IRS Announces Timeline for Finalizing Micro-Captive Regulations

The Internal Revenue Service (IRS or Service) has revealed its intention to finalize micro-captive regulations by mid-2025 as part of its 2024-2025 priority guidance plan. This development follows the agency’s April 2023 decision to retract the controversial Notice 2016-66 and introduce new proposed regulations.

Micro-captive entities, as defined under §831(b) of the Internal Revenue Code, are small non-life captive insurance companies reporting $2.8 million or less in gross written premium (as of 2024) and, upon election, are provided with the option to be taxed only on investment income, thereby not having to report premium income as taxable revenue.

What made the original Notice 2016-66 controversial?

The Notice was initially produced by the Service in 2016 with an effective date of November 1, 2016. It aimed to place micro-captive transactions within the IRS “transactions of interest” realm, thus creating material disclosure requirements and onerous filing penalties for those not in compliance. It applied to captive owners, advisors, and managers participating in certain captive transactions. Transactions of interest are tax transactions that have the potential for tax avoidance or evasion that must be reported to the IRS. Listed transactions are abusive tax transactions that must be reported to the IRS. As issued, the Notice gave stakeholders no meaningful occasion to provide comment or appeal. The IRS had estimated minimal time commitments to complete the disclosure requirements. However, independent estimates placed the time, cost, and human capital to collect, prepare, and file all forms at 62 hours per form, with an estimated cost of $10,000 per form.

The potential repercussions of Notice 2016-66 quickly spread across the captive universe, which at the time was comprised of approximately 5,000 captive insurance companies. A coalition of nearly two dozen captive insurance organizations filed an amicus brief before the U.S. Supreme Court (see CIC Services LLC vs IRS). Through an enduring five-year process, the case was returned to the district court, which ruled that the IRS lacked the authority to make such determinations through notices. Instead, it must provide notification by following the proper notice and public comment procedures that apply to regulations.

This brings us to the current state of the IRS micro-captive project. The Service has now issued proposed regulations through formal notice and public comment procedures. The upcoming regulations aim to classify certain micro-captive transactions as either “listed transactions” or “transactions of interest.” However, the specific criteria for these classifications remain uncertain, leaving industry stakeholders speculating whether the final definitions will align with the original proposals or incorporate changes based on significant industry feedback. The proposed regulations tweak certain facets of the original Notice 2016-66, but the substantial reporting requirements of the Notice remain intact.

A key point of contention in the 2023 proposal was the suggested 65% loss ratio threshold for identifying “listed transactions.” This criterion faced widespread criticism from the captive insurance industry, as both captives (regardless of their 831(b)-tax election status) and commercial insurers frequently report loss ratios at or below this level. The Service response to this complaint maintains that the loss ratio calculation level is a key indicator of abuse when the premiums have been priced far more than what is reasonable to fund the insurance operations, thereby reducing the loss ratio. Further, the Service argues that the 65% benchmark has been based on the National Association of Insurance Commissioners (NAIC) 2021 Annual Property & Casualty and Title Insurance Industries Report that indicated annual loss ratios of P&C companies averaged 72.5% for that year. The Service also reviewed the 10-year single-year average of P&C loss ratios from 2012 to 2021, which indicated an average loss range between 67.2% and 76.2%. Accordingly, the Service takes the stance that the NAIC historical loss data supports its threshold loss ratio benchmarks in the proposed regulations.

A quick note that the proposed regulations place sharp teeth into disclosure noncompliance and/or accuracy-related issues with varying ranges of penalties from a minimum of $5,000 up to $200,000 (IRC §6707). Pairing this fact with the aforementioned estimates of time, cost, and human capital to complete the disclosures, the Service has successfully made its point for dissuading the §831(b) option. Further, disclosure requirements encompass owners, advisors, and managers.

The prolonged process of finalizing these regulations has led some observers to suggest that the IRS may be intentionally extending the timeline to create uncertainty in the micro-captive space. This protracted period of ambiguity has contributed to the closure of several micro-captive entities. Couple this with the timing of the COVID pandemic period reactions and the IRS sending much of its workforce away from the office during that extended event, and the timeline delay was exacerbated.

The captive insurance industry remains divided on the potential impact of these regulations. While industry participants fear the rules could have a detrimental effect on the sector, other proponents for resolving potential abuse view them as a “refreshing change.” As the 2025 target deadline approaches, stakeholders will be closely monitoring any updates or modifications to the proposed regulations.

The finalization of these rules represents a significant development for the captive insurance industry, potentially reshaping the regulatory landscape for micro-captives and their tax treatment. As the IRS works towards its mid-2025 target, industry professionals and regulators alike will be awaiting further clarification on the specifics of these impending regulations.