Understanding Micro-Captives and IRS Regulations

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

HOST: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today we are talking about the final regulations issued earlier this year that generated reg. 1.6011-10, micro-captive listed transactions.

HOST: This regulation lays out the criteria that characterize certain micro-captive insurance arrangements as either listed transactions or transactions of interest. These designations are types of reportable transactions and require extensive additional tax return disclosures by all the involved parties, including related parties.

HOST: Micro-captive insurance arrangements have been a hot enforcement issue for some time, and we have reached a point with these regs that appears to settle one area of tax reporting at least. If that sounds complicated, it is.

HOST: Joining today's conversation is Rick Woods, partner and a member of our national tax team. Rick focuses on tax issues for financial services businesses, including captive insurance arrangements. How are you doing today, Rick?

RICK WOODS: Doing well. Thanks for having me, Brooks. I'm in Louisville, Kentucky. I joined the firm through the MCM transaction a couple years ago, and it's been a fun ride so far.

HOST: And as always, joining me from Greenville, South Carolina is Sarah McGregor. Sarah, how's life treating you?

SARAH MCGREGOR: Life is good. We just went through the time change, so I'm not quite sure what time it is today, but we'll get dialed in pretty soon. I'm looking forward to some brighter evenings.

HOST: I'm Brooks Nelson, partner, normally in Richmond, but today I'm down in Atlanta, and I'm disappointed to have rainy weather when I was hoping for a reprieve from our recent cold spell.

HOST: A little background. In the common fact pattern, the owners of an operating business that generates significant taxable income work with a third-party captive sponsor or manager to create and own a captive insurance company. The captive insurance company is classified as a C corporation for U.S. federal income tax purposes.

HOST: The operating business receives a tax benefit by taking an ordinary deduction for premiums paid to the captive insurance company. Meanwhile, the captive insurance company makes a section 831(b) election to be taxed only on its investment income and thereby exclude the company's underwriting income and, to some degree, investment income from corporate income tax.

HOST: The owners of the micro-captive pay no tax on the income of the micro-captive until and unless the profits are distributed by the micro-captive as dividends. The micro-captive transactions result in deferral of taxable income as well as favorable tax-rate arbitrage due to the lower tax rates that apply to qualified dividend income versus premiums deducted as ordinary business expenses.

HOST: Put more simply: the operating business takes an ordinary deduction for payments it makes to the captive as premiums for insurance. The money stays in the captive, is not taxed until it is distributed, and then is taxed as qualified dividend income, so you get deferral and rate arbitrage.

HOST: All right, Rick, what has been the IRS's interest and focus of concern for micro-captives? Let's hear a recap.

RICK WOODS: The IRS is concerned that taxpayers are using these 831(b) captives to do things that aren't legitimately insurance transactions. In some cases, they function more like savings accounts or rainy-day funds.

RICK WOODS: Self-insuring your own risk may not be deductible; there has to be risk shifting and risk distribution between unrelated parties, and that may not be happening in all cases. Captives may be insuring risks that don't make practical sense just to obtain a tax benefit.

RICK WOODS: Without the section 831(b) election, insurance companies are taxable like any other C corporation at a 21 percent rate. With the election, the insurance company is taxed only on its investment income and can exclude underwriting income, which creates the potential for abuse.

HOST: You've used the term section 831(b) election. Can you provide a little more structure around that? Is it available for anybody all the time? Why aren't large insurance companies using this?

RICK WOODS: The reason every insurance company doesn't make this election is that typical commercial insurance companies have too much premium income. There's a limitation on premiums for the insurance company, and you can't set up multiple captives to circumvent that limitation because a control group test applies.

RICK WOODS: The premium threshold is indexed for inflation. It is $2.85 million for 2025. If premium receipts exceed that amount, the company no longer qualifies for the section 831(b) election.

RICK WOODS: Congress created the election to incentivize entrepreneurs to form insurance companies by reducing their tax burden until they could build up reserves for future losses. Captives have taken advantage of that election in ways that created abuse concerns.

HOST: It almost feels like many captive insurance companies are just subsidiaries of the main company, economically speaking. I know there are legal distinctions, but that is a core IRS concern.

RICK WOODS: Yes, in many cases the captive looks and acts like a subsidiary of the operating company, which raises questions about risk distribution and whether bona fide insurance is occurring.

HOST: Sarah, you've been tracking this for some time. Give us a quick rundown on the IRS's enforcement efforts.

SARAH MCGREGOR: The IRS began auditing and scrutinizing captives around 2010 to 2012. The first prominent case often cited is Havami, decided in favor of the IRS. That case included egregious factors: coverages that weren't appropriate in the marketplace and premium levels pushed to the threshold.

SARAH MCGREGOR: The IRS was able to disallow the premium deduction and treat the amounts as taxable income to the captive. From there, the IRS formed teams to pursue these arrangements and increased audits.

SARAH MCGREGOR: In 2016 the IRS issued Notice 2016-66, identifying criteria that would make an arrangement a transaction of interest and require extra disclosures. That notice drew pushback and was vacated by the courts in various respects.

SARAH MCGREGOR: The IRS then followed the regular rulemaking process, solicited comments, and issued final regulations. These regs replace Notice 2016-66 for identifying reportable transactions.

SARAH MCGREGOR: There has been substantial press coverage, including in the Wall Street Journal. The IRS does not like the abuse, but section 831(b) is in the Internal Revenue Code and the law contemplates these elections and entities. The question is where the line between abusive and nonabusive conduct lies.

