# Micro-Captive Listed Transactions and Micro-Captive Transactions of Interest

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2025-00393

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** January 14, 2025
- **Citation:** 90 FR 3534

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 10029]
RIN 1545-BQ44
Micro-Captive Listed Transactions and Micro-Captive Transactions of Interest

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Final rule.

SUMMARY:

This document contains 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. Material advisors and certain participants in these listed transactions and transactions of interest are required to file disclosures with the IRS and are subject to penalties for failure to disclose. The final regulations affect participants in these transactions as well as material advisors.

DATES:

Effective date:
These regulations are effective on January 14, 2025.

Applicability date:
For dates of applicability,
see
§§ 1.6011-10(h) and 1.6011-11(h).

FOR FURTHER INFORMATION CONTACT:

Allan H. Sakaue, (202) 317-6995 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Authority

This document amends the Income Tax Regulations (26 CFR part 1) by adding final regulations under section 6011 of the Internal Revenue Code (Code) to identify certain micro-captive transactions and substantially similar transactions as listed transactions and certain other micro-captive transactions as transactions of interest, each a type of reportable transaction (final regulations). These regulations are issued pursuant to the authority conferred on the Secretary of the Treasury or her delegate (Secretary) under the following provisions of the Code:

Section 6001, which requires every taxpayer to keep the records, render the statements, make the returns, and comply with the rules and regulations that the Secretary deems necessary to demonstrate tax liability and prescribes, either by notice served or by regulations;

Section 6011, which requires every taxpayer to “make a return or statement according to the forms and regulations prescribed by the Secretary” and “include therein the information required by such forms or regulations”;

Section 6707A(c)(1), which states that “[t]he term `reportable transaction' means any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations prescribed under section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion”; and

Section 6707A(c)(2), which states that, “[t]he term `listed transaction' means a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.”

Reportable transactions are described in § 1.6011-4 and include listed transactions, confidential transactions, transactions with contractual protection, loss transactions, and transactions of interest.
See
§ 1.6011-4(b)(2) through (6). Section 1.6011-4(b)(2) defines a “listed transaction” as a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction. Section 1.6011-4(b)(6) defines a “transaction of interest” as a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest.

The final regulations are also issued under the express delegation of authority under section 7805(a) of the Code.

Background

I. Section 831(b)

As enacted by section 1024 of the Tax Reform Act of 1986, Public Law 99-514, 100 Stat. 2085, 2405 (October 22, 1986), section 831(a) of the Code generally imposes tax on the taxable income (determined under the special rules for calculating taxable income of insurance companies in part II of subchapter L of chapter 1 of the Code) of every insurance company other than a life insurance company (nonlife insurance company), for each taxable year computed as provided in section 11 of the Code. However, certain small nonlife insurance companies may elect to be subject to the alternative tax imposed by section 831(b).

Upon election by an eligible nonlife insurance company (eligible electing company) to be taxed under section 831(b), in lieu of the tax otherwise imposed by section 831(a), section 831(b) imposes tax on the company's income computed by multiplying the taxable investment income of the eligible electing company (determined under section 834 of the Code) for the taxable year by the rates provided in section 11(b) of the Code. 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.

Congress enacted section 333 of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), div. Q. of Public Law 114-113, 129 Stat. 2242, 3040 (December 18, 2015), to both tighten and expand the requirements for qualifying under section 831(b), effective for taxable years beginning after December 31, 2016. As amended by the PATH Act, section 831(b) requires an eligible electing company to be an insurance company (within the meaning of section 816(a) of the Code) having net written premiums or, if greater, direct written premiums, for the taxable year not exceeding $2.2 million as adjusted for inflation (net written premium limitation) and to meet the diversification requirements of section 831(b)(2)(B). The last sentence of section 831(b)(2)(A) provides that an election under section 831(b) applies to the taxable year for which it is made and all subsequent taxable years for which the net written premium limitation and the diversification requirements are met and may be revoked only with the Secretary's consent. In addition, section 831(d) requires every eligible electing company that has a section 831(b) election in effect to furnish to the Secretary “at such time and in such manner as the Secretary shall prescribe such information for such taxable year as the Secretary shall require with respect to” the diversification requirements of section 831(b)(2)(B).

To qualify as an insurance company pursuant to section 816(a), a requirement to elect section 831(b) taxation, more than half of the business of the entity during the taxable 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.
See Helvering
v.
Le Gierse,
312 U.S. 531, 539 (1941) (both risk shifting and risk distribution must be present);
Allied Fidelity Corp.
v.
Commissioner,
572 F.2d 1190, 1193 (7th Cir. 1978) (the risk transferred must be risk of economic loss);
Commissioner
v.
Treganowan,
183 F.2d 288, 290-91 (2d Cir. 1950) (the risk must contemplate the fortuitous occurrence of a stated contingency);
Rent-A-Center, Inc.
v.
Commissioner,
142 T.C. 1, 13 (2014) (the arrangement must constitute insurance in the commonly accepted sense);
see also
Rev. Rul. 2007-47, 2007-2 C.B. 127 (the risk must not be merely an investment or a business risk). 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.
Avrahami
v.
Commissioner,
149 T.C. 144, 191 (2017).

II. Notice 2016-66 and Notice of Proposed Rulemaking (“NPRM”)

On November 21, 2016, the Treasury Department and the IRS published Notice 2016-66, 2016-47 I.R.B. 745, which identified certain micro-captive transactions as transactions of interest. On January 17, 2017, the Treasury Department and the IRS published Notice 2017-08, 2017-3 I.R.B. 423, which modified Notice 2016-66 by providing for an extension of time for participants and material advisors to file their disclosures.

Notice 2016-66 alerted taxpayers and their representatives pursuant to § 1.6011-4(b)(6) and for purposes of § 1.6011-4(b)(6) and sections 6111 and 6112, that the Treasury Department and the IRS identified as transactions of interest certain micro-captive transactions in which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, using contracts that the parties treat as insurance contracts and a related company that the parties treat as an insurance company. Notice 2016-66 also alerted persons involved with the identified transactions that certain responsibilities may arise from their involvement.

The Treasury Department and the IRS issued proposed regulations under section 6011 (REG-109309-22) in an NPRM published in the
Federal Register
(88 FR 21547) on April 11, 2023 (proposed regulations). That NPRM obsoleted Notice 2016-66. The Treasury Department and the IRS considered comments received in response to Notice 2016-66 in developing the proposed regulations.

The proposed regulations would identify taxpayers who file returns reflecting the tax benefits of a transaction described at § 1.6011-10(a) as participants in a listed transaction (“Micro-captive Listed Transaction”). The proposed regulations would identify taxpayers who file returns reflecting the tax benefits of a transaction described at § 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 proposed § 1.6011-10(b)(6)) of an Insured (as defined in proposed § 1.6011-10(b)(4)) holds the necessary interest described in proposed § 1.6011-10(b)(1)(iii) (the “20 Percent Relationship Test”) in Captive (as defined in proposed § 1.6011-10(b)(1)), Captive meets the definition provided in proposed § 1.6011-10(b)(1), and Captive provides financing as described in proposed § 1.6011-10(c)(1) (the “Financing Factor”), determined over the Financing Computation Period defined in proposed § 1.6011-10(b)(2)(i), or has less than a 65 percent loss ratio (the “Loss Ratio Factor”) as described in proposed § 1.6011-10(c)(2), determined over the Loss Ratio Computation Period defined in proposed § 1.6011-10(b)(2)(ii).

