IRS Issues Final Regulations on Captive Reporting Requirements

On Friday, January 10, 2025, the IRS released final regulations that it called “Micro-captive Listed Transactions and Micro-captive Transactions of Interest”. The final regulations, which became effective on January 14, 2025, may be the final stop – more on that later – in a long and winding road that began in November, 2016 with the publication of Notice 2016-66.

What Do the Final Regulations Provide?

The final regulations add two new sections to the treasury regulations under section 6011 of the Internal Revenue Code (the “Code”). Section 6011 requires taxpayers that participate in certain types of transactions to disclose that participation to the IRS. The first new section is section 1.6011-10 – Micro-captive listed transaction, which identifies certain micro-captive transactions as listed transactions. The second is section 1.6011-11 – Micro-captive transaction of interest, which identifies certain micro-captive transactions as transactions of interest.

What is a Micro-Captive?

The IRS first coined the term “micro-captive” in Notice 2016-66. It is a pejorative term that really has no meaning in law. In fact, the term is not even used in the final regulations. Instead, section 1.6011-10 simply uses the term “Captive”, which it defines as an entity that has each of the following three features:

1. The entity makes an election under section 831(b) of the Code;
2. The entity issues an insurance contract to an Insured, reinsures an insurance contract issued by an intermediary to an Insured, or both; and
3. At least twenty percent of the assets or voting power of the entity is owned, directly or indirectly, by an Insured or an Owner of the Insured or persons related to the Insured or an Owner of the Insured.

While this definition is found in section 1.6011-10 of the treasury regulations, which defines a “listed transaction”, it is also incorporated into section 1.6011-11 of the treasury regulations, which defines a “transaction of interest”.

When is a Captive a Listed Transaction?

Under new section 1.6011-10 of the treasury regulations, a Captive is a listed transaction if it satisfies both of the following conditions:

1. At any time during the Financing Computation Period, the Captive made available to a Recipient, whether through a loan or otherwise, any portion of the amounts that the Captive received as premiums.  The Financing Computation Period is the most recent five taxable years of the Captive or all taxable years of the Captive if the Captive has been in existence for less than five years.  A Recipient is an Owner of the Insured, the Insured or any person related to an Owner.  The Owner is an owner of the Insured.  It does not appear that an owner of the Captive is considered an Owner.
2. The Captive’s loss ratio for the Listed Transaction Loss Ratio Computation Period is less than 30%.  The loss ratio is the ratio of the claims and other claim expenses paid by the Captive over the amount of premiums paid to the Captive, less dividends paid by the Captive. The Listed Transaction Loss Ratio Computation Period is the most recent ten taxable years of the Captive.  If the Captive has not been in existence for ten years, then it does not have a Listed Transaction Loss Ratio Computation Period and cannot be a listed transaction.

When is a Captive a Transaction of Interest?

Under new section 1.6011-11 of the treasury regulations, a Captive is a transaction of interest if it satisfies either one of the following conditions:

1. The same financing test as no. 1 for a listed transaction.
2. The Captive’s loss ratio during its Transaction of Interest Loss Ratio Computation Period is less than 60%.  The Transaction of Interest Loss Ratio Computation Period is the most recent ten taxable years of the Captive or all taxable years of the Captive if the Captive has been in existence for less than ten years. 

So, a Captive, which has been in existence for less than ten years, while not a listed transaction, can be a transaction of interest.  From the perspective of the reporting requirements, the difference between a listed transaction and a transaction of interest is immaterial since the filing requirements for transactions of interest are the same as the filing requirements for listed transactions. The difference is that the penalties for failure to report are greater for listed transactions than for transactions of interest.

What Does This Mean?

Essentially, this means that a Captive, an Insured and an Owner of the Insured are required to attach Form 8886 to their tax returns for each year during which the Captive has made an 831(b) election. It does not appear that an owner of the Captive needs to file a Form 8886. However, in most cases, the Captive’s owner will either be an Owner of the Insured or the Insured. Furthermore, an Owner of the Insured is not required to file a Form 8886 if the Owner receives acknowledgement from the Insured that the Insured has filed a Form 8886. In most cases that acknowledgement will be a copy of the Form 8886 filed by the Insured.

The final regulations are effective January 14, 2025. This means that any tax return filed after that date must include the Form 8886. In addition, the form must be filed for any prior tax years for which the limitation period for the assessment of tax has not ended. The final regulations do not state how the Form 8886 for tax years for which returns have already been filed should be filed – whether through an amended tax return or in some other manner.

In addition to attaching the Form 8886 to each tax return filed for each year during which the Captive has made an 831(b) election, the Captive, the Insured and the Owner are required to file their Form 8886 with the Office of Tax Shelter Analysis (“OTSA”) for the first year in which they participated in the transaction. The final regulations have an inherent ambiguity on this point. Many Captives and their Insureds and Owners already filed a Form 8886 with OTSA under Notice 2016-66 before Notice 2016-66 was invalidated. Do they have to file again? That is not clear. Under Notice 2016-66, so-called micro-captives were identified as transactions of interest. Under the final regulations, some of those same, so-called micro-captives may now be listed transactions. Does this require a new filing with OTSA? We do not know. This is something that each Captive, Insured and Owner should discuss with their independent legal and tax advisors.

Will the Final Regulations Be Challenged?

Within hours of the release of the final regulations, the first lawsuit was filed. Ryan, LLC, which describes itself as a “global tax consulting firm”, one of whose businesses is the “establishment and management of captive insurance companies”, filed a Complaint in the United States District Court for the Northern District of Texas. The Complaint contains three counts alleging that:

1. The IRS exceeded its statutory authority in issuing the final regulations.
2. The IRS violated the Administrative Procedures Act because the final regulations are contrary to law.
3. The IRS violated the Administrative Procedure Act because the final regulations are arbitrary and capricious.

The plaintiff is seeking an order from the Court to vacate and to enjoin the enforcement of the final regulations.    

Will the plaintiff succeed? It is impossible to predict. However, we do know that this same plaintiff was successful in the same Court in overturning the rule promulgated by the Federal Trade Commission invalidating most non-compete agreements.

In the meantime, while it is okay to keep your fingers crossed about this lawsuit, you should comply with the reporting requirements of the final regulations.