30 January 2025

Final regulations on micro-captive transactions identify listed transactions and transactions of interest

  • The final regulations likely reduce the number of captives that will fall into the listed transaction category by requiring a listed transaction to have both a "financing factor" during its "financing computation period" and a "loss ratio factor" of less than 30%, which has been lowered from "less than 65%."
  • The final regulations treat a transaction with a captive that has a financing factor during its financing computation period or a loss ratio of less than 60%, but 30% or higher (or a substantially similar transaction) as a transaction of interest.
  • The final regulations specifically identify transactions with captives that insure the risks of unrelated customers (i.e., third-party risk) as excluded from being treated as listed transactions or transactions of interest (subject to certain considerations).
 

In final regulations (TD 10029, Final Regulations), the IRS and Treasury Department identified certain micro-captive transactions that will be treated as listed transactions under Treas. Reg. Section 1.6011-10(c) or as transactions of interest under Treas. Reg. Section 1.6011-4(b). Material advisors and certain participants in these listed transactions and transactions of interest must file disclosures with the IRS or face penalties.

Background

Businesses can create "captive" insurance companies to manage risk exposures and/or develop alternative risk-financing structures to create capital efficiencies. The insured business pays premiums to a "captive" insurance company (i.e., one owned by the insured or related parties) for insurance policies and deducts those premiums. A traditional captive insurance company's taxable income includes its earned premiums, losses and expenses (i.e., net underwriting income) from its insurance and reinsurance business, in addition to its net investment income. A small captive insurance company (i.e., one that meets the standards in IRC Section 831(b)(2)) may elect to be taxed only on its net investment income and exclude its net underwriting income from its calculation of taxable income. Notice 2016-66 defined these electing companies as micro-captives.

Concerned that micro-captive insurance transactions could be used for tax avoidance, the IRS identified in Notice 2016-66 certain transactions with micro-captives as "transactions of interest." Taxpayers (and their material advisors) participating in these transactions on or after November 2, 2006, had to disclose the transactions as outlined in Treas. Reg. Section 1.6011-4 or incur penalties.

In Notice 2016-66, the IRS described the following micro-captive transaction as a transaction of interest:

  • A company that is treated by the parties as an insurance company and elects to exclude net underwriting income from its computation of taxable income under IRC Section 831(b) (Captive).
  • The insured entity (Insured) or its owners or related persons own at least 20% of the voting power or outstanding stock.
  • One or both of following apply:
    • During the Notice Computation Period (i.e., the Captive's most recent five tax years or the entire period of Captive's existence if Captive existed for fewer than five tax years), Captive used a portion of its premiums to provide financing, directly or indirectly, to certain related persons through a guarantee, loan or other transfer of its capital, and these transactions did not result in taxable income or gain to the recipients (Financing Factor).
    • Captive's liabilities for insured losses and claim administration expenses during the Notice Computation Period are less than 70% of the premiums earned during that period, reduced by policyholder dividends paid during that period (70% loss ratio factor).

On April 11, 2023, the IRS obsoleted Notice 2016-66 and issued proposed regulations (Proposed Regulations) that, unlike Notice 2016-66, identified certain micro-captive transactions in two reportable transaction categories: listed transactions and transactions of interest. In the Preamble, the IRS explained that the Proposed Regulations were informed by (1) its experience examining and litigating micro-captive cases, (2) the information provided by taxpayers and material advisors under the Notice and the comments responding to the Notice, and (3) statistical information about loss ratios in the property and casualty insurance industry, which is published by the National Association of Insurance Commissioners.

For purposes of the Proposed Regulations, the IRS defined a Captive as any entity that (1) elects under IRC Section 831(b) to exclude premiums from taxable income, (2) issues a contract to an Insured and/or reinsures an intermediary's contract for an Insured; and (3) has at least 20% of its assets, or the voting power or value of its outstanding stock or equity interests, directly or indirectly owned, individually or collectively, by an Insured, owner or related persons.

