As the IRS tightens rules on micro-captive transactions, industry experts highlight key implications for captive owners and outline strategies to navigate new compliance hurdles
After nearly a decade of legal battles, public consultations, and regulatory revisions, the US Internal Revenue Service (IRS) has unveiled its final regulations on micro-captive transactions, effective from 14 January 2025. These rules establish specific requirements for classifying a micro-captive arrangement as either a ‘listed transaction’ or a ‘transaction of interest’, narrowing the scope of earlier proposals and tightening the regulatory framework.
As the industry braces for these changes, the question remains: how will these new rules impact the future of micro-captive transactions?
Tightening the grip
The IRS’s new regulations aim to crack down on potential tax abuse in micro-captive transactions by splitting them into two categories: listed transactions, presumed abusive, and transactions of interest, which raise red flags but are not automatically labeled as such.
Both classifications carry enhanced reporting duties for taxpayers and advisors, yet listed transactions come with stricter rules and steeper penalties. The IRS contends that some micro-captive setups let taxpayers claim premium deductions without assuming real risk, while critics argue that low loss ratios often reflect prudent underwriting rather than tax avoidance.
Under the rules, a listed transaction is flagged if losses remain under 30 percent of premiums over a 10-year period or if certain financing benefits flow tax-free to related parties.
Transactions of interest, triggered by factors like a loss ratio under 60 per cent or intercompany loans, still demand detailed disclosures and carry significant penalties for noncompliance. For businesses and advisors, the regulations mean heightened scrutiny and greater compliance challenges, as the IRS seeks to separate legitimate risk transfer from tax-driven schemes.
Michael Maglaras, principal of Michael Maglaras & Company, sees these regulations as overdue.
“With the possible exception of the continuing controversy regarding the loss ratio test, I am in complete agreement with the IRS’s finalised regulations,” he says, noting that unscrupulous brokers and consultants have sought to market what he calls “tax avoidance schemes under the guise of risk financing”.
He adds: “The regulations were needed. The regulations draw an important line in the sand. Abusive micro-captive arrangements are obvious on their face when you encounter them and when you are a skilled captive practitioner.”
On the other hand, Matthew Reddington, partner at Zerbe, Miller, Fingeret, Frank & Jadav, cautions that smaller and mid-sized captive owners will face a heavier burden under the new regime.
“The IRS’s release of these final regulations means that certain transactions will trigger additional disclosure by taxpayers, and those taxpayers likely will receive a higher degree of scrutiny going forward,” he says. Reddington worries the heightened oversight could amount to IRS overreach, especially in situations where legitimate risk management practices might be misread as abusive.
Scott Simmons, director of Verve Risk Services, weighs in from an underwriter’s perspective. He believes that if captives maintain underwriting protocols recognised as sound by commercial insurers, compliance should not pose a major obstacle.
Still, he remains concerned about the time and expense these regulations demand, particularly given their retroactive reach.
“Captives should already have an understanding of the high-level changes that the IRS has put forward,” he says, pointing out that capable underwriters have anticipated the IRS’s shift for some time.
Reporting obligations
One of the most consequential elements of these regulations is their application to prior tax years. Although the rules officially took effect on 14 January, taxpayers must disclose arrangements from earlier years if those years remain open under the statute of limitations. This means a captive formed several years ago but still within an audit window might now need to file updated or additional disclosures.
The IRS also secures an extended statute of limitations to pursue enforcement actions against these arrangements, a point Reddington highlights when advising clients: “Those that fail to comply with reporting requirements face severe penalties, including up to US$100,000 monetary penalties for individuals and US$200,000 for entities that fail to disclose a listed transaction and US$10,000 in penalties for individuals and US$50,000 for entities that fail to disclose a transaction of interest.”
He adds: “The heightened categorisation of mirco-captives as listed transactions provides the IRS with an extended statute of limitations to seek penalties years after the fact. Material advisors who fail to file required disclosures would also face heightened audit risks as well as additional enforcement actions.”
Maglaras sees a broader lesson in this enhanced reporting environment, insisting the captive sector should have acted sooner to curb abuses. “We have permitted those who have created abusive captive arrangements to come to our industry meetings, to speak at those meetings, and to pretend that they are a part of our industry,” he says, arguing that the IRS stepped in where the industry failed to self-regulate.
“The long-term impact of letting the IRS ‘peek under the tent’ cannot be over-estimated,” he adds, emphasising that even legitimate micro-captives must now undertake rigorous compliance measures to avoid falling under suspicion.
Revisiting loss ratios benchmarch
Under the final rules, loss ratios now stand as one of the IRS’s primary tools for identifying potentially abusive micro-captive arrangements. According to the IRS, a captive’s loss ratio must remain below 30 per cent over a 10-year span to warrant classification as a listed transaction, with a 60 per cent threshold for those deemed transactions of interest.
Critics, including Reddington, say this single numeric test overlooks the complexities of insurance and the many legitimate reasons claims may be minimal. “The profitability thresholds outlined by the IRS, penalising captives with high efficiency, misrepresent the fundamental purpose of insurance, raising concerns about the rationale underpinning these rules,” he explains.
“Frustratingly, the rules discourage reinvestment back into the insured businesses and disproportionately affect small and medium-sized captives, potentially stifling innovation in risk management.”
