Treasury Publishes Final Regulations For 831(b) Microcaptive Transactions

Eight years ago, in December of 2016, the IRS issued the ill-fated first set of reporting requirements for 831(b) microcaptive transactions by way of Notice 2016-66. These reporting requirements were ultimately invalidated by the U.S. Supreme Court based on the failure of the IRS to fully adhere to the requirements of the Administrative Procedures Act. After that fiasco, the U.S. Treasury Department started the process for a new set of regulations to designate certain microcaptive transactions as either listed transactions or transactions of interest. On January 14, 2025, the Treasury Department formally published those regulations in the Federal Register which makes them law. You can read them for yourself here.

There are two new regulations. Section § 1.6011-10 sets out the listed transaction, while § 1.6011-11 describes the transaction of interest. Or, the abusive tax shelter and the perhaps abusive tax shelter if you want to look at it that way. The regulations were accompanied by very lengthy Treasury comments, including responses to comments made by numerous interested persons. Since both of the regulations are very similar, we will discuss them both and note the differences as they appear.

Before we get into this, however, the standard caveat applies that these are my personal interpretations of the regulations from the viewpoint of a person who is not a tax professional, but has dealt with captive issues extensively over the years, and do not constitute any legal advice or counsel that can or should be relied upon by anybody. To the extent that my musings below conflict in any way with the regulations or the Treasury commentary provided therewith, they control.

Basic Definitions

Before we go into the substance of the regulations, we first have to make a quick stop to understand the terms used by Treasury. The terms in the regulation are somewhat different than those used within the insurance industry. For instance, the term “captive” within the insurance industry is typically understood to be an insurance company that underwrites the risks of an operating business shares a common owner with the captive. Here, the definition found in the regulations is much more precise.

For purposes of these regulations only, a captive is an entity of any type which meets three qualifications:

1. The entity has made an election to be taxed under Tax Code § 831(b);

2. The entity has issued a contract of insurance to an insured or a contract of reinsurance to an intermediary of an insured; and

3. The captive is owned, directly or indirectly and including through a trust or some derivative contract, at least 20% by the insured, the owner of the insured, or a party related to the insured or an owner of the insured.

If the captive did not make the 831(b) election, then these regulations do not apply. Likewise, if the captive was not used to insure the risks of its owner, or related persons or businesses of the owner, then these regulations do not apply. Finally, if the captive did not insure a person or business which was owned by a person or entity that owned at least 20% of the captive, then these regulations do not apply. For example, if five farmers get together and form an 831(b) captive to handle the crop insurance for their farms, then these regulations apply because each own 20% of the captive; however, if there were six farmers with each owning 16.7% of the captive, these regulations would not apply.

A contract is a contract of insurance or reinsurance which any party seeks to be treated as insurance for federal income tax purposes. In other words, an insurance policy. If the insurance policy is not being treated as insurance for federal income tax purposes, it is not a contract for purposes of this regulation.

An insured is a person or entity engaged in business that enters into a contract with a captive, either directly or indirectly through an intermediary (such as by way of insurance) to purchase insurance that will be treated as such for federal income tax purposes. In other words, the customer of the insurance company who purchases a contact.

An intermediary is any entity that issues a contract to an insured, which contract is reinsured directly or indirectly by a captive. The regulations specifically note that a transaction may have more than one such intermediary. For example, Business A purchases insurance from Insurance Company B, and Insurance Company B purchases reinsurance from Captive C which is co-owed by the same person who owns Business A ― in this scenario, Insurance Company B is an intermediary.

An owner is somebody who owns a direct or indirect interest in the insured, including through a trust or derivative contact.

A recipient means an owner, insured party, or any person related to the owner or insured party who engaged in the transaction at issue.

Parties are said to be related when they have a relationship as generally described in certain parts of the Tax Code, which generally means something like related or subordinate.

A seller means a service provider, like an auto dealer, who sells insurance products (like product warranties, which can be considered insurance) in connection with the sales of their services or products, and at least 95% of those sales are to unrelated customers. Similarly, seller’s captive means a captive that is owned by or related to a seller. The term unrelated customer means persons or entities who are not related to the seller or owners of the seller.

The Computation Periods

The regulations define two computational periods which will be very important below.

The first is the financing computation period (financing period) which means either the last five tax years of a captive or, if the captive has existed for less than five years, all the taxable years of the captive.

The second is the listed transaction loss ratio computation period (loss ratio period) which is the last ten tax years of the captive. If the captive has not been in existence for at least ten years, then it cannot have a loss ratio period for purposes of being a listed transaction. However, a captive that has not been in existence for at least ten years will have a loss ratio period that is equal to the time of its existence for purposes of being a transaction of interest.