HOST: Rick, what is a listed transaction or a transaction of interest as it pertains to micro-captives under these regs?

RICK WOODS: Since 2016 taxpayers engaging in what meets the definition of a micro-captive transaction have been disclosing them as transactions of interest. The IRS is now upgrading some of those to listed transactions if they meet higher criteria.

RICK WOODS: To be a listed transaction you must meet two general criteria. First, there has to be a financing factor as defined in the regulations. The IRS has always been concerned about circular flow of funds where premiums end up back in the operating company through loans, guarantees, or other arrangements that economically benefit the operating company.

RICK WOODS: Second, the IRS looks at the captive's loss ratio—the actual losses paid out as a percentage of premiums. Captives often have unusually low loss ratios because they are building capital and may not pay claims, especially when the same party controls both the captive and the operating company.

RICK WOODS: If the loss ratio is less than 30 percent over a 10-year period, and a financing factor is present, the arrangement can meet the definition of a listed transaction.

HOST: What if the captive has been in existence for fewer than 10 years?

RICK WOODS: You must be in existence at least 10 years to meet the listed-transaction threshold. Otherwise, you remain a transaction of interest.

RICK WOODS: As for transactions of interest, if you have either a financing factor or a loss ratio less than 60 percent, you are a transaction of interest. You do not need 10 years of existence for that determination.

RICK WOODS: Therefore, many micro-captives will be transactions of interest rather than listed transactions. Expect every first-year captive to be a transaction of interest because it is unlikely premiums will be used to pay claims in year one.

HOST: That is technical. Sarah, what does this classification mean for reporting?

SARAH MCGREGOR: It means substantial reporting on the tax return. Taxpayers must disclose the type of transaction, the period involved, how much is invested in the transaction, all related parties, and a description of the transaction.

SARAH MCGREGOR: Taxpayers must also disclose fees paid to captive managers, sponsors, or other related entities. The IRS will use this information to identify sponsors, related entities, and potential financing factors as they audit and examine these arrangements.

SARAH MCGREGOR: The disclosures provide information; they do not change net taxable income. They give the IRS data to determine whether to examine the transaction further.

HOST: Who files the disclosures?

SARAH MCGREGOR: The captive files the disclosure, the insured operating company files the form, and the owners of the operating company must disclose as well. Direct and indirect owners must disclose, and the form is filed with the return.

SARAH MCGREGOR: In the initial year, taxpayers must also send a copy to the Office of Tax Shelter Analysis, OTSA, a division within the IRS that focuses on tax shelter transactions. Filing with OTSA will likely put the transaction on the IRS's radar.

HOST: There is an exception in these regs for customer product or service insurance coverage. Rick, explain that exception and where it applies.

RICK WOODS: There is an exception for product or service insurance coverage, commonly seen with auto dealers. Many auto dealers have captives that insure extended warranties provided to unrelated customers buying vehicles. Because the ultimate insured is an unrelated party, these arrangements typically qualify for the exception.

RICK WOODS: The regs spell out the exception, and taxpayers that meet the exception do not have to file the disclosure. Our auto-dealer clients and partners are pleased to have clarity on that point.

HOST: If a CFO or business owner wants to exit an 831(b) captive because it's become too risky, how can they exit?

RICK WOODS: The regs made it easy to revoke a section 831(b) election. You can now file a simple statement with the IRS to revoke the election.

RICK WOODS: Historically, revocation required a private letter ruling, a user fee, and a time-consuming process. The new process is much simpler, making it easier to exit the IRS's crosshairs.

RICK WOODS: Once a captive revokes the election, it becomes a regular insurance company paying tax on premiums and listing losses like any other insurer.

RICK WOODS: There remain legitimate operational reasons to form a captive unrelated to taxes—for example, lack of commercial coverage or high commercial premiums. We often recommend 831(a) insurance companies rather than 831(b) where appropriate.

RICK WOODS: Until Congress or the courts provide more certainty, 831(b) can be risky, and many clients choose to avoid it for that reason.

HOST: The regulation deals with disclosure requirements; it does not resolve whether particular arrangements will prevail under IRS scrutiny. It simply outlines required disclosures for arrangements the IRS believes may be used as tax shelters.

RICK WOODS: We are approached regularly by clients being marketed on 831(b) captives. Many clients do not want IRS contact and would avoid the risk. Others are willing to litigate. You must know your client and how they will handle IRS scrutiny.

RICK WOODS: As a firm, we must manage our involvement and risk exposure when advising clients on these arrangements.

SARAH MCGREGOR: It is helpful to have clarity on what must be disclosed and which transactions qualify for the exception. The consumer-product insurance exception is particularly useful. Overall, I am pleased with how these final regs turned out.

HOST: My perspective is that clients need to understand the risk of entering into an 831(b) captive. There are legitimate economic reasons to form a captive, and section 831(b) exists in the tax code.

HOST: If you decide to pursue an 831(b) captive, do it right. Use reputable managers and consultants, and document actuarial analysis and underwriting as you would expect from a real insurance company. Proper setup and documentation are essential.

HOST: From our firm's perspective, if a client chooses this route, we must ensure robust analysis and documentation support the arrangement.

HOST: That's a wrap on the discussion of the final regs for micro-captive insurance arrangements. A quick disclaimer: we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast.

HOST: Check the firm's website at cbh.com for the latest guidance and materials on this and other tax and business topics. That concludes the podcast. Please like, share, and subscribe.

HOST: Thank you, Rick. Thank you to our listeners for spending your time with us.