A Micro-captive Transaction of Interest is a transaction in which an Owner (as defined in proposed § 1.6011-11(b)(6)) of an Insured (as defined in proposed § 1.6011-11(b)(4)) holds the necessary interest in Captive (as defined in proposed § 1.6011-11(b)(1)), Captive meets the definition provided in proposed § 1.6011-11(b)(1), and Captive has less than a 65 percent loss ratio, as described in proposed § 1.6011-11(c), determined over the Transaction of Interest Computation Period defined in proposed § 1.6011-11(b)(2).

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 as set forth in proposed §§ 1.6011-10(f) and 1.6011-11(f). The Treasury Department and the IRS developed these objective factors to ensure administrability and clarity for taxpayers whose transactions are identified in the regulations, so taxpayers can clearly determine whether they are participants or material advisors, and thus be on clear notice of their obligations.

The Treasury Department and the IRS received 110 public comments in response to the proposed regulations and notice of public hearing that are the subject of this final rulemaking. The comments are available for public inspection at
https://www.regulations.gov
or upon request. A public hearing on the proposed regulations was held by teleconference on July 19, 2023, at 10 a.m. Eastern Time, at which six speakers provided testimony.

The Summary of Comments and Explanation of Revisions of these final regulations summarizes the proposed regulations, which are described in greater detail in the preamble to the proposed regulations. After full consideration of all the comments received and the testimony provided, these final regulations adopt the proposed regulations with the modifications described in this Summary of Comments and Explanation of Revisions.

Summary of Comments and Explanation of Revisions

This Summary of Comments and Explanation of Revisions summarizes all significant comments addressing the proposed regulations, and describes and responds to comments concerning: (1) the authority to issue the proposed and final regulations generally; (2) the Loss Ratio Factor described in proposed §§ 1.6011-10(c)(2) and 1.6011-11(c); (3) the Financing Factor described in proposed § 1.6011-10(c)(1); (4) the exception for certain consumer coverage arrangements described in proposed §§ 1.6011-10(d)(2) and 1.6011-11(d)(2); (5) requests for safe harbors from either identification as a reportable transaction or from the reporting requirements upon identification as a reportable transaction; and (6) other matters including clarifications and changes not specifically related to the identified factors already addressed. This Summary of Comments and Explanation of Revisions also explains revisions adopted by the final regulations in response to those comments. Comments outside the scope of this rulemaking are generally not addressed.

As an initial matter, the final regulations incorporate non-substantive changes to the description of the

election under section 831(b) at proposed § 1.6011-10(b)(1)(i) (defining in part the term Captive) to better reflect the text of the statute.
See
§ 1.6011-10(b)(1)(i) of the final regulations.

Furthermore, §§ 1.6011-10(e) and 1.6011-11(e) are added to the final regulations, to provide more clarity on when a transaction is considered substantially similar as defined in § 1.6011-4(c)(4) to the identified transactions. The term “Substantially Similar” has also been defined in the final regulations by cross-reference to § 1.6011-4(c)(4).

I. Comments on Authority To Issue the Proposed Regulations

A. The McCarran-Ferguson Act

Several commenters argued that the proposed regulations implicate “the business of insurance” under the McCarran-Ferguson Act, 15 U.S.C. 1011
et seq.
(“McCarran-Ferguson”). In addition, commenters argued that sections 6011, 6111, and 6112 do not explicitly reference insurance, and thus McCarran-Ferguson prohibits the application of the proposed regulations thereunder. Commenters also asserted that the inclusion of a Loss Ratio Factor and a Financing Factor in the proposed regulations will invalidate, impair, or supersede State law governing insurance companies. For example, commenters contended that because State regulators must approve related-party financing transactions entered into by insurance companies, State law to that effect will preempt identification of a captive insurance transaction involving related-party financing as a reportable transaction. Similarly, commenters contended that because State regulators establish solvency requirements for insurers licensed in their domicile, State laws regarding premium pricing will preempt identification of a captive insurance transaction as a reportable transaction based on the Loss Ratio Factor. Commenters also asserted that the Loss Ratio Factor, by encouraging payment of policyholder dividends, impacts the insurer and policyholder relationship and therefore implicates McCarran-Ferguson.

Contrary to the commenters' arguments, and as discussed in more detail in the following paragraphs, McCarran-Ferguson does not apply to these regulations for two primary reasons: first, because the regulations do not invalidate, impair, or supersede State law, and second, because the regulations do not implicate the business of insurance.

First, the proposed regulations do not “invalidate, impair, or supersede” any State law. As relevant here, McCarran-Ferguson provides that “[n]o Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance.” 15 U.S.C. 1012(b). In other words, McCarran-Ferguson prohibits application of Federal law not specifically relating to the business of insurance if it would invalidate, impair, or supersede State laws enacted for the purpose of regulating the business of insurance.
Humana Inc.
v.
Forsyth,
525 U.S. 299, 307 (1999). Courts have uniformly upheld Tax Code provisions pertaining to the taxation of insurance companies in the face of a McCarran-Ferguson challenge.
See, e.g., Modern Life & Acc. Ins. Co.
v.
Commissioner,
420 F.2d 36, 37 (7th Cir. 1969) (
holding
that taxpayer did not show that Commissioner's determination of taxpayer's status under the Internal Revenue Code “will interfere with the choice made by [State].”);
Indust. Life Ins. Co.
v.
United States,
344 F. Supp. 870, 875 (D.S.C. 1972),
aff'd,
481 F.2d 609 (4th Cir. 1973) (
holding
that Congress did not give up the right to tax by passing McCarran-Ferguson);
Hanover Ins. Co.
v.
Commissioner,
65 T.C. 715, 722 (1976) (“Congress did not, under the McCarran-Ferguson Act, surrender to the States the power of the Federal Government to tax insurance companies and to issue regulations implementing the taxing statute.”).

Moreover, McCarran-Ferguson was enacted to prevent inadvertent Federal intrusion on the State's rights to regulate insurance.
See Barnett Bank of Marion Cty.
v.
Nelson,
517 U.S. 25, 39. McCarran-Ferguson does not prevent the Federal Government from issuing insurance regulations.
Id.
The Supreme Court has stated that McCarran-Ferguson does not “cede the field of insurance regulation to the States, saving only instances in which Congress expressly orders otherwise.”
Humana,
525 U.S. at 308;
see also SEC
v.
Nat'l Sec., Inc.,
393 U.S. 453, 459-60 (1969) (“The [McCarran-Ferguson Act] did not purport to make the States supreme in regulating all the activities of insurance companies.”);
Modern Life & Acc. Ins. Co.,
420 F.2d at 37-38;
Indust. Life Ins. Co.,
344 F. Supp. at 875;
Hanover Ins. Co.,
66 T.C. at 721-22. The Supreme Court also stated that “[t]he term `invalidate' ordinarily means `to render ineffective, generally without providing a replacement rule or law . . . [a]nd the term `supersede' ordinarily means `to displace (and thus render ineffective) while providing a substitute rule.”
Humana,
525 U.S. at 307 (citations omitted). The Supreme Court relied on the dictionary definition of “impair,” which is “[t]o weaken, to make worse, to lessen in power, diminish, or relax, or otherwise affect in an injurious manner.”
Humana,
525 U.S. at 309-10 (
citing
Black's Law Dictionary 752 (6th ed. 1990)). Thus, “[w]hen federal law does not directly conflict with state regulation, and when the application of federal law would not frustrate any declared state policy or interfere with a State's administrative regime, the McCarran-Ferguson Act does not preclude its application.”
Humana,
525 U.S. at 310.