For purposes of determining whether an Insured owns at least 20% of the assets, directly or indirectly, the Proposed Regulations would have:

  • Treated a person holding a derivative as indirectly owning the assets referenced by the derivative
  • Determined each beneficiary's interest in a trust's or estate's assets by assuming the fiduciary exercised maximum discretion in the beneficiary's favor and maximized use of the trust's or estate's interest in the company to satisfy the beneficiary's interests

Final regulations

Listed transactions

The Final Regulations consider a transaction with a Captive to be a listed transaction if it is the same as, or substantially similar to, a transaction with both of the following features:

  • During the Financing Computation Period (i.e., the Captive's most recent five tax years or the entire period of Captive's existence if the Captive existed for fewer than five tax years), a Captive directly or indirectly financed or conveyed (or agreed to finance or convey) a guarantee, loan or other transfer of its capital to a recipient using payments under the contract, and the transaction did not result in taxable income or gain to the recipient. This includes financing or conveyances that occurred before the Financing Computation Period, but which remain outstanding or in effect at any point in the tax year for which disclosure is required.
  • A Captive's liabilities for insured losses and claim administration expenses during the Loss Ratio Computation Period (i.e., the Captive's 10 most recent tax years) are less than 30% of the premiums earned, reduced by policyholder dividends paid, during the same period. The Loss Ratio Factor is calculated by dividing the liabilities incurred for insured losses and claims administration expenses by the premiums earned by the Captive, less any policyholder dividends paid, during the Loss Ratio Computation Period.

The Final Regulations narrow the listed transaction description from the Proposed Regulations, which considered a transaction to be a listed transaction if only one of those two factors were present. Furthermore, the Final Regulations lower the Loss Ratio Factor for listed transactions from "less than 65%" to "less than 30%."

The definition of a listed transaction excludes a transaction that would otherwise be characterized as a listed transaction if a Captive (1) provides insurance for certain kinds of employee compensation arrangements, or (2) is a "Seller's Captive." The Final Regulations define a Seller's Captive as a Captive owned by a Seller, a Seller's owner, or individuals or entities related to the Seller or owners of its Captive; a Seller is a service provider, automobile dealer, lender, or retailer that sells products or services to unrelated customers who purchase insurance contracts for those products or services.

Transactions of interest

The Final Regulations treat a transaction with a Captive that has a Financing Factor during its Financing Computation Period or a loss ratio of less than 60%, but 30% or higher (or a substantially similar transaction) to be a transaction of interest. The Loss Ratio Computation Period and the Financing Computation Period for a transaction of interest are the same as provided under the listed transactions provisions.

Because a listed transaction by definition has both a Financing Factor and a Loss Ratio Factor of less than 30%, a transaction with a Captive without a 10-year loss history, even if it has a Financing Factor, may only be designated as a transaction of interest.

A transaction with a Captive that has a Loss Ratio Factor of more than 60% falls outside the Final Regulations' scope even if it has a Financing Factor.

Revocation of IRC Section 831(b) election

An entity that revokes its IRC Section 831(b) election would not be a Captive beginning in the year of revocation. If the alternative tax under IRC Section 831(b) does not apply because premiums exceed the threshold or the entity fails the diversification requirements for that year, the entity may still be a Captive if the IRC Section 831(b) election remains in effect.

In response to comments seeking a streamlined method for revoking an IRC Section 831(b) election, the IRS on January 13, 2025, released Revenue Procedure 2025-13, which describes the procedure for taxpayers to receive automatic consent from the Commissioner to revoke an IRC Section 831(b) election.

Reportable transaction rules for taxpayers

Generally, a taxpayer that has participated in a reportable transaction and is required to file a tax return must file a disclosure statement with the IRS. Reportable transactions include listed transactions, confidential transactions, transactions with contractual protection, loss transactions and transactions of interest.

A taxpayer that participates in a reportable transaction must attach a disclosure statement, Form 8886, Reportable Transaction Disclosure Statement (or successor form), to its federal tax return for each tax year in which it participates in the reportable transaction. The taxpayer must also send the disclosure statement to the IRS's Office of Tax Shelter Analysis (OTSA) at the same time that it first files a disclosure statement for a particular reportable transaction.

