Breaking Down the IRS's Final Regulations on Micro-Captive Insurance Transactions

Editor's Note: This article from Johnson Lambert breaks down the Internal Revenue Service (IRS) final regulations on micro-captive insurance transactions, highlighting key implications for the industry.

On January 10, 2025, the Internal Revenue Service (IRS) and US Treasury Department finalized regulations regarding micro-captive transactions. These regulations classify certain micro-captive transactions as "listed transactions" and others as "transactions of interest" requiring additional disclosure from involved parties. Furthermore, these regulations mandate enhanced reporting requirements for taxpayers and related parties participating in such transactions.

Background

In 2016, IRS Notice 2016–66 (the Notice) identified certain 831(b) captives as "transactions of interest" necessitating increased disclosure. The IRS suspected that some of these transactions might not align with arm's-length business practices and could be used to avoid or evade taxes. The Notice defined a "transaction of interest" as encompassing the following elements:

• a business purchases insurance from a captive, or the captive reinsures the risk through a third party;
• the captive has made a § 831(b) election and is taxed solely on investment income;
• the owner of the insured entity owns, directly or indirectly, at least 20 percent of the voting power or the value of the captive, and
• at least one of the following conditions applies:
• captive's liabilities incurred for insured losses and administrative costs are less than 70 percent of earned premiums, excluding any policyholder dividends paid by the captive during the 5-year computation period, or 
• captive has provided or agreed to provide financing to the insured or related parties, through guarantees, loans, or investments that are not treated as taxable income by the recipient.

Then, the IRS issued proposed regulations on April 11, 2023, that apply to most captive insurance companies that have made a § 831(b) election. The proposed regulations stemmed from a Sixth Circuit ruling that deemed the Notice lacked authority because the IRS failed to adhere to proper notice and comment procedures. The 2023 proposed regulations introduced the concept of classifying certain micro-captives as "listed transactions" in addition to "transactions of interest."

The Final Regulations

On January 14, 2025, the IRS and US Treasury Department issued the final regulations that establish specific requirements for classification as a "listed transaction" or "transaction of interest" for micro-captive transactions.

The table below highlights the key differences between the 2023 proposed regulations and the final regulations released in 2025.

The final regulations serve to narrow the scope of the proposed regulations for both listed transactions and transactions of interest in the following ways:

• listed transactions require both the financing factor and the average loss ratio, rather than just one;
• the loss ratio percentage for listed transactions and transactions of interest is lower in the final regulations; and
• the transaction of interest computation period increased from 9 to 10 years.

Disclosure Requirements

Micro-captives are required to file Form 8886, Reportable Transaction Disclosure Statement, if they are determined to be either a listed transaction or a transaction of interest under the final regulations. Disclosure filings are applicable for all open tax years a taxpayer has participated in either the listed transaction or transaction of interest. Impacted taxpayers will have 90 days from January 14, 2025, the date the regulations are published in the federal register, to comply with the regulations.

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) to ensure that all information is collected in one place. The Form 8886 should then be filed with the income tax return for each tax year the taxpayer has participated in the transaction.

Exclusion for Consumer Coverage Reinsurance

Both the 2023 proposed regulations and the 2025 final regulations exempt micro-captives that provide consumer coverage reinsurance arrangements (i.e., third-party risk) from classification as listed transactions or transactions of interest. This exemption is considered appropriate as long as the commissions paid for the consumer coverage by the captive are comparable to those paid for similar consumer coverage not issued by the captive.

The final regulations define a seller's captive as a service provider, dealer (including an automobile dealer), lender, wholesaler, or retailer that sells products or services to customers who purchase insurance contracts in connection with those products or services, provided that at least 95 percent of the seller's captive's business is purchased by unrelated customers to the captive or persons related to the seller. If a seller's captive meets the definitions in the final regulations, it is not required to file Form 8886.

Revoking the Section 831(b) Election

Commenters requested a streamlined method by which taxpayers could obtain the US Treasury Secretary's consent to revoke § 831(b) elections. The 831(b) election was previously irrevocable, requiring a request for letter ruling and consent of the Commissioner to revoke the election. In response to the comments, the IRS issued Rev. Proc. 2025–13 on January 13, 2025, that allows for a simplified procedure to revoke an 831(b) election that was previously made. 

Summary

In conclusion, the final regulations modified the 2023 proposed regulations in meaningful ways. The regulations are final as of January 14, 2025, and impacted taxpayers have 90 days to comply with the regulations.