The proposed regulations do not render ineffective any State law, nor do they displace or diminish any State regulator's ability to regulate the insurers within their jurisdiction. Rather, the proposed regulations run parallel to the State laws. Identification of a transaction as a listed transaction or a transaction of interest, solely for Federal tax purposes, does not in any way invalidate, impair, supersede, or affect State insurance laws. As in
United States
v.
Redcorn,
“state insurance regulations remain fully in force.” 528 F.3d 727, 736 (10th Cir. 2008) (
holding
that prosecution under 18 U.S.C. 669 (“Theft or embezzlement in connection with health care”) did not conflict in any way with state insurance law for purposes of McCarran-Ferguson);
see also United States
v.
Del. Dep't of Ins.,
66 F.4th 114, 132 (3d Cir. 2023) (
holding
that Delaware State law prohibiting the Delaware Department of Insurance from disclosing certain information about captive insurance companies to anyone, including the Federal Government, did not, under McCarran-Ferguson, override the IRS's statutory authority to issue summonses to the Department and have them enforced).

Commenters cite to
United States Dep't of Treasury
v.
Fabe,
508 U.S. 491 (1993), to support their argument that the proposed regulations violate the McCarran-Ferguson Act, but the proposed regulations can be readily distinguished from the Federal statute at issue in
Fabe.
In
Fabe,
a State preference for distributions to policyholders for claims and expenses incurred in the administration of insolvency proceedings was found to be the “business of insurance.” The Supreme Court found that the Ohio statute at issue in
Fabe
was “aimed at protecting or regulating, directly or indirectly, the relationship between the

insurance company and its policyholders.”
Fabe,
508 U.S. at 491-92 (
citing SEC
v.
Nat'l Sec., Inc.,
393 U.S. at 460). Considering the relationship between the insurer and the insured, the Supreme Court held that, to the extent (1) the State law at issue in
Fabe
protected policyholders and (2) the Federal priority statute under 31 U.S.C. 3713(a)(1)(A)(iii) would impair that relationship, Federal law did not preempt State law. The Court in
Fabe
had to choose between Federal and State statutes because they were in direct conflict. Conversely, the proposed regulations are not in conflict with any State regulations; the relationship between insurer and insured is in no way impacted. Taxpayers remain free to enter into captive insurance transactions in any State and to structure such transactions within the confines of State regulations, and States remain free to regulate such transactions. However, if such structure is described in § 1.6011-10 or § 1.6011-11, participants must disclose information about the arrangement to the IRS. In other words, the proposed regulations attach specific tax obligations (in the form of disclosure) to specific acts (in the form of participating in a transaction described in § 1.6011-10 or § 1.6011-11), but the proposed regulations do not change how those acts are done.

Second, the act of disclosing a transaction to the tax authorities is not the “business of insurance.” The threshold question under 15 U.S.C. 1012(a), in determining whether the anti-preemption mandate of 15 U.S.C. 1012(b) applies, is whether the challenged conduct broadly constitutes the “business of insurance” in the first place. If the contested activities are wholly unrelated to the insurance business, then McCarran-Ferguson has no place in analyzing Federal regulation because only when “[insurance companies] are engaged in the `business of insurance' does the act apply.”
Sabo
v.
Metropolitan Life Ins. Co.,
137 F.3d 185, 190 (3d Cir. 1998) (
citing SEC
v.
Nat'l Sec., Inc.,
393 U.S. at 459-60);
see also United States
v.
Del. Dep't of Ins.,
66 F.4th at 125 (reaffirming the threshold inquiry precedent set in
Sabo
). The “core of `the business of insurance” is “[t]he relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation and enforcement.”
United States
v.
Del. Dep't of Ins.,
66 F.4th at 130 (
citing SEC
v.
Nat'l Sec., Inc.,
393 U.S. at 460). The “business of insurance” is also understood to be “[an]other activity of insurance companies [that] relate[s] so closely to [their] status as reliable insurers that [it] must be placed in the same class.”
Id.
The conduct at issue in the proposed regulations is the filing of disclosure statements upon identification as participants in or material advisors of a transaction that, for Federal tax purposes, either is a listed transaction or a transaction of interest. Like the information gathering conduct via the summonses at issue in the
United States
v.
Del. Dep't of Ins.,
the disclosure requirements in the proposed regulations are not “the business of insurance.” The final regulations do not adopt any changes based on these comments.

B. Federalism Implications

Commenters also argued that the proposed regulations have federalism implications and fail to satisfy Executive Order 13132 (Federalism). Executive Order 13132 generally provides that an agency is prohibited from publishing any rule that has federalism implications if the rule imposes substantial, direct compliance costs on State and local governments, and is not required by statute, or if the rule preempts State law, unless the agency satisfies, among other things, the consultation and federalism summary impact statement requirements of section 6 of the Executive order.

The proposed regulations do not have federalism implications, and the requirements in section 6 of Executive Order 13132 to consult with State and local officials and issue a federalism impact statement do not apply. As described in this preamble, the proposed regulations do not preempt State law, nor do they impose substantial, direct compliance costs on State and local governments, as there is no obligation created by the regulations with which any State or local agency may need to comply. The final regulations do not adopt any changes based on these comments.

C. Constitutionality, Fairness, and Retroactivity

Commenters contended that the proposed regulations are unconstitutional for a number of reasons. First, commenters argued that requiring participants to disclose transactions they participated in, even if such taxpayers were examined for one or more years for which reporting would be required and for which the IRS did not make any adjustments to the taxpayers' returns, is unconstitutional and retroactive in nature. Second, commenters argued that the proposed regulations are intended to shut down the captive insurance industry and may constitute a “taking” under the Fifth Amendment of the U.S. Constitution, by restricting the rights of taxpayers to engage in captive insurance transactions.

With respect to the first argument, commenters did not specify what provision of the Constitution is allegedly violated by the potential need to disclose participation in a transaction after an examination resulted in no change to the examined returns, and we are not aware of any Constitutional provision that would be violated. In addition, any such disclosure requirement in these regulations is not retroactive in nature; the final regulations will be effective January 14, 2025. To the extent the final regulations result in a disclosure obligation with respect to transactions occurring in prior taxable years for which the statute of limitations on assessment has not expired, such obligation is a current reporting obligation that arises after January 14, 2025.

With respect to the comment about reporting requirements for taxpayers whose returns have been examined, the reporting rules are outside the scope of these final regulations, which merely identify a listed transaction and a transaction of interest, respectively. The reporting rules for listed transactions and transactions of interest are found in § 1.6011-4, which was issued pursuant to notice and comment and finalized most recently on August 3, 2007, in TD 9350 (72 FR 43146), and which is not amended by these regulations. However, there are tax administration reasons to maintain these reporting requirements. Most importantly, initial disclosures of reportable transactions are filed with the Office of Tax Shelter Analysis (OTSA) to ensure that all information is collected in one place. The OTSA's mission is, among other things, to ensure that the IRS has the information necessary to detect abusive tax shelters and identify issues of significant compliance risk to tax administration. The OTSA collects and analyzes information about abusive tax shelters and reportable transactions to identify trends and disseminates the results to those in a position to take appropriate action. In order to identify participants and promoters of tax avoidance transactions, the OTSA needs to receive and review Forms 8886 in a timely and efficient manner. Limiting disclosure to a subset of transaction participants (such as taxpayers whose examinations have been closed) would provide an incomplete picture of the transaction and hinder the OTSA's efforts. Accordingly, the final regulations do not

adopt any changes based on these comments.

