IRS Finalizes Micro-Captive Regulations

On January 14, 2025, the Internal Revenue Service (IRS) and the Treasury Department published final regulations on micro-captive insurance arrangements, marking an effort to refine the framework for identifying and reporting abusive practices. These regulations classify certain micro-captive transactions as either "listed transactions" (abusive tax transactions requiring reporting to the IRS) or "transactions of interest" (potentially abusive tax transactions also subject to reporting). The final regulations aim to address both abuse concerns and industry pushback, including issues raised in response to earlier guidance.

A micro-captive is a small captive insurance company that may qualify for taxation under Internal Revenue Code § 831(b), allowing it to pay income tax only on investment income, provided its written premiums do not exceed an annual threshold ($2.8 million for 2024, subject to inflation adjustments). This tax treatment makes micro-captives attractive, especially for insuring risks with quick reporting and payout profiles, as underwriting profits can be retained or distributed without being taxed, provided gross premiums remain within the threshold.

To qualify, the captive must meet specific criteria: it must operate as a legitimate insurance company with adequate risk shifting and sharing, have sufficient capital, and be a US taxpayer, either domiciled domestically or offshore with a § 953(d) election.

One major issue with § 831(b) captives is the misconception that meeting the premium threshold alone is sufficient for qualification. In reality, the captive must operate as a legitimate insurance company with a primary business purpose beyond tax reduction. Micro-captives marketed for tax deductions, wealth transfer, and estate planning benefits have faced scrutiny for potentially undermining their legitimacy as insurance entities. Captives are regulated financial institutions requiring careful formation and ongoing management by experienced professionals to withstand IRS and regulatory review. Captive insurance companies formed solely for tax avoidance risk heightened IRS attention, effectively inviting audits and jeopardizing their validity.

Consequently, the IRS issued Notice 2016–66, which categorized micro-captive transactions as reportable due to their perceived potential for abuse. However, this notice was vacated by a US District Court in 2022 for failing to follow proper administrative procedures. The IRS then issued proposed regulations in 2023 to address these procedural flaws and refine its approach to identifying potentially abusive transactions.

The same year, the IRS received over 110 comments on the proposed regulations, reflecting widespread captive insurance industry concerns over their scope and the burdens placed on compliant captives. Captive managers and advisors highlighted the lack of clarity and fairness in the IRS's criteria, particularly regarding legitimate micro-captive arrangements.

As part of the final regulations published on January 14, 2025, the Treasury Department responded to submitted comments in an 88-page section, with the following points summarizing some of the topics addressed in this section.

• The proposed regulations do not violate the McCarran-Ferguson Act, which generally reserves insurance regulation to the states, the Fifth Amendment, or the Administrative Procedures Act, according to the Treasury Department.

• The use of a loss ratio factor and financing factor to identify "listed transactions" highlights fact patterns consistently observed in micro-captive cases where the IRS determined the transactions failed to meet established criteria for qualifying as insurance for federal tax purposes under existing case law, rather than redefining insurance for tax purposes.
• Section 831(b) of the tax code was enacted to simplify tax rules for small insurers, not to "encourage" small captive formation.
• The proposed regulations do not discriminate against small and midsized businesses, do not adversely affect the formation of "valid" captive insurance companies, and do not assume all § 831(b) captives are created for tax avoidance purposes, considering other relevant facts.
• Regarding loss ratio thresholds, the minimum loss ratio factor proposed at 65 percent in the initial regulations was revised to 30 percent for "listed transactions" and 60 percent for "transactions of interest" in the final regulations.
• Comments offering alternative proposals, such as taking into account policyholder dividends, modifying the computation period for micro-captive transactions, or addressing the financing factor related to captive investments in shareholders or others, were rejected.
• In response to another comment, it was noted that a captive's status as a state-licensed insurer, a risk retention group, or a provider of deductible reimbursement coverage is not considered relevant.
• Exemptions for captives offering consumer coverage (often recognized as warranty-type coverage) were adjusted, including the removal of the commissions test.
• A micro-captive will be designated as a "listed transaction" only if it satisfies both the financing factor and the loss ratio factor, which has been reduced to 30 percent for "listed transactions" under the final regulations.

The IRS also has issued Rev. Proc. 2025–13, which provides taxpayers with micro-captive elections with a streamlined method to obtain automatic consent from the Secretary of the Treasury to revoke such elections, helping them adjust their status while avoiding potential penalties.

Footnote: Of relevance to the above, the case Loper Bright Enters. v. Raimondo, 144 S. Ct. 2244 (2024), decided by the US Supreme Court in June 2024, has implications for regulatory actions by federal agencies like the IRS. The court overruled the Chevron doctrine, a legal principle that required courts to defer to agency interpretations of ambiguous statutes. This ruling may lead to greater scrutiny of the IRS's authority to regulate micro-captives utilizing § 831(b) for tax treatment, potentially opening the door to more legal challenges.

Editor's Note: This article draws upon information from various IRMI articles and publications, including contributions from our valued partners.