Reddington warns that the compliance burden may force smaller captives to divert resources or close altogether if they cannot keep pace. “The regulations unfairly target small and middle-market insurers that provide efficient, tailored coverage that is often absent from the commercial market,” he says.
“The IRS attack on the captive market will quash small business creativity and allow larger insurance companies with substantial capital to take over what is left of the market. The IRS’s approach to this compliance issue also creates uncertainty for businesses that rely on captives for risk management during periods of heightened natural disasters.”
Meanwhile, Maglaras, who has spent more than four decades in the captive industry, echoes concerns about oversimplification. He notes that long-tail exposures sometimes generate claims years down the line, while excess-layer policies may only respond to catastrophic events. “Insurance is never one-size-fits-all,” he says, emphasising that similar premiums can produce drastically different claims patterns.
Simmons worries that this heavy focus on loss ratios might prompt some owners to scale back underwriting just to avoid scrutiny. “The forced approach taken by the IRS in some of the underwriting metrics could push underwriting processes to be scaled back in an effort to reduce costs and negatively impact underwriting results,” he says.
He notes: “The lower loss ratios for both classifications are undoubtedly going to challenge underwriting practices. There is a possibility that captives could look to further reduce expense budgets and costs to ensure compliance.
“I have concerns that additional costs attributed to third-party professionals for the industry make it a less attractive proposition and the captive industry loses the entrepreneurial spirit that exists today.”
Loan-back arrangements
One area of particular concern in the final rules is loan-back arrangements, where captives redirect funds to benefit insured parties or related persons through loans, dividends, or guarantees.
Reddington warns these practices threaten the core principle of risk transfer, which underpins genuine insurance. “Commenters requested clearer definitions and examples of such practices, but the IRS reaffirmed that loan-back arrangements strongly indicate abusive behaviour and must be evaluated on a case-by-case basis,” he says.
He believes the new rules leave little room for these setups going forward. “Loan-back arrangements will now elevate the captive arrangement to be categorised as a listed transaction, intensifying the IRS’s scrutiny,” he adds.
“While these arrangements have long been discouraged, the new rules virtually eliminate their viability. In rare cases where loan-back arrangements are deemed necessary, they must be structured at arm’s length and comply with legal requirements. Even then, disclosure is mandatory, and an audit is almost certain to follow.”
Meanwhile, Simmons sees the increased focus on financing as a potential catalyst for more disciplined underwriting practices. “The heightened scrutiny could refocus the industry and flush out any bad actors,” he says.
Simmons notes that his team anticipated these changes well before the final regulations, particularly when creating their Micro Defender product.
“The bigger picture could impact captive D&O rating on a wider scale if the IRS were to attack the captive industry as a whole. During our own creation of the Micro Defender product we did consider rating factors that included loan arrangements and classification by the IRS of these transactions.”
The road ahead
The captive industry, once described by Michael Maglaras as “self-regulated,” now operates under a more rigorous federal regime — a shift many insiders consider inevitable given longstanding IRS allegations that questionable practices went unchecked for too long.
Although the final regulations have taken effect, Reddington expects further legal battles.
“Other avenues to remedy this situation include legal challenges to the regulations under the Administrative Procedure Act (APA) that argue the regulations are arbitrary, capricious, and exceed permitted authority,” he explains.
He points to a recent lawsuit filed by tax consulting firm Ryan in the US District Court for the Northern District of Texas, arguing the new rules violate the APA and impose “additional limitations and burdens upon the use of captive insurance companies that Congress has not authorised.”
Reddington predicts more challenges ahead, prompting courts to scrutinise the regulations’ validity and the IRS’s adherence to proper rulemaking standards.
While the industry awaits these legal outcomes, micro-captive owners must decide whether to maintain, reconfigure, or dismantle current structures to comply with heightened disclosure and documentation demands.
Simmons insists that “any thought of forming a micro captive should start and end with appropriate compliance and risk management,” adding that rigorous underwriting remains the best safeguard. “It could go one of two ways,” he says.
“Either owners struggle to find appropriate professional firms and underwriting partners to assist in setting up and managing the captive, and we see a reduction in new 831(b) captives, or the opportunity is grasped and these new regulations bring the cream to the top and those setting up an 831(b) for legitimate reasons succeed.”
Simmons also anticipates narrower profit margins for managing general agents and underwriters due to the added scrutiny, yet he believes this environment could reward experts adept at transparency and precise risk assessment.
Though some captive managers may hesitate to create new 831(b) captives, he points out that states like Florida are still experiencing growth in this arena, largely driven by escalating insurance costs that are steering more businesses toward self-insurance.
Maglaras, for his part, remains confident that legitimate captives can flourish under the new framework. If arranged properly — with real risk transfer, strong documentation, and authentic business purposes — he believes they should survive any IRS challenge.
“The best way I know how to do this is to rely on the findings and conclusions of the actuary’s study,” he says, emphasising the importance of rigorous actuarial reports. “Find me a captive without an annual actuarial study, and I will find you a captive ripe for demolition by the IRS.”
The industry veteran charts a clearer path forward: “This never should have happened to begin with, but it has happened, and what we in the industry must do about this is make certain that it never happens again by calling out the purveyors of abusive transactions for the bad actors they are.”
The new direction has arrived, and the burden now falls on legitimate captive players to demonstrate they adhere to core insurance principles.