The commenters' second Constitutional argument, under the Fifth Amendment, is also without merit. As relevant here, the Fifth Amendment provides, in addition to the other limitations on government power, that “private property [shall not] be taken for public use, without just compensation.” The proposed regulations identify a transaction as a listed transaction or a transaction of interest for Federal tax purposes and require the filing of disclosures with the IRS and the OTSA. Requiring disclosure of participation in these transactions does not implicate the Fifth Amendment; no property interest is taken for public use by the government under the proposed regulations necessitating compensation.

Taxpayers remain free to engage in any captive insurance transaction, regardless of whether such transaction is identified in § 1.6011-10 or § 1.6011-11, respectively; however, there may be Federal tax consequences if the transaction is not a valid captive insurance transaction. As there is no limitation on participation in any transaction by operation of the proposed regulations, there is no “taking” for Fifth Amendment purposes.

D. The Administrative Procedure Act

Commenters argued that the proposed regulations lack legal foundation and assert that the regulations will be challenged and set aside just as Notice 2016-66 was set aside in
CIC Services, LLC
v.
IRS,
592 F.Supp.3d 677 (E.D. Tenn. 2022). In
CIC Services,
the district court followed the analysis in
Mann Construction, Inc.
v.
United States,
27 F.4th 1138 (6th Cir. 2022),
rev'g
539 F.Supp.3d 745 (E.D. Mich. 2021), which held that the identification of a listed transaction must follow the notice-and-comment procedures of the Administrative Procedure Act (“APA”). The district court in
CIC Services
held that Notice 2016-66 should be vacated because the IRS did not follow the APA's notice-and-comment procedures. The district court held in the alternative that the IRS acted arbitrarily and capriciously based on the administrative record.
CIC Services,
592 F.Supp.3d at 687.

In light of the decision by the district court in
CIC Services
and other judicial decisions, the Treasury Department and the IRS published the proposed regulations and obsoleted Notice 2016-66. The NPRM provided for a comment period from April 11, 2023, through June 12, 2023, and more than 100 comment letters were received. The Treasury Department and the IRS conducted a public hearing on July 19, 2023, providing further opportunity for taxpayers to comment on the proposed regulations. The APA notice-and-comment procedures have been followed.

Some commenters suggested that the IRS's purpose for publishing the proposed regulations is to harass otherwise valid businesses, but the purpose is simply to require disclosures with respect to transactions described in §§ 1.6011-10 and 1.6011-11, in the interest of tax administration. Examinations of taxpayers and promoters have helped to clarify the Treasury Department's and the IRS's understanding of micro-captive transactions, including the scope of participation. The factors used to identify the Micro-captive Listed Transaction and the Micro-captive Transaction of Interest are neither arbitrary nor capricious. They reflect the IRS's long-standing positions with respect to abusive micro-captives as made public in annual Dirty Dozen tax schemes publications and case law. The factors are objective and reasonably determined, based on relevant factors in existing statutory provisions, on available industry data, and on a careful review of case law and examination information. The objectivity and reasonableness of each factor is discussed more fully throughout this Summary of Comments and Explanation of Revisions, notably in part II. (Loss Ratio Factor); part III. (Financing Factor); and part VI.B. (20 Percent Relationship Test). The existing case law with respect to micro-captives demonstrates the commonalities in the fact patterns in these transactions, which is relevant to the development of the transaction fact patterns identified in these regulations. The Tax Court has consistently determined in its section 831(b) decisions issued to date that taxpayers in the relevant micro-captive transactions remitted amounts treated as premiums for something other than insurance.
See Avrahami,
149 T.C. at 197-98;
Syzygy
v.
Commissioner,
T.C. Memo. 2019-34, at *45;
Caylor Land & Dev., Inc.
v.
Commissioner,
T.C. Memo. 2021-30, at *48-49;
Keating
v.
Commissioner,
T.C. Memo. 2024-2, at *64;
Swift
v.
Commissioner,
T.C. Memo. 2024-13, at *44-45;
Patel
v.
Commissioner,
T.C. Memo. 2024-34, at *51-52, and
Royalty Mgmt. Ins. Co., Ltd.
v.
Commissioner,
T.C. Memo. 2024-87, at *49-50. Current examinations and litigation also are relevant, as they demonstrate consistency with the transaction fact patterns identified in these regulations.

Section 6707A(c) delegates to the IRS the authority to promulgate regulations pursuant to section 6011 identifying reportable transactions. Specifically, section 6707A(c)(1) states that “[t]he term `reportable transaction' means any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations prescribed under section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.” Section 6707A(c)(2) defines the term “listed transaction” as “a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.” Section 6707A(a) provides that “[a]ny person who fails to include on any return or statement any information with respect to a reportable transaction which is required
under section 6011
to be included with such return or statement shall pay a penalty in the amount determined under subsection (b)” (
emphasis
added). Under section 6011(a), returns and statements, including disclosures, should be filed “according to the forms and regulations prescribed by the Secretary.” The proposed regulations do not create any law that is contrary to any statute; rather, the proposed regulations identify transactions that must be disclosed per the existing rules under the Code with respect to reportable transactions, as sections 6707A(c) and 6011 prescribe.

In addition, the Secretary has general regulatory authority under section 7805(a) to “prescribe all needful rules and regulations for the enforcement of” the Code. The Treasury Department and the IRS have clear authority to issue the proposed regulations and have followed the procedural requirements of the APA. As explained more fully throughout this Summary of Comments and Explanation of Revisions, these final regulations are based on consideration of comments in response to the proposed regulations, case law, and the IRS's years of experience with abusive micro-captives.

E. Definition of Insurance for Federal Tax Purposes

Commenters also argued that by identifying a micro-captive transaction as a listed transaction or a transaction of interest on the basis of a Loss Ratio Factor, a Financing Factor, or both, the proposed regulations define insurance for Federal tax purposes in a manner inconsistent with case law. Commenters cited a number of cases, including
Reserve Mech. Corp.
v.
Commissioner,

34 F.4th 881 (10th Cir. 2022),
aff'g,
T.C. Memo. 2018-86;
United Parcel Service of America, Inc.
v.
Commissioner,
254 F.3d 1014 (11th Cir. 2001);
Harper Grp.
v.
Commissioner,
979 F.2d 1341 (9th Cir. 1992),
aff'g,
96 T.C. 45 (1991);
Sears Roebuck & Co.
v.
Commissioner,
972 F.2d 858 (7th Cir. 1992);
AMERCO
v.
Commissioner,
96 T.C. 18 (1991);
Humana, Inc.
v.
Commissioner,
881 F.2d 247 (6th Cir. 1989);
Caylor,
T.C. Memo. 2021-30;
Syzygy,
T.C. Memo. 2019-34;
Avrahami,
149 T.C. 144 (2017);
R.V.I. Guar. Co.
v.
Commissioner,
145 T.C. 209 (2015);
Rent-A-Center,
142 T.C. 1 (2014); and
Securitas Holdings, Inc.
v.
Commissioner,
T.C. Memo. 2014-225. Additionally, several commenters pointed to the IRS's concession in
Puglisi
v.
Commissioner,
2021 WL 7162530 (T.C. Oct. 29, 2021), as proof that the IRS has accepted facts similar to those described in the proposed regulations as insurance for Federal tax purposes, and therefore, the apparent attempt by the proposed regulations to redefine insurance for Federal tax purposes is contrary to established precedent.