For purposes of these two periods, if one captive ceases operations and another takes its place, known as a successor in the regulations, then the two captives will be treated as one for purposes of the computation periods.

The Listed Transaction

It is important to remember that these regulations are aimed at suppressing what Treasury views as an abusive tax shelter. Because of that, the regulations use certain terms that are found in similar regulations for other abusive tax shelters, and the term transaction is how abusive tax shelters are almost always described. For those in the insurance industry, it is probably best to think of the transaction as constituting the captive arrangement as a whole.

The regulations stated that a transaction which is the same as, or “substantially similar” the transaction described below is a listed transaction, which basically means a presumed abusive tax shelter. When a transaction is deemed to be a listed transaction, there are all sorts of tax shelter reporting requirements that come into effect and very steep fines if those reporting requirements are not met.

The regulations state that a transaction has occurred when both of two elements exist:

1. During the financing period, either an insured or an owner received from the captive any moneys that were derived from the premiums that were paid (directly or indirectly) from the insured to the captive, and which moneys were not reported as either taxable income or taxable gain. Here, the regulations give examples of what might satisfy this element, such as the captive making or guaranteeing loans, other than loans that were made by the captive and repaid during the same tax year. In other words, this element is satisfied if the insured or owner receives any cash back from the captive that was never taxed, including so-called loanbacks which are loans from the captive back to its insured. Further, there is a presumption that such moneys come from the premiums if they exceed in amount the captive’s investment income less any financings or other transfers.

2. The total amount of insured losses and claim administration expenses during the loss ratio period are not at least 30% of the premiums received by the captive. If the captive has paid policyholder dividends back to the insured, the amount of those dividends is subtracted from the premiums received. Maybe it is easier to think of this calculation as underwriting profits. If the underwriting profits are greater than 70% during the loss ratio period (10 years), then this element is satisfied.

If both of these elements exist, then the captive arrangement is a listed transaction.

As I read this part of the regulations, because the loss ratio period is a minimum of ten years, a captive arrangement cannot be a listed transaction unless it has operated for at least ten years. For captive arrangements that have not yet operated for at least ten years, then the question each year (until 10 years) will be whether it is a transaction of interest which is next discussed.

The Treasury comments to the regulations explain:

“In the context of closely held section 831(b) entities, the Loss Ratio Factors generally identify transactions involving circumstances inconsistent with insurance for Federal tax purposes, including excessive pricing of premiums and artificially low or nonexistent claims activity. The Loss Ratio Factor measures whether the amount of liabilities incurred for insured losses and claims administration expenses is significantly less than the amount of premiums earned, adjusted for policyholder dividends. The primary purpose of premium pricing is to ensure funds are available should a claim arise.

“With respect to concerns that transactions that are not tax avoidance transactions could be identified as Micro-captive Listed Transactions based on a ten- year Loss Ratio Computation Period and proposed 65 percent Loss Ratio Factor, the IRS recognizes that low loss ratios may be the result of coverage of low-frequency, high-severity risks. Inherent in insurance underwriting is the concept that by assuming numerous independent risks that will occur randomly, losses will become more predictable over time, and pricing should reflect those anticipated losses.

“The inclusion of a ten-year Loss Ratio Computation Period is intended to allow a Captive significant time to develop a reasonable loss history that supports the use of a micro-captive for legitimate insurance purposes. The final regulations retain the ten-year Loss Ratio Computation Period in the proposed listed transaction regulations, but in response to concerns that the proposed Loss Ratio Factors are nevertheless set too high and will capture transactions that are not tax avoidance transactions, the final regulations lower the Loss Ratio Factor for purposes of designating a listed transaction under §1.6011-10 to 30 percent.”

As to the recycling of premiums paid to the captive back to the insured or its owners, the Treasury comments state:

“One of the key abuses seen in micro-captive transactions is the indefinite deferral of tax. Such abuses may be compounded by the use of tax-deferred income for the personal benefit of the related persons involved. * * * In an abusive micro-captive transaction, an Insured entity deducts amounts paid directly or indirectly to the Captive that the parties treat as insurance premiums in an arrangement that does not constitute insurance for Federal tax purposes. Captives then exclude those amounts from taxable income under section 831(b). When a financing arrangement is involved, such Captives return some portion of those tax-deferred amounts directly or indirectly to the Insured or related parties via a loan, capital contributions to a special purpose vehicle, or other financing arrangement for which a current tax does not apply. Thus, in a financing arrangement involving an abusive micro-captive transaction, amounts paid as premiums have not only avoided ordinary taxation but have continued to avoid tax while back in the hands of the related parties who caused the premiums to be paid and deducted. This deliberate, continuing avoidance of income tax using benefits to which the participants are not entitled is abusive and identifying transactions with similar fact patterns as listed transactions is consistent with the IRS’s pronouncements with respect to micro-captives since before the publication of Notice 2016-66.

