Overview of IRS Final Rule on Micro-Captive Insurance 

On January 14, 2025, the Internal Revenue Services’ (IRS) “Micro-Captive Listed Transactions and Micro-Captive Transactions of Interest” Final Rule became effective.  See TD 10029, 90 FR 35341.  The Rule classifies certain micro-captive transactions as “listed transactions” and others as “transactions of interest” requiring additional disclosure from involved parties.  The Rule impacts Section 831(b) captive insurance companies, company owners, insured customers and related parties and mandate enhanced reporting requirements. 

Background  

The IRS has been concerned that some taxpayers have used Section 831(b) to avoid or evade federal income taxes.  In 2016, IRS Notice 2016-66 (the Notice) identified certain 831(b) captives as “transactions of interest” necessitating increased disclosure. The IRS described these transactions as: 

“The Department of the Treasury (“Treasury Department”) and the Internal Revenue Service (the “IRS”) are aware of a type of transaction, described below, in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, using contracts that the parties treat as insurance contracts and a related company that the parties treat as a captive insurance company. Each entity that the parties treat as an insured entity under the contracts claims deductions for premiums for insurance coverage. The related company that the parties treat as a captive insurance company elects under § 831(b) of the Internal Revenue Code (the “Code”) to be taxed only on investment income and therefore excludes the payments directly or indirectly received under the contracts from its taxable income. The manner in which the contracts are interpreted, administered, and applied is inconsistent with arm’s length transactions and sound business practices.” 

The Notice went on to state:  “The Treasury Department and the IRS believe this transaction (“micro-captive transaction”) has a potential for tax avoidance or evasion. See IR-2016-25 (discussing characteristics of an abusive micro-captive insurance structure).” 

The Notice defined a “transaction of interest” as follows (over a 5 year computation period): 

1. A, a person, directly or indirectly owns an interest in an entity (or entities) (“Insured”) conducting a trade or business; 

1. An entity (or entities) directly or indirectly owned by A, Insured, or persons related to A or Insured (“Captive”) enters into a contract (or contracts) (the “Contracts”) with Insured that Captive and Insured treat as insurance, or reinsures risks that Insured has initially insured with an intermediary, Company C; 

1. Captive makes an election under § 831(b) to be taxed only on taxable investment income; 

1. A, Insured, or one or more persons related (within the meaning of § 267(b) or 707(b)) to A or Insured directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of Captive; and 

1. One or both of the following apply: 

1. the amount of the liabilities incurred by Captive for insured losses and claim administration expenses during the Computation Period (defined in section 2.02 of this notice) is less than 70 percent of the following: 

1. premiums earned by Captive during the Computation Period, less 

1. policyholder dividends paid by Captive during the Computation Period; or 

1. Captive has at any time during the Computation Period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, Insured, or a person related (within the meaning of § 267(b) or 707(b)) to A 10 or Insured (collectively, the “Recipient”) in a transaction that did not result in taxable income or gain to Recipient, any portion of the payments under the Contract, such as through a guarantee, a loan, or other transfer of Captive’s capital. 

Court decisions in the Sixth Circuit2 and the U.S. Tax Court3 ruled that the IRS lacks authority to identify listed transactions and transactions of interest by notices, such as Notice 2016-66, and must instead identify such transactions by following the notice and public comment procedures that apply to regulations.  As such, the IRS, while stating that it did not agree with these court decisions, stated that it would no longer take the position that transactions of interest can be identified without complying with APA notice-and-comment procedures.  The IRS also obsoleted Notice 2016-66 (as modified by Notice 2017-8), and stated that it would not enforce the disclosure requirements or penalties that are dependent upon the procedural validity of Notice 2016-66 .  The IRS then issued proposed regulations on April 11, 2023, that applied to most captive insurance companies that made an 831(b) election, which now have become the Final Rule. 

Court Cases 

The IRS has also been successful over the last 8 years in litigating cases against 831(b) captives. 

IRS Tax Court Cases Since 2017

Avrahami vs. Com’r (2017)

Denied deductions for premiums paid to off-shore insurance companies, and determined, among other things, that elections under IRC Section 831(b) were invalid, as the amounts paid did not qualify as insurance premiums for federal income tax purposes.