The proposed regulations do not redefine insurance for Federal tax purposes by identifying the specific fact patterns set forth in §§ 1.6011-10 and 1.6011-11 as listed transactions or transactions of interest, respectively. The proposed regulations identify fact patterns that are consistently present in the micro-captive cases tried on their merits and the examined cases with respect to which the IRS has determined that the transaction at issue lacked the necessary characteristics, based on the specific facts in each case, to qualify as insurance for Federal tax purposes under existing caselaw. (Although section 6103 prohibits the IRS from disclosing specific taxpayer information, it does not preclude the IRS from identifying consistent fact patterns based on specific taxpayer information.)

For specific cases with respect to which the IRS received comments, section 6103 of the Code prohibits the IRS from discussing taxpayer return information. However, section 6103(b)(2) clarifies that the IRS is not prohibited from disclosing information to the extent it is “in a form which cannot be associated with, or otherwise identify, directly or indirectly, a particular taxpayer,” such as, for example, fact patterns based on specific taxpayer return information. In general, there are a variety of reasons why certain examined cases may have conceded an otherwise valid challenge to the taxpayer's position, either by the IRS Independent Office of Appeals (Appeals) or in litigation.

Several commenters incorrectly assumed that the proposed regulations declare all entities electing the alternative tax under section 831(b) as tax avoidant or potentially tax avoidant, contrary to Congressional intent to encourage the use of small captives by enacting section 831(b) and subsequent amendments thereof, including section 333 of the PATH Act. This assumption is incorrect for several reasons. First, the proposed regulations identify a specific fact pattern involving related parties, including a Captive, at least 20 percent of the voting power or the value of the outstanding stock or equity interest of which is owned, directly or indirectly, by an Insured, an Owner, or persons Related to Insured or an Owner (as such terms are defined in § 1.6011-10(b)). The definition of Captive includes the section 831(b) election, but there are several other factors that must be met before the transaction is described as a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest. The closely held nature of the arrangement coupled with the section 831(b) election and the use of premiums for personal investments or for related-party financing and not to pay losses are what renders these transactions appropriate subjects of disclosure as tax avoidance transactions or transactions of interest.

Second, Congress enacted section 831(b) in the interest of simplifying the Code, not to encourage the use of small captive insurance companies. H.R. Rep. No. 99-426, at 678 (1985) (“The present law applicable to small and certain ordinary mutual companies is inordinately complex and should be simplified.”). Congress amended section 831(b) to provide that the election may be revoked only with the consent of the Secretary, with the clear intent “that the election not be used as a means of eliminating tax liability (
e.g.,
by making the election only for years when the taxpayer does not have net operating losses), but rather as a simplification for small companies.” H.R. Rep. No. 100-795, at 121 (1988); S. Rep. 100-445, at 127 (1988). Nothing in the statutory language or the legislative history of section 831(b) suggests that Congress intended to provide the benefits of section 831(b) to companies that do not qualify as insurance companies for Federal tax purposes.

Third, the Code does not permit a current deduction for amounts set aside for self-funding of future losses.
See, e.g., Harper Grp,
96 T.C. at 46 n.2 (1991) (“Losses incurred by the self-insured taxpayer are deductible (if at all) only in the year paid out from the reserve fund.”),
aff'd,
979 F.2d 1341 (9th Cir. 1992);
Stearns-Roger Corp.
v.
United States,
774 F.2d 414, 415 (10th Cir. 1985) (“Payments [for self-insurance] are not deductible as insurance premiums”). The transactions described in § 1.6011-11 have many of the characteristics of self-insurance, and as such, taxpayers who deduct amounts paid to captives in such transactions may be engaged, as a matter of substance, in self-insurance, but more information is needed to determine if that is the case.

F. Small and Mid-Sized Businesses and the Captive Industry

A number of commenters suggested that the proposed regulations discriminate against small and mid-sized businesses by designating certain micro-captive transactions as listed transactions, and certain other micro-captive transactions as transactions of interest. Commenters also stated that the proposed regulations will impermissibly chill the captive insurance industry. Although it may be the case that many small and mid-sized businesses utilize captive insurance entities that make an election under section 831(b), the proposed regulations do not discriminate against such businesses on the basis of their size by identifying their captive as a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest. Regarding Insureds, there is no specific size of company at issue; large and small businesses alike may engage in a captive insurance transaction, but if such transaction meets the description of a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest, the participants in and material advisors thereof must file disclosure statements. The Treasury Department and the IRS do not intend to discourage the use of section 831(b) by entities that qualify for the election, nor should these regulations be construed as intending to discourage the use of section 831(b) by such entities. These regulations do not hinder the formation of valid captive insurance companies, as discussed more fully at parts VI.C. and H. of the Summary of Comments and Explanation of Revisions.

II. Comments and Changes Relating to the Loss Ratio Factors as Described in Proposed §§ 1.6011-10(c)(2) and 1.6011-11(c)

A. Overview of Comments Relating to the Loss Ratio Factors

Commenters expressed a number of concerns about the Loss Ratio Factors

and Computation Periods. In response to these concerns, the final regulations significantly narrow the scope of the Micro-captive Listed Transaction description by providing that transactions are identified as listed transactions under the final regulations only if both the Financing Factor and the Loss Ratio Factor tests are met. The final regulations also lower the Loss Ratio Factors for both Micro-captive Listed Transactions and Micro-captive Transactions of Interest in response to comments. With respect to the proposed Loss Ratio Computation Period set forth at proposed § 1.6011-10(b)(2)(ii) and the proposed Transaction of Interest Computation Period set forth at proposed § 1.6011-11(b)(2) (collectively, the “Computation Periods”), as further discussed in this part II. of the Summary of Comments and Explanation of Revisions, the final regulations make no substantive changes to the Loss Ratio Computation Period but do extend the Transaction of Interest Computation Period to a period of up to ten years.

Many of the comments related to the Loss Ratio Factors in the proposed regulations raised multiple concerns that were not clearly delineated from other comments or recommendations. For clarity, comments received with respect to the Loss Ratio Factors are addressed categorically in the remaining subparts of this part II. of the Summary of Comments and Explanation of Revisions.

B. Tax Avoidance or Potential for Tax Avoidance Identified by Loss Ratio Factors

Several commenters suggested that the Loss Ratio Factors as set forth at proposed §§ 1.6011-10(c)(2) and 1.6011-11(c) are inappropriate metrics for the captive insurance industry and should not be determinative of whether a transaction is a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest. Some cited
Puglisi,
2021 WL 7162530, for support, suggesting that the IRS conceded the case because the captive at issue, which had a loss ratio below 65 percent, was not participating in a tax avoidance transaction. Commenters also argued that the IRS is treating similarly situated taxpayers differently, by predicating whether a micro-captive transaction involving an entity electing the alternative tax under section 831(b) is a reportable transaction using the Loss Ratio Factors but not doing the same for entities that do not make the section 831(b) election. Other commenters asserted that the Loss Ratio Factors were inappropriate because captives may recover funds through reinsurance, which would have the effect of lowering loss ratios.

