Understanding Micro-Captive Insurance Reporting Obligations

Womble Bond Dickinson recently published an article titled "Micro-Captive Insurance Reportable Transactions and the Reporting Requirements," authored by Eryn Brasovan, Doug Butler, Andrew Rennick, and Jeffrey Simpson. The article details the final regulations issued by the Treasury Department and the Internal Revenue Service (IRS) on January 14, 2025, which reclassify certain micro-captive insurance transactions as either listed transactions or transactions of interest.

According to the authors, the new regulations replace the prior reporting framework that evolved under IRS Notice 2016-66, which was voided for noncompliance with the Administrative Procedure Act. A "captive" under these regulations is defined as an entity electing taxation under Section 831(b) of the Internal Revenue Code, issuing or reinsuring insurance contracts, and being at least 20 percent owned by an insured-related party.

The authors stated that whether a transaction is classified as a listed transaction or a transaction of interest depends on two primary factors: loss ratio and related-party financing. The loss ratio is measured over a period of up to ten years, with captives falling below a 60 percent loss ratio potentially categorized as transactions of interest. If the loss ratio is below 30 percent over ten years and the captive is at least ten years old, it may be deemed a listed transaction. The loss ratio, as specified in the final regulations, is calculated by dividing the sum of insured losses and claim-related expenses by the total earned premiums minus policyholder dividends.

The authors also noted that related-party financing significantly impacts how a captive is classified. If a captive engages in such financing and its loss ratio is below 30 percent over a 10-year period, it is classified as a listed transaction. If the loss ratio is below 30 percent but there is no related-party financing, the transaction is still categorized as a transaction of interest. If the loss ratio is below 60 percent, regardless of related-party financing, it is considered a transaction of interest. Captives with loss ratios of 60 percent or higher are generally categorized as transactions of interest if related-party financing is involved; otherwise, they are not considered reportable transactions.

According to the authors, the IRS differentiates between transactions of interest and listed transactions based on the perceived level of tax avoidance risk. Transactions of interest require additional information disclosure for further IRS scrutiny, while listed transactions are presumed to involve tax avoidance and thus carry more severe reporting obligations.

The authors outlined that the final regulations provide exceptions for certain types of captives. Captives that have received a Prohibited Transaction exemption from the US Department of Labor for providing employee benefits are excluded. Additionally, "seller's captives"—captives formed by businesses to insure risks associated with the sale of their goods or services—are exempt if at least 95 percent of their business comes from unrelated customers.

The article states that reporting obligations under the regulations apply broadly to all participants in a reportable transaction, including captives, insured parties, and material advisers. Captives and insureds must file Form 8886 with the IRS Office of Tax Shelter Analysis, detailing the nature of their involvement, premiums received, claims paid, and ownership structures. The initial disclosure must be filed within 90 days of the regulation's publication and include all applicable open tax years.

The authors emphasized that material advisers—those who provide tax-related advice on reportable transactions and receive compensation exceeding certain thresholds—must also report their involvement. Advisers earning at least $10,000 from a listed transaction (or $50,000 from a transaction of interest) must file Form 8918 by April 30, 2025. These advisers must report transactions dating back to January 14, 2019.

The authors noted that the final regulations are less burdensome than initially proposed. The IRS modified its approach based on public comments, lowering the loss ratio threshold for listed transactions and requiring that both the loss ratio and related-party financing conditions be met before classification as a listed transaction. The initial proposal would have designated all related-party financing as listed transactions and set higher loss ratio thresholds.

The authors advised that taxpayers subject to these regulations should seek professional guidance to ensure compliance. The IRS also introduced Revenue Procedure 2025-13, which outlines a streamlined process for revoking a captive's Section 831(b) election, thereby removing it from reportable transaction status.

The article underscores the need for compliance with these regulations to avoid penalties. Taxpayers and advisers engaged in micro-captive transactions should carefully review their structures and consult with legal and tax professionals for compliance.