establishing a 5 percent threshold for such transactions.

We urge Treasury and the IRS to remove the second prompt, the unrelated commission percentage from the seller's captive exemption. A wide range of extended warranty insurance, and similar contracts, are sold by dealerships and, due to promotions by third parties, the range of fees, commissions or other remuneration offered may also vary significantly. In light of the range of products and how quickly they change, monitoring and enforcing the unrelated commission percentage requirement would be time-consuming and put an undue burden on dealerships, and IRS field examiners.

If a test is deemed necessary to provide abusive transactions, a bright-line, measurable standard should be provided. This could be accomplished by providing that a fee, commission or other remuneration earned by any person, or persons, in the aggregate, for the sale of contracts issued, or reinsured by the seller's captives, is equal to or greater than 50 percent of the premiums paid by the seller's customers.

We also urge Treasury and the IRS to expand the type of consumer coverages listed in the explanations to include coverages for diminished value. This is another coverage that is currently purchased by consumers, to cover the loss in value of vehicle may occur from a covered peril that does not result in a total lost vehicle.

The consumer is the ultimate beneficiary of this contract. And the product is similar to GAF (phonetic). In addition to the recommendations related to consumer coverage arrangements, we offer the following general considerations: We urge Treasury and the IRS to apply the adopted regulations prospectively.

Finally, we urge Treasury and the IRS to permit advanced consent for a one-time revocation of the 831-B elections without a private letter ruling. And to permit the revocation to apply to open tax years, if the retroactive provisions of the proposed regulations are finalized. This would expedite the exit process for taxpayers that do not want to risk a listed transactions categorization merely due to claims history or failure to meet the commission-to-premium ratio.

Thank you for the opportunity to comment, and for considering these comments.

MS. HILL: Thank you very much, Mr. Magyar. We really appreciate your comments today.

We have now gone through all of our six guests and speakers. And I just want to take a moment to truly express my appreciation for everyone's comments today, all the comments that were submitted online. We do sincerely appreciate your candor. We will be taking everything that was shared today under consideration, along with those public comments, and everything else that has been submitted to us with respect to this NPRM (phonetic).

So, again, we sincerely appreciate your candor. But as we are now at the end of hearing, I will go ahead and turn it back to our operator. And, again, my sincere thanks to everyone for all of your commentary and thoughts.

OPERATOR: Ladies and gentlemen, thank you for calling and appreciating the call. We appreciate your assistance in calling and using ATT Teleconference Center. And you may now disconnect.

MS. HILL: Thank you.

OPERATOR: You're welcome.

(Whereupon, at 11:03 a.m., the PROCEEDINGS were adjourned.)

* * * * *