“However, the Treasury Department and the IRS agree that the presence of related-party financing in a micro-captive transaction by itself may not rise to the level of tax avoidance, as it may be that such financing was determined at arm’s length or otherwise treated as a bona fide financing arrangement between the related parties. * * * The concern with respect to financing arrangements is the continuing deferral of tax. Such deferral should not be considered tax avoidance unless coupled with the continued accumulation of tax- deferred amounts in a transaction involving circumstances inconsistent with insurance for Federal tax purposes, including the excessive pricing of premiums and artificially low or nonexistent claims activity. Accordingly, the final regulations have revised the factors identifying a listed transaction to reflect a conjunctive test: taxpayers who are engaged in a transaction described by the regulations that meets the Financing Factor as described in §1.6011-10(c)(1), in conjunction with the Loss Ratio Factor as described in §1.6011-10(c)(2), are identified as listed transactions in the final regulations. This change, to require both the Financing Factor and the Loss Ratio Factor in the identification of Micro-captive Listed Transactions, should provide substantial relief to taxpayers participating in transactions with loss ratios below 30 percent but for which the Financing Factor is not met.”

Transactions Of Interest

The transaction of interest described in the § 1.6011-11 regulations is very similar to the listed transaction described in the preceding § 1.6011-10. In fact, the regulations partially overlap insofar as listed transaction will also be a transaction of interest, but not every transaction of interest will be a listed transaction.

There are several major differences between a listed transaction and a transaction of interest. One is that the loss ratio period is the entire number of years of the captive arrangement if it has not existed for at least ten years.

Next, to be a listed transaction, both of two elements had to exist, being that the some of the premiums recycled back to the insured or owner by an untaxed method and the total amount of insured losses and claim administration expenses during the loss ratio period are not at least 30% of the premiums received by the captive. However, only one of these elements has to exist for a transaction of interest to arise and, further, to be a transaction of interest, the total amount of insured losses and claim administration expenses during the loss ratio period are not at least 60% (instead of 30%) of the premiums received by the captive.

Restated, a captive arrangement will be a transaction of interest if either of two conditions are met:

1. Premium were recycled back to the insured or owner on a tax-free basis as with the listed transaction, or

2. The total amount of insured losses and claim administration expenses during the loss ratio period are not at least 60% of the premiums received by the captive. Stated differently, if the underwriting profits exceed 40% during the loss ratio period (10 years), then this element is met.

The Treasury comments to the regulations explain:

“If an established transaction that is otherwise described in the final regulations has not had adequate time to develop a ten-year loss history, the transaction may only be designated as a transaction of interest rather than a listed transaction.”

Further comments on how the 60% figure was determined by Treasury after looking at various insurance industry data:

“By removing the high frequency, low severity coverages that captives are unlikely to cover for each year from 2013 through 2022 from the annual data and computing the comparison of liabilities incurred for insured losses and claim administration expenses to premiums earned less policyholder dividends as set forth in the regulations, the average nine-year modified loss ratio is approximately 66 percent, which is slightly higher than the proposed 65 percent established in the proposed regulations. The average ten-year modified loss ratio is also slightly higher, at approximately 67 percent.

“In light of commenters’ concerns that the proposed 65 percent modified loss ratio is still too high, the Loss Ratio Factor percentage for identification of a transaction of interest in these regulations is lowered to 60 percent. This amount represents a discount from the lowest loss ratio supported by available data.”

Exceptions

Even if the two elements for a listed transaction are satisfied, there are two exceptions. First, involving employee compensation or benefits for which the U.S. Department or Labor has issued a Prohibited Transaction Exemption. Second, involving seller’s captives (recall the auto-warranty type captives) for which 100% of the seller’s captive is in providing insurance to persons or entities which have purchased the seller’s non-insurance products or services, and at least 95% of the captive’s premiums deriving from insuring or reinsuring policies that were bought by the purchases of those products and services.

These exceptions are the same for transactions of interest but with an additional exception, being that if the captive arrangement is a listed transaction then it need not also be reported as a transaction of interest.

The Bright-Line Rules

The regulations make clear that the transaction will not ― negative ― be a listed transaction if it has either one of two characteristics:

1. The entity has not made the 831(b) election to be taxed only on its investment income; or

2. During the loss ratio period, the total amount of insured losses and claim administration expenses are at least 30% of the premiums received by the entity.

The bright-line rules for a transaction of interest are the same, but the 30% calculation during the loss ratio period goes to 60%, i.e., if the entity has losses and claims expenses greater than 60% of net premiums received during the loss ratio period, it is not a transaction of interest (or a listed transaction either).