Treas. Reg. Section 1.6011-4(e)(2) requires a taxpayer to disclose past transactions if a transaction becomes a listed transaction or a transaction of interest between the time a taxpayer files a tax return (including an amended return) reflecting its participation in the listed transaction or transaction of interest and the end of the period of limitations for assessment for that tax year. The regulation requires the taxpayer to file the disclosure statement with the OTSA within 90 calendar days after the date on which the transaction becomes a listed transaction or transaction of interest. Therefore, taxpayers that have participated in any micro-captive listed transactions or micro-captive transactions of interest and filed a tax return (including an amended return) before January 14, 2025, must disclose their participation in such a transaction for any tax year for which the statute of limitations has not yet expired.

Thus, taxpayers may have both a current and a prior tax year disclosure obligation. Taxpayers should refer to the Final Regulations for additional information regarding disclosure requirements, including the application of an exception, and consult their tax advisor accordingly.

Taxpayers that participate in a reportable transaction and fail to disclose may be subject to penalties under IRC Section 6707A. Those taxpayers may also be subject to other penalties, including accuracy-related penalties under IRC Sections 6662 or 6662A.

Material advisor disclosures

An advisor that has made or makes a tax statement with respect to a listed transaction or a transaction of interest and meets the criteria to become a material advisor may also have both a disclosure and a list-maintenance obligation under IRC Section 6111 and IRC Section 6112, and their regulations.

Generally, Treas. Reg. Section 301.6111-3(e) requires a material advisor's disclosure statement to be filed with the OTSA by the last day of the month following the end of the calendar quarter in which the advisor became a material advisor with respect to a transaction or be subject to penalties upon a failure to disclose.

For a transaction that was not a reportable transaction but is identified as a listed transaction or a transaction of interest in published guidance after the occurrence of the events described in Treas. Reg. Section 301.6111-3(b)(4)(i), Treas. Reg. Section 301.6111-3(b)(4)(iii) treats the person as becoming a material advisor on the date the transaction is identified as a listed transaction or a transaction of interest. The Final Regulations state that material advisors must disclose only if they have made a tax statement on or after the date six years before January 14, 2025, the effective date of the Final Regulations for prior periods.

Thus, advisors may have a disclosure obligation for the current year and one for prior periods. An advisor should refer to the Final Regulations for additional information regarding disclosure requirements, including the application of an exception.

Implications

The Final Regulations may be viewed as relieving some of the worry and burden that IRC Section 831(b) Captives faced in the Proposed Regulations and reducing the number of Captives that would fall into the listed-transaction bucket. These more favorable terms include adjustments to the Loss Ratio Factor, extension of the Loss Ratio Computation Period, inclusion of a conjunctive test (Loss Ratio Factor and Financing Factor) for listed transaction purposes and exclusion of transactions with Seller's Captives as listed transactions (subject to certain requirements and regulations).

The Final Regulations specifically identify transactions with Captives that insure the risks of unrelated customers (i.e., third-party risk) as excluded from treatment as listed transactions or transactions of interest (subject to certain considerations). This should be a welcome clarification for some companies that previously filed Form 8886 on a protective basis to avoid potential noncompliance challenges.

While the Final Regulations represent a welcomed step by the IRS in the spirit of addressing concerns raised by the Proposed Regulations, certain areas remain unclear, especially when it comes to coordination with prior rulings and court decisions around third-party business ratios and certain other aspects. One such grey area is the application of the Tax Court's holding in The Harper Group v. C.I.R., 96 T.C. 45 (1991) (i.e., that a captive that derives at least 30% of its premiums from insuring unrelated parties may insure its affiliates), and the IRS's safe harbor ruling on the presence of third-party risk in a captive (Revenue Ruling 2002-89) (i.e., that a captive that derives at least 50% of its premiums from insuring unrelated parties may insure its affiliates) to transactions with captives that are designated either as a listed transaction or as a transaction of interest under the Final Regulations. This lack of clarity may present challenges for some participants in the captive insurance market and the market overall, which continues to grow in response to overall insurance market conditions and the availability of adequate insurance coverage for certain risks. Nevertheless, the Final Regulations do address several key concerns related to the Proposed Regulations, while attempting to preserve the IRS's ability to administer tax audits efficiently and expeditiously.

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Contact Information

For additional information concerning this Alert, please contact:

Financial Services Office — Tax Controversy

Americas Captive Insurance Services

Published by NTD’s Tax Technical Knowledge Services group; Chris DeZinno, legal editor

Document ID: 2025-0359