Reserve Mechanical Corporation vs. Com’r (2018)

The Tax Court determined that transactions in which a foreign captive insurance company participated in were not insurance contracts for Federal income tax purposes.

Syzygy Ins. Co. v. Commissioner (2019)

Premiums paid to Syzygy were not deductible either as premiums or other “ordinary and necessary expenses” under IRC § 162.  Syzygy was not in the business of insurance and as such its election under IRC § 831(b) was invalid.  Amounts paid to Syzygy as premiums were taxable.  Fronting company must be a bona insurance company.

Swift v. Commissioner (T.C. Memo. 2024–13)

Royalty Management Insurance Co. Ltd. v. Commissioner (T.C. Memo. 2024-87)

Keating et al. v. Commissioner (T.C. Memo 2024-2)

Patel v. Commissioner (T.C. Memo. 2024–34)

 

A common fact pattern in many of these cases is that the owners of an operating business that generated significant taxable income formed a captive insurance company.  The operating business was generally classified as a C corporation for U.S. federal income tax purposes and therefore received a tax benefit by taking an ordinary deduction for premiums paid to the captive insurance company.  The captive, meanwhile, made a Section 831(b) election to be taxed only on its investment income and thereby exclude the company’s insurance underwriting income from corporate income tax.  Thus, the owners of the captive paid no tax on the income of the captive unless the profits were distributed by the captive as a dividend, while having an corresponding deduction for the premiums paid to the captive. 

In these cases, the IRS argued that the captives making the Section 831(b) election were not legitimate insurance, mainly due to inadequate risk shifting and risk distribution.  The IRS also pointed out that in many of these cases the captives had insured implausible risks or low-frequency risks, that the risk insured failed to match the insurance with genuine business needs, and, in many cases, the coverages issued by the captive were simply duplications of the taxpayer’s other commercial insurance coverages.  The IRS also argued that the premiums paid under the captive arrangements were not actuarial sound, were excessive and did not reflect arm’s length pricing. 

Final Rule  

TD 10029, 90 FR 3534, effective January 14, 2025, largely adopt the proposed regulations issued in April 2023, with some adjustments based on public feedback.  The final rule establishes specific requirements for classification as a “listed transaction” or “transaction of interest” for micro-captive transactions.   

Listed Transactions:   

The insured or a related person/entity must own at least 20% of the voting power, stock value, or equity in the captive insurer.  Additionally, both of the following conditions must be met: 

• There is a financing factor with a related party that has not generated taxable income for the recipient in the most recent five tax years; and 

• The average loss ratio is below 30% over the past 10 tax years. 

For a transaction to be considered a listed transaction, the micro-captive must have been in operation for at least ten years. 

Transactions of Interest:  

The insured or a related person/entity must own at least 20% of the voting power, stock value or equity in the captive insurer; and at least one of the following must be present: 

• There is a financing element with a related party that has not generated taxable income for the recipient in the past five tax years; or 

• The captive’s loss ratio is below 60% for the ten-year computation period. If the captive hasn’t been in operation for ten years, the period includes all tax years of existence. 

The final regulations refined and narrowed the proposed regulations for both listed transactions and transactions of interest by: 

• Requiring both the financing element and average loss ratio conditions to be satisfied for a Listed Transaction; 

• Lowering the loss ratio percentage that triggered listed transactions and transactions of interest; and  

• Extending the computation period for transactions of interest from nine to ten years. 

Disclosure Requirements for 831(b) Transactions 

Taxpayers involved in transactions identified as either a listed transaction or a transaction of interest under the Final Rule must file Form 8886, Reportable Transaction Disclosure Statements. This applies for all open tax years in which a taxpayer participated in such transactions.  Taxpayers have 90 days from January 14, 2025 to comply.  

Taxpayers making an initial disclosure of reportable transactions, or changing the disclosure type, are required to file the initial Form 8886 with the Office of Tax Shelter Analysis (OTSA).  The Form 8886 must also be filed with the income tax return for each tax year the Taxpayer has participated in the transaction.   

