The Direct-File program allowed about a dozen IRS employees to file their tax returns using the new software.

Bridget Roberts is the IRS leader of the Direct-File program. On February 8, 2024, she noted the agency employees had used the initial version of the pilot program. Roberts indicated that the next phase of the program will be approximately 1,200 taxpayers who are federal and state employees.

The pilot program will now expand to 12 states. Federal and state employees who volunteer may use the program if they are from Arizona, California, Florida, Massachusetts, Nevada, New Hampshire, New York, South Dakota, Tennessee, Texas, Washington or Wyoming. Most of the states were selected because they do not require a state income tax return.

IRS Commissioner Daniel Werfel indicated the pilot program will continue to expand to larger groups of taxpayers. He hopes that there will be several hundred thousand taxpayers who use the Direct-File program this year.

Commentators have noted the IRS is being very cautious with this new program. The program is limited to individuals with W-2 income and those who may benefit from the child tax credit (CTC) or the earned income tax credit (EITC). This is a very limited group and the IRS is intentionally being quite careful.

IRS representative Roberts indicated she has a plan to test the success of the Direct-File program. She stated, "We will be looking holistically at all of that and what the story is that it tells so the IRS and Treasury can make a decision about it."

The IRS is tracking the number of taxpayers who start the Direct-File program but then do not complete their tax return. There also will be some taxpayers who want to use Direct-File but are not able because of the limitations of the program.

Editor's Note: There are advocates for and against Direct-File in Congress. There also are eight Free File companies that oppose the Direct-File program. Given the potential opposition, it is understandable the IRS is moving slowly and carefully.

AICPA Comments on DAF Proposed Regulations

CPA Blake Vickers is Chair of the American Institute of CPAs (AICPA) Tax Executive Committee. Vickers and his committee submitted comments to the Department of Treasury on the proposed regulations (REG-142338-07) on Section 4966 donor advised funds (DAFs).

The AICPA appreciates the efforts of Treasury to provide proposed DAF regulations. Under Section 4966(d)(2), a DAF is an account that is owned and controlled by a sponsoring organization but allows a donor or another individual to have advisory privileges with respect to either distribution or investment of the funds. There are two types of funds that are excluded from this DAF definition. A fund for a single identified organization or a fund that makes grants to individuals for travel, study, or similar purposes are excluded.

The AICPA recommends the proposed regulations not be applicable until after the publication date of final regulations. There are "many complex provisions that will require additional time for taxpayers to implement in order to adjust their current operations to comply with the new rules." Therefore, the final regulations should only be applicable in the year after they are published.

There are multiple provisions in the regulations that the AICPA suggests should be modified.

1. Permitted Advice DAF Exception — The donor may have certain advisory rights or privileges that are outside the DAF regulations. A donor may earmark a donation for a particular fund and does not constitute a DAF. Under the Uniform Prudent Management of Institutional Funds Act (UPMIFA), there are permissible revisions or changes to restrictions. Because the mission of the charity may change after a period of time, a donor may have the ability to recommend a modification to the restriction. If it is an infrequent change (once every five years), this should not require a classification of that fund as a DAF.

2. Single Charity Fund DAF Exception — There are organizations that allow donors to create a fund that supports specific programs of the charity. The AICPA recommends that the fund is not a DAF if it meets several criteria. The fund must be established by a public charity, funds must only support programs at that charity, the donor is permitted to only advise on the public charity use and is not permitted to recommend any distributions to third-party recipients. This single identified organization or governmental entity exception should not be considered a DAF, provided the fund complies with these criteria.

3. Investment Advisors as Donor-Advisor — Section 4966(d)(2)(A)(iii) defines a "donor-advisor" as an individual who has advisory privileges with respect to either distribution or investment of the fund. The proposed regulations expand the definition to state, "the term donor-advisor means a person appointed or designated by a donor to have advisory privileges regarding the distribution or investment of assets held in a fund or account of the sponsoring organization." This definition would include the personal investment advisor of a donor if he or she provides investment counsel for that specific DAF. The proposed regulations in this case classify the investment advisor compensation as an automatic excess benefit transaction under Section 4958(c)(2)(A). This provision would essentially eliminate the ability of a donor to designate an advisor to invest the DAF and be compensated for services.

The AICPA recommends that investment advisors be excluded from this definition and be permitted to invest DAF funds. The Treasury Department determined that there were several risks. The investment advisor could be directed by the donor, there may be conflicts of interest and the investments could produce "more than incidental benefit" for a donor. A possible benefit to the donor is that the investment advisor would reduce his or her fees on other donor personal investments if the advisor were compensated for DAF investments.

If the Treasury Department determines that excluding advisors is not permitted, then the AICPA recommends multiple factors for determining when an investment advisor is permitted to manage DAF funds. The AICPA states the multiple factors could include a requirement for approval by the DAF custodian Board, a listing of all of the advisors who have been approved, a requirement to follow Board-approved investment policies and a requirement for an advisor to provide services to multiple organization DAFs. The AICPA recognizes the proposed regulations include an exception to exclude the investment advisor if he or she provides services to all DAFs but believes that this is unduly restrictive.