In the context of closely held section 831(b) entities, the Loss Ratio Factors generally identify transactions involving circumstances inconsistent with insurance for Federal tax purposes, including excessive pricing of premiums and artificially low or nonexistent claims activity. The Loss Ratio Factor measures whether the amount of liabilities incurred for insured losses and claims administration expenses is significantly less than the amount of premiums earned, adjusted for policyholder dividends. The primary purpose of premium pricing is to ensure funds are available should a claim arise. The pricing of premiums should naturally reflect the economic reality of insurance operations, to ensure that policies are “price[d] in such a way that the premiums brought in cover losses and the insurer's business expenses with enough profit left over to keep investors happy.”
Avrahami,
149 T.C. at 152. Typically, actuaries establish a policy rating scheme and classify risks “`to allow credible statistical inferences regarding expected outcomes.'”
Id.
(
quoting
Actuarial Standard of Practice No. 12: Risk Classification (for All Practice Areas), sec. 3.3 (Actuarial Standards Bd. 2005). The work should be reproducible and permit “another actuary qualified in the same practice area [to] make an objective appraisal of the reasonableness of the actuary's work.” Actuarial Standard of Practice No. 41: Actuarial Communications, sec. 3.2 (Actuarial Standards Bd. 2010),
https://www.actuarialstandardsboard.org/standards-of-practice/
(last visited Jan. 6, 2025). Pricing premiums far in excess of what is reasonably needed to fund insurance operations results in a lower loss ratio and remains a strong indicator of tax avoidance. Further, while amounts paid for insurance may be deductible business expenses, amounts set aside in a loss reserve as a form of self-insurance are not.
See, e.g., Harper Grp.,
96 T.C. at 46 n.2;
Stearns-Roger Corp.,
774 F.2d at 415.

With respect to comments suggesting that the outcome of specific examined cases (such as
Puglisi,
2021 WL 7162530) demonstrates the impropriety of using Loss Ratio Factors generally, or that determinations in such cases demonstrate that the Service is treating similarly situated taxpayers differently, section 6103 prohibits the IRS from disclosing specific taxpayer information. However, as discussed in part I.E. of this Summary of Comments and Explanation of Revisions, section 6103 does not preclude the IRS from identifying consistent fact patterns based on specific taxpayer information. The IRS's decision to concede or settle a given case in no way alters these findings and conclusions, nor are these findings and conclusions altered by the examination of entities that do not fit the identified fact pattern.

Further, commenters suggested that the inclusion of a section 831(b) election as an identifying factor in the proposed regulations but not doing the same for entities that do not make a section 831(b) election means similarly situated taxpayers are being treated differently. However, an entity that does not make a section 831(b) election is not similarly situated. An insurance company taxed under section 831(a) has a corresponding income recognition for amounts paid as insurance premiums, lessening the potential of ongoing tax deferral present in the transactions identified by these regulations.

In response to the commenters who asserted that reinsurance would have the effect of lowering loss ratios, the Treasury Department and the IRS respectfully disagree. Any reinsurance obtained by the Captive for risks attributable to direct written coverage would tend to reduce the premiums earned by the Captive (as most if not all amounts attributable to the reinsurance would typically be ceded to the reinsurer and deducted from premiums earned), thereby increasing the Captive's Loss Ratio Factor percentage and making it less likely that such transaction would be described in the regulations. The final regulations do not eliminate the Loss Ratio Factors based on these and similar comments.

C. Potential To Capture Transactions That Are Not Tax Avoidance Transactions as Listed Transactions

Commenters asserted that micro-captive transactions that are not tax avoidance transactions may have loss ratios that fall below the threshold established by the Loss Ratio Factors. Commenters opined that a loss ratio factor of 65 percent leaves determination of whether a transaction is a listed transaction up to “random chance,” because future loss experience cannot be known when premiums are set, which makes the Loss Ratio Factors inappropriate for identifying tax avoidance transactions or transactions of interest. Commenters stated that premiums are intentionally set at high rates for long periods of time to ensure that there are adequate reserves to pay claims in case of catastrophic loss. Some suggested that transactions meeting the proposed 65 percent Loss Ratio Factor

using a ten-year Loss Ratio Computation Period be identified as Micro-captive Transactions of Interest instead of Micro-captive Listed Transactions. Commenters expressed concern that transactions that are not tax avoidance transactions would be captured if the Loss Ratio Factors are retained, arguing that limited loss history does not mean that risks are not present, or that premiums are overpriced. Commenters pointed to a governmental program that provides reimbursement coverage for certain losses attributable to acts of terrorism set forth in the Terrorism Risk Insurance Act of 2002 (“TRIA”) as an example for why a loss ratio well below the proposed 65 percent is not inherently indicative of tax avoidance. Several commenters pointed to the Tax Court's holdings in
R.V.I. Guar. Co., Ltd. & Subs.
v.
Commissioner,
145 T.C. 209 (2015), as support for why the proposed 65 percent for a loss ratio is too high.

With respect to concerns that transactions that are not tax avoidance transactions could be identified as Micro-captive Listed Transactions based on a ten-year Loss Ratio Computation Period and proposed 65 percent Loss Ratio Factor, the IRS recognizes that low loss ratios may be the result of coverage of low-frequency, high-severity risks. Inherent in insurance underwriting is the concept that by assuming numerous independent risks that will occur randomly, losses will become more predictable over time, and pricing should reflect those anticipated losses.
See, e.g., Clougherty Packing Co., Inc.
v.
Commissioner,
811 F.2d 1297, 1306 (9th Cir. 1987) (“The likelihood that a loss will occur is of uncertain but predictable magnitude; the size of the loss is similarly uncertain but predictable.”). This concept is notably absent from the micro-captive cases tried to date, as premiums were consistently priced to meet the target threshold under section 831(b) without regard to reasonable estimates for loss experience.
See Avrahami,
149 T.C. at 194-198;
Syzygy,
T.C. Memo. 2019-34, at *33-34;
Caylor,
T.C. Memo. 2021-30, at *45-47;
Keating,
T.C. Memo. 2024-2, at *59-61;
Swift,
T.C. Memo. 2024-13, at *40-42;
Patel,
T.C Memo. 2024-34, at *48-50; and
Royalty Mgmt.,
T.C. Memo. 2024-87, at *23, 46-48;
see also Reserve Mech.,
34 F.4th at 891-94. The Loss Ratio Factor percentage is not intended to act as a proxy for the actuarial basis of premium pricing, as such a basis would be too fact specific to establish an administrable test that would adequately put all relevant taxpayers on notice of their obligations under the Code in accordance with every taxpayer's right to be informed.
See Taxpayer Bill of Rights, https://www.irs.gov/taxpayer-bill-of-rights
(last visited Jan. 6, 2025).

Commenters identifying loss ratios at issue in specific Tax Court cases did not specify what the loss ratios would be in those cases if computed as set forth in the proposed regulations over the proposed ten-year Loss Ratio Computation Period, nor did they specify an administrable metric that would enable better identification of tax avoidance transactions. The inclusion of a ten-year Loss Ratio Computation Period is intended to allow a Captive significant time to develop a reasonable loss history that supports the use of a micro-captive for legitimate insurance purposes. The final regulations retain the ten-year Loss Ratio Computation Period in the proposed listed transaction regulations, but in response to concerns that the proposed Loss Ratio Factors are nevertheless set too high and will capture transactions that are not tax avoidance transactions, the final regulations lower the Loss Ratio Factor for purposes of designating a listed transaction under § 1.6011-10 to 30 percent.