Disclosure Requirements

If the transaction is found to be a listed transaction or a transaction of interest, that does not mean that the IRS will immediately assess fines and penalties. What it does mean is that additional reporting requirements will arise. Primarily, all the participants in the transaction will have to file Form 8886, entitled Reportable Transaction Disclosure Statement. For this purpose, participants include (but is not limited to) any owner, insured, intermediary or material advisor. An owner might not have to individually report if the insured has filed Form 8886, and there are disclosure “safe harbors” which negate the filing requirements for years in which the entity’s 831(b) election has been revoked or is no longer effective.

For all participants required to file the Form 8886, other than the captive itself, the disclosures on the form would have to describe the captive arrangement generally but including when, how and from whom the participant learned of the transaction and how the participant was involved with the transaction.

The captive itself is also required to file the Form 8886 but must also supply a great deal of additional information. The captive must disclosed the types of policies that it issued and reinsured, the amounts of premiums received in each year, the names and contact information for all actuaries and underwriters who assisted in its premium calculations, the total amount of claims paid by the captive in each year, and the names and percentage interest of each of the captive’s owners who held 20% of more of the total interests in the captive.

An insured also must supply additional information in Form 8886, including the amounts paid to the captive which were treated as premiums and the identity of its owners.

Material advisors to either a listed transaction or a transaction of interest themselves have similar disclosure requirements as owners, plus they must maintain lists of all their clients who participated in such transactions.

The Treasury comments to the regulations state:

“Section 1.6011-4(d) and (e) provides that the disclosure statement—Form 8886 (or successor form)—must be attached to the taxpayer’s tax return for each taxable year for which a taxpayer participates in a reportable transaction. A copy of the disclosure statement must be sent to the OTSA [Office Of Tax Shelter Analysis] at the same time that any disclosure statement is first filed by the taxpayer pertaining to a particular reportable transaction. Section 1.6011-4(e)(2)(i) provides that if a transaction becomes a listed transaction or a transaction of interest after the filing of a taxpayer’s tax return reflecting the taxpayer’s participation in the transaction and before the end of the period of limitations for assessment for any taxable year in which the taxpayer participated in the transaction, then a disclosure statement must be filed with the OTSA within 90 calendar days after the date on which the transaction becomes a listed transaction or transaction of interest. This requirement extends to an amended return and exists regardless of whether the taxpayer participated in the transaction in the year the transaction became a listed transaction or transaction of interest.”

ANALYSIS

Even when deliberately used as a tax shelter, 831(b) captives were never highly efficient. In the long run, at best the taxpayer could get a deferral of taxes and then an eventual arbitrage between ordinary income tax rates and long-term capital gains rates. Against this arbitrage had to be deducted, however, the typically high annual costs of maintaining the captive and the fact that the investment income of the captive was taxable as ordinary income. The 831(b) tax shelter only was a net positive for those who employed it if they had few or no claims. Indeed, when we look at the so-called “risk pools” that have been examined in the U.S. Tax Court opinions, those risks pool never had more than 5% claims in any given year, most years were less than 2% paid in claims, and many years they had no claims at all.

The requirement in these regulations that net losses and claims expenses be at least 30% in the case of a listed transaction or 60% in the case of a transaction of interest kills any efficiency of an 831(b) captive as a tax shelter. That, of course, is the very purpose of the regulations.

The disclosure requirements should also kill off the easy promotion of 831(b) captives as tax shelters. First, nobody wants to file Form 8886. Second, the mere requirement that the Form 8886 must be filed should trigger some deep consideration by potential participants in these deals, including that the participant might do the smart thing and obtain a second opinion from an independent qualified tax professional.

This is not to say that these regulations will completely kill off the marketing of 831(b) captives as tax shelters, since we’ve seen with other listed transactions that there will also be some unscrupulous promoters who will continue to aggressively market their tax shelters and frankly lie to their clients about the consequences. But these regulations will kill off most of those marketing efforts and set up any remaining marketer for a potential promoter injunction by the U.S. Department of Justice.

Otherwise, these regulations should be the final nail in the coffin for folks who were trying to use their 831(b) captive as a tax shelter. While many of the standalone 831(b) captives have already been voluntarily terminated, there seem to still be quite a few of the “cell captive” 831(b) shelters that are still trying to hold on. These are the varietal where Series 1 or Series A or similar is used as the risk pool, and they usually have some backdoor arrangement where each client indemnifies the the risk pool such that it is actually risk free as to the promoter. Because of this, these cell captive 831(b) deals never worked in the first place, and they never made much sense from an insurance perspective either.

There will be challenges to these regulations, but this time Treasury was much more careful to comply with the Administrative Procedures Act than with the ill-fated Notice 2016-66, and its lengthy comments are of course designed to help sustain any such challenges. But we’ll have to wait and see what happens with these challenges.

Stay tuned.