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Final Regs Identify Micro-Captive Insurance Transactions as Listed Transactions and Transactions of Interest
(Parker Tax Publishing January 2025)
The IRS issued final regulations that identify transactions that are the same as, or substantially similar to, certain micro-captive transactions as listed transactions, a type of reportable transaction, and certain other micro-captive transactions as transactions of interest, another type of reportable transaction. The IRS also issued a procedure providing a simplified process for revocation of a Code Sec. 831(b) election. T.D. 10029; Rev. Proc. 2025-13.
Background
Code Sec. 831(a) generally imposes tax on the taxable income of every insurance company other than a life insurance company. Upon election by an eligible nonlife insurance company to be taxed under Code Sec. 831(b), an alternative tax is imposed, computed by multiplying the taxable investment income of the eligible electing company. Thus, an eligible electing company pays no tax on its underwriting income, including amounts paid as premiums, for taxable years for which its election is in effect.
Code Sec. 831(b) requires an eligible electing company to be an insurance company (within the meaning of Code Sec. 816(a)) having net written premiums or, if greater, direct written premiums, for the tax year not exceeding $2.2 million as adjusted for inflation (net written premium limitation) and to meet the diversification requirements of Code Sec. 831(b)(2)(B). To qualify as an insurance company under Code Sec. 816(a), more than half of the business of the entity during the tax year must be the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. An insurance contract must meet all four prongs of the test for insurance set forth by the courts: risk shifting, risk distribution, insurable risks, and insurance in the commonly accepted sense. To determine whether an arrangement is insurance in the commonly accepted sense, courts consider several non-exclusive factors, including: (1) whether the company was organized, operated, and regulated as an insurance company; (2) whether the company was adequately capitalized; (3) whether the policies were valid and binding; (4) whether premiums were reasonable and the result of arm's length transactions; (5) whether claims were paid; (6) whether the policies cover typical insurance risks; and (7) whether there was a legitimate business reason for acquiring insurance from the captive.
Proposed Regulations
In April of 2023, the IRS issued proposed regulations in REG-109309-22 that identified taxpayers who file returns reflecting the tax benefits of a transaction described in Prop. Reg. Sec. 106011-10(a) as participants in a listed transaction (Micro-captive Listed Transaction). In addition, the proposed regulations identified taxpayers who file returns reflecting the tax benefits of a transaction described in Prop. Reg. Sec. 1.6011-11(a) as participants in a transaction of interest (Micro-captive Transaction of Interest).
Generally, a Micro-captive Listed Transaction is a transaction in which an Owner (as defined in Prop. Reg. Sec. 1.6011-10(b)(6)) of an Insured (as defined in Prop. Reg. Sec. 1.6011-10(b)(4)) holds the necessary interest described in Prop. Reg. Sec. 1.6011- 10(b)(1)(iii) (the 20 Percent Relationship Test) in Captive (as defined in Prop. Reg. Sec. 1.6011-10(b)(1)), Captive meets the definition provided in Prop. Reg. Sec. 1.6011-10(b)(1), and Captive provides financing as described in Prop. Reg. Sec. 1.6011-10(c)(1) (the Financing Factor), determined over the Financing Computation Period defined in Prop. Reg. Sec. 1.6011-10(b)(2)(i), or has less than a 65 percent loss ratio (the Loss Ratio Factor) as described in Prop. Reg. Sec. 1.6011-10(c)(2), determined over the Loss Ratio Computation Period defined in Prop. Reg. Sec. 1.6011-10(b)(2)(ii).
Under the proposed regulations, participants in a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest, and material advisors with respect to Micro-captive Listed Transactions and Micro-captive Transactions of Interest, would be required file disclosure statements on Form 8886, Reportable Transaction Disclosure Statement, or Form 8918, Material Advisor Disclosure Statement, as set forth in Prop. Reg. Secs. 1.6011-10(f) and 1.6011-11(f).
T.D. 10029
On January 14, the IRS published final regulations in T.D. 10029 that adopt the proposed regulations with modifications in response to practitioners' comments.
The IRS received comments regarding related-party financing, stating that the presence of such financing in a micro-captive transaction by itself may not rise to the level of tax avoidance because the financing may have been determined at arm's length or otherwise treated as a bona fide financing arrangement between the related parties. The IRS stated that the concern with respect to financing arrangements is the continuing deferral of tax. According to the IRS, 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 revise 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 Reg. Sec. 1.6011-10(c)(1), in conjunction with the Loss Ratio Factor as described in Reg. Sec. 1.6011-10(c)(2), are identified as listed transactions in the final regulations. The IRS states that 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.
The proposed regulations provided a Consumer Coverage Exception to identification as either a Micro-captive Listed Transaction or Transaction of Interest for certain arrangements in which a service provider, automobile dealer, lender, or retailer (Seller) sells contracts that the parties treat as insurance contracts either issued or reinsured by a Captive related to the Seller to its Unrelated Customers in connection with the products or services being sold. The proposed exception applied to arrangements in which the following criteria are met: (1) the arrangement involves a Seller's Captive (meaning a Captive related to Seller); (2) Seller's Captive insures or reinsures some or all of the Contracts sold by Seller; (3) 100 percent of the business of the Seller's Captive is insuring or reinsuring Contracts in connection with products or services being sold by the Seller or persons related to Seller; and (4) commissions or remunerations paid for the sale of such Contracts, as a percentage of the premiums paid by the Seller's customers, is at least the greater of: (i) 50 percent; or (ii) the unrelated commission percentage (meaning the highest commission for the sale of Contracts connected to Seller's products that are not issued or reinsured by Seller's Captive).
A practitioner asked the IRS to modify the definition of Seller in the proposed regulations to prevent an occasional sale or an automobile and insurance contract to a related party from disqualifying the Seller's Captive from the Consumer Coverage Exception. The practitioner also suggested a de minimis exception for related party sales by establishing a five percent threshold for such transactions. In response to these comments, Reg. Sec. 1.6011-10(b)(9) of the final regulations clarifies that a Seller is a service provider, dealer is a service provider, dealer (including an automobile dealer), lender, wholesaler, or retailer that sells products or services to customers who purchase insurance contracts in connection with those products or services provided no more than five percent of all its sales of products or services to persons who purchase insurance contracts in connection with those products or services are to customers other than Unrelated Customers. Additionally, the Consumer Coverage Exception in Reg. Sec. 1.6011-10(d)(2) and Reg. Sec. 1.6011-11(d)(2) of the final regulations is modified to require that no more than five percent of the Seller's Captive's business is issuing or reinsuring Contracts purchased by persons other than Unrelated Customers in connection with products or services sold by the Seller or persons Related (as defined in Reg/ Sec. 1.6011-10(b)(8) of the final regulations) to the Seller.
Rev. Proc. 2025-13
Comments on the proposed regulations requested a streamlined process by which the IRS will approve requests for revocation of a Code Sec. 831(b) election (Section 831(b) election). In Rev. Proc. 2025-13, the IRS provides such a procedure. The procedure applies to a taxpayer that has made a Section 831(b) election that has not been revoked and has no net operating losses arising in a tax year to which the Section 831(b) election applied that can be carried over to the revocation year. A taxpayer within the scope of Section 3 of Rev. Proc. 2025-13 may obtain the automatic consent of the IRS to revoke its Section 831(b) election by submitting the revocation request described in Section 4.02 of the procedure. A model revocation request letter is provided in Section 5 of Rev. Proc. 2025-13.
For a discussion of reportable transactions, see Parker Tax ¶253,130.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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