The percentage was selected in response to comments indicating that the Tax Court's holding in
R.V.I.
supports a lower loss ratio.
R.V.I.
is the one case cited by commenters that analyzed loss ratios for time periods corresponding to the Loss Ratio Computation Period for the Micro-captive Listed Transaction. In
R.V.I.,
the Tax Court listed the captive's loss ratios from 2000 through 2013.
R.V.I.,
145 T.C. at 216. The listed loss ratios ranged from a low of 0.2 percent (2012) to a high of 97.9 percent (2008).
Id.
As the Tax Court found, when considered in their totality, these ratios reflect “significant claims and . . . . significant insurance losses.”
Id.
at 215. The average loss ratio in
R.V.I.
for the five ten-year periods analyzed by the Tax Court (2000 through 2009; 2001 through 2010; 2002 through 2011; 2003 through 2012; and 2004 through 2013) themselves ranged from a low of 28 percent (2000 through 2009) to a high of 35 percent (2004 through 2013). Taking the average of those five ten-year periods, the average ten-year loss ratio in the
R.V.I.
case was 32 percent. This amount is rounded down to 30 percent in the final regulations.

Further, to better target those transactions that are properly identified as listed transactions rather than as transactions of interest, the final regulations require that the transaction meet both the Loss Ratio Factor and the Financing Factor (a conjunctive test) to be designated as a listed transaction, as explained more fully in part III. of this Summary of Comments and Explanation of Revisions. This change to a conjunctive test, coupled with the lower Loss Ratio Factor percentage for Micro-captive Listed Transactions, significantly narrows the scope of the Micro-captive Listed Transaction in the final regulations and should provide adequate relief for taxpayers who suggested comparisons to specific business line loss ratios, as well as for taxpayers who expressed concerns about the breadth of the Micro-captive Listed Transaction under the proposed regulations or who requested that transactions that would have met the proposed 65 percent Loss Ratio Factor be identified as transactions of interest instead. Although the example of the TRIA's loss experience is not strictly relevant (that is, because the TRIA is a governmental relief program, not an insurance company) the significantly narrowed scope of the Micro-captive Listed Transaction is intended to respond to concerns that lower losses do not necessarily mean risks were not present or that premiums were overpriced.

For clarity, the proposed Loss Ratio Computation Period is retitled as the “Listed Transaction Loss Ratio Computation Period” and the proposed Transaction of Interest Computation Period is retitled as the “Transaction of Interest Loss Ratio Computation Period”. The final regulations generally retain the substance of the proposed Computation Periods except the Transaction of Interest Loss Ratio Computation Period is increased in the final regulations from a Captive's nine most recent taxable years to its ten most recent taxable years (or all taxable years of the Captive's existence if it has been in existence for less than ten taxable years) as discussed more fully in part II.D. of this Summary of Comments and Explanation of Revisions. If an established transaction that is otherwise described in the final regulations has not had adequate time to develop a ten-year loss history, the transaction may only be designated as a transaction of interest rather than a listed transaction. In addition, the Loss Ratio Factor for identification as a transaction of interest is also lowered from 65 percent to 60 percent in the final regulations, as described in part II.D. of this Summary of Comments and Explanation of Revisions.

D. Comparison to National Averages

The proposed Loss Ratio Factors were generally formulated by using the medical loss ratio in section 833 of the

Code, to inform the original loss ratio factor in Notice 2016-66, and by using national data for commercial property and casualty insurers, to inform the proposed regulations. A number of commenters contended that these metrics are inappropriate because section 831(b) captive insurers are materially different from commercial insurers due to the different types of coverage offered by commercial and captive insurers. For example, several commenters asserted that the inclusion in national averages of certain lines of coverage (identified by one commenter as private passenger auto liability, commercial auto liability, and accident and health coverage lines) that captives do not typically write, or may not be permitted to write, may tend to skew industry-wide loss ratios higher. Another commenter relatedly suggested that the Loss Ratio Factor's reliance on data from the National Association of Insurance Commissioners (NAIC) as a benchmark was inappropriate because the data does not include the experience of the vast majority of captive insurance companies, including those which have elected to be taxed under section 831(b). One commenter asserted that the national industry average relied upon in the proposed regulations lacks an actuarial basis, and another commenter stated that aggregated data of the U.S. property-casualty insurance industry would reflect more risk diversification and geographic diversity than would be present in a typical micro-captive arrangement.

As noted in the preamble to the proposed regulations, the Loss Ratio Factors are modified loss ratios spread out over the course of many years, unlike the single-year NAIC averages, and are also lower than the NAIC industry averages. The NAIC industry averages ranged between 67.2 and 76.2 percent per year from 2012 to 2021.
See Insurance Industry Snapshots and Analysis Reports, https://naic.soutronglobal.net/Portal/Public/en-US/RecordView/Index/26555
(last visited Jan. 6, 2025). In the latest published NAIC industry report, national averages ranged between 69.0 and 76.4 percent per year from 2014 to 2023.
See 2023 Annual Property & Casualty Insurance and Title Insurance Industries Analysis Report, https://naic.soutronglobal.net/Portal/Public/en-US/RecordView/Index/26555
(last visited Jan. 6, 2025). Accordingly, even a Captive electing the alternative tax under section 831(b) that has a loss ratio below the industry-wide average for property and casualty companies in a given year will not necessarily have a loss ratio that causes it to be a participant to a transaction identified by the regulations.

With respect to concerns that the use of NAIC data as a benchmark for the Loss Ratio Factor is inappropriate because the NAIC does not capture micro-captive data, the commenter did not identify any alternative published data set that would capture the experience of “the vast majority of captive insurance companies, including micro-captive insurance companies,” nor is the IRS aware of one. The commenter included a table illustrating the distribution of AM Best Company's average loss and loss administration expenses ratios for small insurance companies, described as insurers grouped by capital and surplus up to $10 million, but this data set is inappropriate. As the commenter noted, the AM Best Company's data set includes “vastly different claims characteristics than micro-captives” covering risks that micro-captives are not generally permitted to cover, such as personal automobile liability and homeowner's liability. The NAIC data, conversely, represents industry averages generally applicable to all nonlife insurers, and, accordingly, was relied upon in the proposed regulations as a starting point, which was modified by the inclusion of policyholder dividends in the computation and by the application of an extended Computation Period. Further, as previously discussed in part II.C. of this Summary of Comments and Explanation of Revisions, the threshold for the Loss Ratio Factor for identification of a Micro-captive Listed Transaction has been lowered significantly in the final regulations.

The comments regarding the lines of coverage included in the NAIC averages provide support for a reduction to the proposed Loss Ratio Factor for identification as a transaction of interest. The specific business lines identified by the commenters would, based on the NAIC Profitability Study provided by one of the commenters, result in an average nine-year loss ratio of approximately 59 percent. However, there are other high frequency, low severity coverages and other business lines that captives are unlikely to cover in the data provided by the commenter that the commenter failed to mention: private passenger auto physical damage, homeowners' multiple peril, and mortgage guaranty lines. Removing these lines from the data set provided by the commenter would reduce the average nine-year loss ratio percentage from 65 percent identified in the proposed regulations to slightly over 60 percent.