Exception Criteria for Consumer Coverage Arrangements 

The Final Rule does exempt certain micro-captive transactions from the reportable transaction criteria if the micro-captive provides direct insurance or reinsurance to a consumer, and the insurance is related to products or services sold by an associated operating company (defined as the “seller”). The rule specifies that:   

• A seller is a service provider, dealer, lender, wholesaler, or retailer selling products or services, to customers who buy insurance contracts in connection with those products or services; 

• The captive is related to the seller or its owners; 

• The captive issues or reinsures contracts purchased by unrelated customers in connection with the seller’s products or services; 

• The captive’s business involves issuing or reinsuring contracts linked to the seller’s products or services; and 

• At least 95% of the captive’s business for the taxable year involves unrelated customers 

When these conditions are met, the seller and its captive are not required to file Form 8886.  An example of a captive that has related third-party business that might meet this definition is a product warranty captive.  

Revoking Section 831(b) Election 

In response to comments the IRS received on the proposed regulations, the IRS has created a simplified process for revoking a Section 831(b) election.  Previously, a 831(b) election was irrevocable absent receiving a letter ruling and consent of the Commission to revoke the election.  Now under Revenue Procedure 2025-13, issued on January 13, 2025, there is a streamlined method to revoke a Section 831(b) election4: 

• A taxpayer may obtain the automatic consent of the Secretary to revoke its § 831(b) Election by submitting the revocation request described in section 4.02 of the revenue procedure. A user fee is not required for a revocation request submitted under this revenue procedure. 

• A revocation request must: 

1. Identify the taxpayer and contains the taxpayer’s taxpayer identification number, address, and telephone number; states that the taxpayer requests automatic consent to revocation of its § 831(b) Election under this revenue procedure; and identifies the revocation year.  

1. Include representations that the taxpayer (a) has made a § 831(b) Election that is in effect as of the date of filing the request; (b) has no net operating losses arising in a taxable year that was prior to the revocation year to which the § 831(b) Election applied that can be carried over to the revocation year; (c) is timely submitting the request (as provided in section 4.02(3) of this revenue procedure) no later than the date on which it files its timely-filed (including extensions) Federal income tax return for the revocation year; and (d) will not make a § 831(b) Election for the five taxable years following the revocation year. 

1. Be signed in accordance with section 7.01(13) of Rev. Proc. 2025-1 (or successor), dated, and submitted (as described in section 4.02(3)(a) or (b) of this revenue procedure) no later than the date on which the taxpayer files its timely-filed (including extensions) Federal income tax return for the revocation year. Requests submitted by an authorized representative of the taxpayer must adhere to the authorized representative requirements set forth in section 7.01(14) of Rev. Proc. 2025-1 (or successor), and the request must be accompanied by a duly executed Form 2848, Power of Attorney and Declaration of Representative, in accordance with section 7.01(15) of Rev. Proc. 2025-1 (or successor). 

1. Be accompanied by the following declaration, which is signed in accordance with section 7.01(16)(b) of Rev. Proc. 2025-1 (or successor): “Under penalties of perjury, I declare that I have examined this request, including the representations set forth herein and any accompanying documents, and, to the best of my knowledge and belief, the request contains all the relevant facts relating to the request, and such facts are true, correct, and complete.”. Once revoked, the final regulations no longer apply to the captive’s transactions from the year of revocation onward, and the captive’s underwriting and investment income is taxed under section 831(a). 

Of course, despite making an 831(b) revocation, the IRS may still scrutinize aspects of the captive arrangement, such as the validity of the insurance contracts, the appropriateness of premiums, and the operations of the insurance company, to ensure compliance with legitimate insurance practices. 

Summary 

Captive owners should recognize that the final rule does not lessen the IRS scrutiny of 831(b) arrangements.   The final rule does, however, provide guidance for new compliance obligations and does provide a safe harbor for those captives which engage in consumer-related insurance transactions.  Finally, the new revenue procedure offers an opportunity for taxpayers to revoke an 831(b) election.  This may be particularly helpful for those captives that made an 831(b) election and now regularly exceed the 831(b) premium limitation. 

If you need help reviewing a captive arrangement or making the decision to revoke an 831(b) election, the attorneys at Allison & Mosby-Scott can help.