4. Definition of Significant Contributor — A donor is generally deemed to be a "donor-advisor” for purposes of a DAF. The proposed regulations state there is an exception if the donor is on a committee comprised of three or more individuals, the donor’s appointment is based on objective criteria related to expertise in a particular field and the donor is not a "significant contributor" to the fund. Instead of using “significant contributor,” the AICPA suggests using the definition of "substantial contributor" as defined in Section 507(d)(2)(A). The Section 507(d)(2)(A) definition lists substantial contributors and includes any person who donated more than $5,000, provided that the total constitutes 2% or more of total contributions in the tax year in which the gift is received. In addition, the person should not be treated as a substantial contributor if he or she has not made gifts for 10 years or the gift amounts are "insignificant when compared to the aggregate amount of contributions to the fund."

Editor's Note: The AICPA comments are an excellent overview of the major changes and definitions in the proposed DAF regulations. A major issue for many DAF custodians is the use of the donor’s personal investment advisor. Many donors are more likely to fund a DAF if their investment advisor can invest DAF assets.

Premium Deductions Denied for Microcaptive Insurance Companies

In Bernard T. Swift Jr. et al. v. Commissioner; No. 13705-16; No. 5354-18; No. 11261-19; T.C. Memo. 2024-13, the Tax Court determined that contributions to a microcaptive insurance company did not qualify as business deductions because the plan failed to qualify as insurance.

Dr. Bernard T. Swift, Jr. operated multiple urgent care centers from 1982 through 2015. He had worked as an emergency physician and a military flight surgeon prior to opening Texas MedClinic (Clinic). Dr. Swift expanded Clinic to 13 facilities that utilized approximately 350 physicians and other staff.

During the initial years, Clinic purchased medical malpractice insurance, casualty insurance and other types of insurance from commercial entities. In 2004, Dr. Swift incorporated a microcaptive insurance company named Castlegate Insurance Co., Ltd. (Castlegate). The previous premiums for insurance were increased by approximately tenfold to over $1 million per year for insurance with Castlegate. Dr. Swift obtained premium estimates from KPMG LLP representative Anthony Bustillo. In 2010, Dr. Swift formed two new microcaptives — Castlerock Insurance Co., Ltd. (Castlerock) and Stonegate Insurance Co., Ltd. (Stonegate). The microcaptives were operated from the Federation of St. Christopher and Nevis (St. Kitts) and two companies from St. Kitts were the directors of the microcaptives. These microcaptives received premiums from $1 million to $2.4 million per year between 2010 and 2015. The microcaptive insurance included business income, business risk, indemnity, computer operations and data, employment practices liability, litigation expenses, cost of defense, terrorism and political violence. The premiums were based on a claimed survey of rating plans. Between 2010 and 2015, Clinic paid approximately $10 million in premiums. There were three claims submitted to the microcaptives and the coverage for the three claims was $339,224.

The microcaptives acquired substantial resources. They invested in public securities and in real estate in Texas. The microcaptives also participated in risk distribution pools through Jade Reinsurance Group, Inc. and Emerald International Reinsurance, Inc.

The IRS audited Dr. Swift and the returns prepared by CPA Tim Schultz. The IRS informed Dr. Swift that they would not permit the premium deductions and assessed tax, penalties and interest of approximately $2.5 million.

The Tax Court noted insurance is not defined under statute and "has thus been developed chiefly through a process of common-law adjudication." A key factor is showing that there is actual risk distribution. The Tax Court noted, "Microcaptive insurers have not fared as well with respect to showing risk distribution; all of our previous cases have found compliance with this requirement lacking.”

Dr. Swift claimed that the number of clients served in the centers demonstrated large numbers and risk distribution. However, the Tax Court noted that the number of doctors is the key issue. The Tax Court determined that the microcaptives were not entering into reasonable business contracts. The loss ratios in the commercial insurance industry ranged generally between 50% and 60%, while the microcaptives had loss ratios of 0.13% in 2012 to 7.91% in 2015. Because the loss ratios were very far from the normal business arrangements, the Tax Court determined that these "policies were not bona fide insurance arrangements."

Microcaptive insurance companies must provide insurance in the commonly accepted sense. The Swift captives "made investment choices only an unthinking insurance company would make." Because the premiums were unreasonable and designed to reach a "preordained target for tax purposes," they failed the basic insurance test. Even though the premiums were supported by a KPMG analysis, they were not reasonable and actuarially determined.

While the Swift captives displayed some attributes of insurance company, they "failed to operate as insurance companies and their premiums were nonsense. We therefore conclude the Swift captives did not provide insurance in the commonly accepted sense.”

Because the premiums and plans were not qualified insurance, they were not deductible. While Dr. Swift claimed that he had reasonable cause for reliance on CPA Schultz and therefore the penalties should not apply, the court determined that he did not rely on substantive tax advice by Mr. Schultz and the 20% accuracy penalty was valid.

Applicable Federal Rate of 4.8% for February -- Rev. Rul. 2024-3; 2024-6 IRB 1 (16 January 2024)

The IRS has announced the Applicable Federal Rate (AFR) for February of 2024. The AFR under Sec. 7520 for the month of February is 4.8%. The rates for January of 5.2% or December of 5.8% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2024, pooled income funds in existence less than three tax years must use a 3.8% deemed rate of return. Charitable gift receipts should state, “No goods or services were provided in exchange for this gift and the nonprofit has exclusive legal control over the gift property.”