Background
A micro-captive insurance company is a small captive insurance company that may qualify for taxation under section 831(b), allowing it to pay income tax only on investment income, provided its written premiums do not exceed an annual threshold ($2.8 million for 2024, subject to inflation adjustments). To qualify, the captive must operate as a legitimate insurance company with a primary business purpose beyond tax reduction. A proper section 831(b) captive must have adequate risk shifting and sharing, have sufficient capital, and be a U.S. taxpayer, either domiciled domestically or offshore with an section 953(d) election.
Listed transactions: a conjunctive test
Under the final regulations, a micro-captive insurance transaction qualifies as a listed transaction if it meets two criteria. First, the micro-captive’s Loss Ratio Factor, as calculated over the Loss Ratio Computation Period, must be less than 30%. An insurance company's loss ratio factor is generally the ratio of its losses to its premiums, expressed as a percentage.1 The Loss Ratio Computation Period is the most recent 10 years.
The second test that must be met is the Financing Factor test. A micro-captive satisfies this test if, during the micro-captive's most recent five tax years or the entire period of the micro-captive's existence if the micro-captive existed for fewer than five tax years (the Financing Computation Period), it 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 insurance contract, and the transaction did not result in taxable income or gain to the recipient. This test focuses on transactions where micro-captives engage in financial transfers or arrangements that benefit related parties by creating a circular flow of funds. A common example is the issuance of related party loans.
Transactions of interest
If only one of the two tests is satisfied, the transaction is classified as a transaction of interest. However, for purposes of transactions of interest, the Loss Ratio Factor test described above is modified in two ways: first, such that the test is considered met if the loss ratio factor is less than 60% (rather than 30%). Second, the loss ratio is measured over the prior 10 tax years or since the micro-captive has been in existence.
Note that if a micro-captive arrangement that is otherwise described in the final regulations has not had adequate time to develop a 10-year loss history, the transaction may only be designated as a transaction of interest rather than a listed transaction. This is because the Loss Ratio Factor test (see above) as described for listed transactions cannot be applied to such an arrangement.
The consumer coverage arrangement exception
The final regulations provide an exception to listed transactions and transactions of interest involving captives that participate in consumer coverage arrangements. The intent of the exception was to distinguish bona fide consumer coverage arrangements, including warranty arrangements, from potential tax avoidance schemes. Thus, the definition of a listed transaction excludes a transaction that would otherwise be characterized as a listed transaction if a micro-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.
Acknowledging that on occasion a Seller might engage in a transaction with a related individual, the final regulations provide that a Seller’s Captive need only derive 95% of its business from product or service-related insurance sold to unrelated customers of the Seller in order to take advantage of the consumer coverage arrangement exception.
Why should you care?
The final regulations result in a disclosure obligation with respect to transactions occurring in prior taxable years for which the statute of limitations on assessment has not expired. Thus, a taxpayer who entered into a micro-captive insurance transaction in a year for which the relevant income tax return was filed after Jan. 13, 2022, likely has a requirement to submit a Form 8886 to the Office of Tax Shelter Analysis (OTSA) by April 14, 2025.
See Reg. section 1.6011-4(e)(2)(i).
Taxpayers should also consult their tax advisors concerning whether an amended income tax return is also advisable. While the final regulations do not require taxpayers who entered into micro-captive insurance transactions to file an amended return or an Administrative Adjustment Request (AAR) (for certain partnerships), taxpayers who have filed tax returns reporting such transactions may wish to consider filing an amended return or AAR since the IRS is likely to take the position that taxpayers are not entitled to the purported tax benefits.
What can you do now to prepare?
Captive insurers should monitor their claims activity relative to their premium earnings to avoid falling below the threshold that would trigger reporting obligations. Meticulous documentation of premiums, claims, loss adjustment expenses, policy holder dividends, and support of loss reserves will be critical to determining filing obligations.
Taxpayers who have entered into micro-captive insurance arrangements should also review Rev. Proc. 2025–13, which provides taxpayers with micro-captive elections with a streamlined method to obtain automatic consent from the Secretary of the Treasury to revoke such elections, helping them adjust their status while avoiding potential penalties.
Plan for uncertainty today
Taxpayers should prepare to comply with the final regulations based on their applicability date. Despite the executive order issued by the current administration on Jan. 20, 2025, freezing all regulatory rulemakings not yet published in the Federal Register and directing agencies to consider a 60-day delay in the effective date of any rules recently published in the Federal Register, neither the administration nor the Internal Revenue Service has made any announcement that could be interpreted to portend a rescission of these regulations. The 60-day period ended March 15, 2025.
