IRS Moves Forward with Micro-Captive Regulations

The US Department of the Treasury and the Internal Revenue Service (IRS) have included micro-captive insurance arrangements in their 2024-2025 Priority Guidance Plan. A micro-captive is a small captive insurance company taxed under § 831(b), which allows these companies to pay tax only on investment income, provided their written premiums stay below the annual threshold of $2.8 million in 2024, adjusted for inflation. These captives have drawn attention due to the potential tax advantages they offer.

As part of this initiative, the IRS is finalizing regulations under § 6011, first proposed in April 2023, which govern the disclosure of potentially abusive tax transactions. These regulations specifically target micro-captive transactions, categorizing them as either listed transactions or transactions of interest. The IRS expects to finalize these regulations by mid-2025.

Industry experts have raised concerns about the proposed regulations, particularly regarding their potential impact and fairness. The IRS is seeking more detailed disclosures from micro-captives to flag arrangements that may be used for tax avoidance. The proposed regulations focus on criteria such as loan-backs of assets to affiliates or low loss ratios, which could automatically trigger reporting requirements.

Industry Feedback on the Proposed Regulations

The public comment period for the proposed regulations closed on June 12, 2023, with over 110 stakeholders—including captive managers, service providers, government entities, and trade associations—submitting detailed feedback. During a public hearing in July 2023, several key themes emerged. A major point of contention was the IRS's criteria for determining whether a micro-captive arrangement qualifies as a listed transaction or a transaction of interest. Under the proposed rules, transactions involving loan-backs of assets to affiliates or loss ratios below 65 percent over a 10-year period would automatically be considered listed transactions.

Experts argue that these broad criteria risk misclassifying legitimate captives as engaging in tax avoidance. This concern has led to fears that the regulations might unfairly penalize captives with valid risk management practices, prompting significant pushback from the industry.

Loan-Backs and Loss Ratios in Focus

Several commentators challenged the inclusion of loan-backs and low loss ratios as automatic triggers for listed transactions. Loan-backs, while sometimes problematic, were accepted in Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1 (2014). Additionally, the American Academy of Actuaries pointed out that using a fixed 65 percent loss ratio as a benchmark for all captives is inappropriate, given the natural variability in insurance claims and coverage needs.

This sentiment was echoed by the National Council of Insurance Legislators (NCOIL), which urged the IRS to reconsider the loss ratio requirement. NCOIL argued that imposing a uniform loss ratio standard contravenes the McCarran-Ferguson Act, which grants states exclusive authority over insurance regulation.

Concerns over Regulatory Overreach

A central issue raised by many commentators is whether the IRS's proposed regulations extend beyond what is legally permissible under the McCarran-Ferguson Act. Several stakeholders argued that the IRS should not attempt to regulate insurance companies' loss ratios or impose other restrictions traditionally overseen by state insurance regulators. The Oklahoma Insurance Department, among others, suggested that the IRS form a joint task force with state regulators and industry representatives to ensure that the regulations are developed with input from all relevant stakeholders.

Next Steps for the IRS

The case, Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 (2024), decided by the US Supreme Court in June 2024, has significant implications for regulatory actions by federal agencies like the IRS. The court overruled the Chevron doctrine, requiring courts to exercise independent judgment on ambiguous statutes, no longer deferring to agency interpretations. This ruling may lead to greater scrutiny of the IRS's authority to regulate micro-captives that utilize § 831(b) for tax treatment, as the proposed regulations under § 6011 aim to impose stricter disclosure requirements on potentially abusive transactions. With the possibility of more legal challenges, the IRS may need to proceed cautiously in finalizing these regulations to avoid potential setbacks in court.

Looking Ahead: What Should Industry Stakeholders Do?

Industry stakeholders should closely monitor developments as the IRS finalizes the new regulations. Given the pushback from various sectors and the potential for legal challenges, it's important for companies to review their structures, ensure compliance with current rules, and prepare for potential changes. Micro-captive arrangements are likely to remain a focal point for IRS scrutiny, so maintaining detailed documentation to support legitimate risk management practices remains essential. The new regulations, expected by mid-2025, could significantly reshape the landscape for micro-captives.