The IRS's 831(b) Regulations: Industry Concerns and Legislative Responses

Editor's Note: This article, authored by Matthew Queen and published on behalf of the 831(b) Institute, reflects the Institute's advocacy efforts on behalf of small and midsized businesses that utilize 831(b) captives for risk management. It examines the potential impact of recent Internal Revenue Service regulations on these captives and explores legislative options, including congressional action, as proposed by the author and the 831(b) Institute.

As regulatory discussions continue to evolve, we encourage readers to stay informed on industry developments, consider multiple viewpoints, and consult with professionals to gain a well-rounded understanding of the potential implications for captive insurance.

The Internal Revenue Service (IRS) has intensified its scrutiny of the 831(b) election with the release of final regulations classifying certain micro-captive insurance transactions as "listed transactions" or "transactions of interest." These changes come at a time when businesses are grappling with rising insurance costs and heightened exposure to natural disasters such as record-breaking wildfires and severe hurricanes—reinforcing the need for stable and effective risk management solutions.

These regulations could significantly limit the use of 831(b) captives, which serve as a critical tool for businesses seeking alternative risk financing solutions. Businesses that utilize or seek to establish 831(b) captives now face increased compliance burdens and new barriers to risk management.

For this reason, the 831(b) Institute advocates for Congress to review these regulations and consider action to ensure they do not disrupt legitimate captive insurance arrangements. The Congressional Review Act (CRA) provides a mechanism for Congress to pass a joint resolution of disapproval, which would overturn the IRS's newly issued regulations. However, because the CRA is time-sensitive and requires legislative and executive approval, alternative solutions—including potential litigation or legislative amendments—may also be necessary.

To protect the viability of 831(b) captives, industry stakeholders are encouraged to engage with their congressional representatives and advocate for a measured regulatory approach that distinguishes legitimate captives from tax avoidance schemes.

The following sections outline the key provisions of the regulations, the concerns they raise, and potential areas of conflict with existing federal law.

Regulations Overview

The IRS's new regulations impose expanded disclosure requirements for captive insurance companies making the 831(b) election. These requirements apply under the following conditions.

1. Listed Transactions—The IRS automatically classifies these as tax avoidance schemes, subjecting captives to strict reporting requirements and potential penalties for nondisclosure. A captive falls into this category if it
   • has an insured entity owner who holds at least 20 percent of the captive,
   • elects 831(b) tax treatment,
   • finances related parties, and
   • maintains a loss ratio below 30 percent over a 10-year period.
2. Transactions of Interest—The IRS considers these potentially tax-avoidant and requires additional reporting if a captive meets the listed transaction criteria and also
   • satisfies the financing factor, or
   • maintains a loss ratio of 60 percent or less over a 10-year period.

The IRS's use of fixed loss ratio thresholds raises concerns because loss ratios naturally fluctuate due to claims experience and capital preservation needs. Captives require surplus accumulation to ensure long-term solvency and claims-paying ability, yet the IRS's approach fails to consider broader risk financing principles that validate a captive's role in insurance markets.

Problems with the Regulations

These regulations introduce significant challenges for captive insurers, raising concerns about compliance burdens, financial restrictions, and regulatory overreach.

1. Increased Compliance Burdens—Captive owners and managers now face extensive reporting requirements, with penalties for even unintentional nondisclosures of past transactions. The complexity of these rules may increase administrative costs and compliance risks for legitimate captives.
2. Unjust Financial Restrictions—The financing factor forces captives to distribute underwriting profits in a way that triggers taxation, or risk being flagged under new reporting requirements. This could discourage the reinvestment of profits in business operations, creating financial constraints for captives that operate prudently.
3. Arbitrary Loss Ratio Thresholds—The IRS's approach treats loss ratios as a primary indicator of tax abuse, yet insurers, including captives, must set premiums conservatively to cover future claims, operational costs, and regulatory capital requirements. Loss ratios alone do not determine the legitimacy of an insurance transaction, as they naturally fluctuate due to claims variability, surplus accumulation, and actuarial risk modeling.

The IRS justifies these regulations by pointing to past enforcement actions involving allegedly abusive transactions. However, while the IRS states that it is not eliminating the 831(b) election outright, these new barriers could make it significantly more difficult for small and midsized businesses to use captives as intended by Congress.

