The U.S. Supreme Court on Monday agreed to hear a case involving a captive manager’s challenge to an Internal Revenue Service notice on microcaptives that stated they could be used for tax evasion and labeling them “a transaction of interest” reportable to the IRS.  

The case, CIC Services LLC v. Internal Revenue Service, was heard by the 6th U.S. Court of Appeals in Cincinnati last year. In a majority ruling, the appeals court affirmed a lower court ruling in favor of the IRS over its reporting requirements.

The 2016 IRS notice at the heart of the case identified certain transactions involving microcaptives, which are often referred to as 831(b) captives, as having “a potential for tax avoidance or evasion,” but noted that the IRS lacked enough information to distinguish between lawful and illegal transactions.

By deeming the transactions reportable, the notice imposed requirements and potential penalties on people or entities using them and on their advisers, including penalties for not reporting on their use of microcaptives.

CIC Services, a Knoxville, Tennessee-based captive manager sued the IRS alleging that the notice violated the Administrative Procedure Act and the Congressional Review Act and that the notice required congressional review before it could go into effect.

The IRS countersued arguing that CIC Services’ suit was barred by the Anti-Injunction Act and the Declaratory Judgment Act, which limit courts’ jurisdiction over tax assessments.

The lower court ruled in favor of the IRS, and the ruling was upheld on appeal.

The CIC Services case “has a lot of significance on the procedural side, but it doesn’t directly address whether these transactions are insurance for federal tax purposes,” said Charles J. Lavelle, senior partner at Dentons Bingham Greenebaum LLP in Louisville, Kentucky.

However, “I think it’s a very significant item and good news for taxpayers,” he added.

Captives that elect to be taxed under Section 831(b) of the Internal Revenue Code are taxed only on their investment, not their underwriting income, effectively lowering their tax liabilities compared with other captives and commercial insurers. The 831(b) captives are often used by small and midsize firms that are too small to establish conventional captives, but many observers say they have also been used by wealthy individuals, their family members and others to create the appearance of insurance coverage while being used to avoid tax.

The IRS has cracked down on 831(b) captives over the past several years and has won all the cases that have been ruled on so far. Last year, the IRS made a settlement offer to up to 200 owners of microcaptives, and about 80% accepted it.

The IRS has continued to seek more information on microcaptives. In March it sent a letter to microcaptive owners asking for more information on deductions they had previously taken.