State Law and Federal Overreach

The McCarran-Ferguson Act (1945) establishes that insurance regulation is primarily a state function, limiting the ability of federal agencies to override state insurance laws. While the IRS asserts that these regulations do not violate McCarran-Ferguson because they are framed as tax enforcement measures, their implementation effectively questions the legitimacy of state-licensed insurance entities.

The IRS frequently applies the step transaction doctrine, which disregards the formal structure of a transaction in favor of its underlying economic substance. However, applying this principle to the IRS's own regulatory actions suggests that these rules function as indirect insurance regulations rather than purely tax-related measures. This raises concerns about federal overreach into areas traditionally governed by state law.

The IRS's Application of Insurance Principles and Court Challenges

The IRS relies on Helvering v. LeGierse (1941) as a foundational case for defining insurance, applying a test that emphasizes two key elements.

1. Risk shifting—the transfer of risk from an insured to an insurer
2. Risk distribution—the spreading of risk among multiple policyholders

While LeGierse did not establish a four-part test, courts have since considered additional factors, such as whether a transaction involves an insurable risk and resembles traditional insurance. However, the IRS often applies LeGierse narrowly, without fully accounting for the differences between life insurance transactions and modern captive insurance structures.

Risk shifting is a key component of both life and property and casualty (P&C) insurance, but the IRS's approach fails to consider that many P&C insurance policies incorporate high deductibles and self-insured retentions. Many 831(b) captives are structured to finance these layers, making them an essential part of a business's broader risk management strategy. The IRS's strict interpretation of risk shifting does not fully reflect how risk financing functions in modern insurance markets.

Several key court cases have ruled against the IRS's restrictive interpretation of risk shifting and risk distribution, reinforcing that captives can provide legitimate insurance coverage even when the insured has an ownership interest in the captive.

• Sears v. CIR (7th Circuit, 1987)—The court rejected the IRS's argument that an insurer could not provide genuine insurance simply because it was owned by the insured business. The ruling reinforced that risk distribution can still exist within a broader insurance pool, even if the insured and insurer have an economic relationship.
• AMERCO v. CIR (9th Circuit, 1991)—The court ruled that a captive insurance subsidiary provided real insurance coverage despite IRS objections.
• Rent-A-Center v. CIR (Tax Court, 2019)—The IRS argued that a captive failed to meet the risk distribution requirement, but the court disagreed, ruling that the captive's structure satisfied recognized actuarial principles.

These cases demonstrate that the IRS's approach to captives has not always aligned with judicial interpretations of risk shifting and risk distribution. While the agency maintains that certain captives lack the hallmarks of genuine insurance, courts have recognized that captives can function as legitimate insurers even when the insured has an ownership interest.

Given the variability in court rulings, the IRS's strict stance on captives remains a point of contention within the industry, particularly as it expands its enforcement focus on 831(b) captives under the new regulations.

Next Steps: Industry Action Needed

To address these concerns, industry stakeholders should consider multiple avenues for regulatory or legislative action.

• Congressional Review Act (CRA)—Congress has the authority to pass a joint resolution of disapproval, which could overturn these finalized regulations within the CRA's review period. However, given the narrow window for action and political considerations, alternative solutions may be necessary.
• Industry Engagement—Captive insurance stakeholders are encouraged to engage with their congressional representatives and advocate for a measured regulatory approach that distinguishes legitimate captives from tax avoidance schemes.
• Legal and Administrative Challenges—If legislative solutions do not materialize, affected parties may need to pursue litigation or advocate for administrative guidance to address ambiguities in the IRS's regulatory approach.

Conclusion

The IRS's new 831(b) regulations mark a significant shift in how micro-captive insurance companies are treated under federal tax law. While the IRS asserts that these rules are intended to curb tax abuse, they also introduce rigid compliance burdens and financial constraints that could impact captives' ability to function as effective risk management tools.

To ensure that policymakers fully understand the implications of these regulations, the captive insurance industry must remain actively engaged in the regulatory process. Without careful oversight and potential revisions, these rules could limit access to captives for small and midsized businesses, making it more difficult to manage risk in an increasingly volatile insurance market.

Congress has the authority to review and address these concerns—now is the time to act.