However, this relies on the national average computation of loss ratios, which as commenters pointed out, is not the modified computation set forth in the proposed regulations. The modified computation ratio in the final regulations would potentially be lower, in part because policyholder dividend payments reduce the ratio. To determine what the average loss ratio would be using the modified loss ratio computation set forth in the proposed regulations, the IRS considered the annual NAIC Report on Profitability by Line by State for each year from 2013 through 2022 to understand a typical property and casualty company loss ratio.
See, e.g., 2013 Report on Profitability by Line by State,
Center for Insurance Policy & Research,
https://naic.soutronglobal.net/Portal/Public/en-US/RecordView/Index/7008
(last visited Jan. 6, 2025). By removing the high frequency, low severity coverages that captives are unlikely to cover for each year from 2013 through 2022 from the annual data and computing the comparison of liabilities incurred for insured losses and claim administration expenses to premiums earned less policyholder dividends as set forth in the regulations, the average nine-year modified loss ratio is approximately 66 percent, which is slightly higher than the proposed 65 percent established in the proposed regulations. The average ten-year modified loss ratio is also slightly higher, at approximately 67 percent.

In light of commenters' concerns that the proposed 65 percent modified loss ratio is still too high, the Loss Ratio Factor percentage for identification of a transaction of interest in these regulations is lowered to 60 percent. This amount represents a discount from the lowest loss ratio supported by available data. The Loss Ratio Factor percentage for identification as a listed transaction has been reduced much more substantially to 30 percent, for other reasons, as described in part II.C. of this Summary of Comments and Explanation of Revisions. In the interest of ensuring all taxpayers can easily determine their status under the regulations, the Loss Ratio Factor remains based on the aggregated NAIC average as modified in the final regulations; although commenters were critical of the aggregated data provided by the NAIC, commenters did not point to, and the IRS is not aware of, an alternative publicly-available data set that would be more appropriate.

Further, the Treasury Department and the IRS considered alternative

Computation Periods and determined that a difference of one year in the Computation Periods between the Micro-captive Listed Transaction and the Micro-captive Transaction of Interest when the loss ratio thresholds are different adds unnecessary complexity and burden to affected taxpayers. The Transaction of Interest Loss Ratio Computation Period is accordingly increased to a period of up to ten years, or if the Captive has not been existence for ten full years, all years of the Captive's existence. This change will afford affected taxpayers more time to develop a loss history and will enable the computation of one ratio when affected taxpayers are considering if they need to report under § 1.6011-10 or § 1.6011-11.

E. Proposed Alternatives to the Loss Ratio Factors

Commenters suggested alternatives to the Loss Ratio Factors including: (1) evaluating the methodology used to price premiums to ensure the premiums either are priced commensurate with commercial insurance market premiums, or are priced at arm's length, given that several Code sections (such as section 482) and the regulations thereunder place strict limitations on what may be considered arm's length in a given industry; (2) applying the definition of a qualified insurance company (QIC) set forth in the passive foreign investment company rules; (3) comparing micro-captives to commercial carriers and special markets, such as commercial excess and surplus lines (“E&S”) carriers; (4) comparing micro-captives to county mutual insurance companies, which commenters said have loss ratios of 40 percent and frequently make section 831(b) elections; or (5) establishing variations of the Loss Ratio Factors for specific regions or States. These recommendations are addressed in turn in this part II.E. of the Summary of Comments and Explanation of Revisions.

1. Premium Pricing Methodology

Many commenters stated that they believe a better standard for assessing whether a micro-captive transaction should be identified as a listed transaction is to evaluate whether an independent, licensed actuary annually determines the premiums. Some commenters suggested that the IRS's real concern is whether premiums are priced fairly, and that if taxpayers can demonstrate that the premiums were priced by a credentialed actuary, employing actuarial techniques to establish premium rates that appropriately reflect the risk of loss and applicable costs, the transaction should be of no concern to the IRS.

The determination of whether a transaction is insurance for Federal tax purposes is based on the totality of the circumstances, but these regulations are not defining insurance for either Federal or State law purposes. Rather, these regulations identify a set of recurring and consistent fact patterns indicating the lack of a non-tax business purpose in related-party transactions that purport to offer insurance for Federal tax purposes. In related party transactions, the lack of arm's length dealing is often a source of abuse. In the micro-captive cases tried to date, the participation of an actuary or other professional in the computation of the premiums (and the taxpayer's insistence that pricing was at arm's length) was not sufficient to make the premiums reasonable, as is necessary for a valid insurance transaction for Federal tax purposes.
See, e.g., Avrahami,
149 T.C. at 196;
Syzygy,
T.C. Memo. 2019-34, at *34-36;
Caylor,
T.C. Memo. 2021-30, at *45-47;
Keating,
T.C. Memo. 2024-2, at *61-62;
Swift,
T.C. Memo. 2024-13, at *41-44;
Patel,
T.C. Memo. 2024-34, at *49-50; and
Royalty Mgmt.,
T.C. Memo. 2024-87, at *46-47;
see also Reserve Mech.,
T.C. Memo. 2018-86, at *55-56, 61;
cf. Harper Grp.,
96 T.C. at 59 (premiums were stipulated to be priced at arm's length);
Securitas,
T.C. Memo. 2014-225, at *12 n.4 (“Respondent does not challenge the reasonableness of premiums.”).

For example, in
Avrahami,
the premiums were priced by a credentialed actuary. The Tax Court was unpersuaded that the actuary's involvement resulted in reasonable premiums and found that the actuary's “calculations [were] aimed not at actuarially sound decision-making but at justifying total premiums as close as possible to $1.2 million—the target—without going over.” 149 T.C. at 196. The Tax Court expressed similar skepticism in subsequent micro-captive cases.
See, e.g., Syzygy,
T.C. Memo. 2019-34, at *17-18, 34-36 (finding that premiums were not actuarially determined after concluding that there was no evidence demonstrating that actuarial methods were followed; that a feasibility study completed by an actuarial consulting firm and an actuarial review completed by the State of Delaware Department of Insurance were focused on solvency, not the reasonableness of premiums; and that the advice of a credentialed actuary was ignored regarding the allocation of premiums between layers in a layered reinsurance arrangement);
Caylor,
T.C. Memo. 2021-30, at *45-47 (finding that a captive manager's pricing methodology was not actuarially sound);
Keating,
T.C. Memo. 2024-2, at *30 n.30 (actuary's opinion that pricing methodology was reasonable did not address specific policies). Further, while section 482 and the regulations thereunder provide standards for when a transaction between related parties is considered arm's length, such determination is wholly fact specific to each arrangement and thus inappropriate as a metric for identifying reportable transactions.

Accordingly, the final regulations do not adopt the commenters' recommendation to replace the Loss Ratio Factors with a metric evaluating pricing methodology. While commenters were critical of the Loss Ratio Factors and suggested that the IRS evaluate pricing methodology, they provided no specific pricing methodology or reliable commercial market source that would enable the IRS to better distinguish between transactions that are or may be tax avoidance transactions and those that are not. The final regulations do not adopt any changes based on this recommendation.

2. Qualified Insurance Company Rules

Section 1297 of the Code sets forth the rules for determining whether a foreign corporation is a passive foreign investment company (PFIC), which can result in adverse Federal tax consequences to a U.S. shareholder of that corporation. Generally, pursuant to section 1297(a), a foreign corporation is a PFIC if: (1) 75 percent or more of its gross income for the taxable year is passive income or (2) the average percentage of assets held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent. However, section 1297(b)(2)(B) provides that passive income does not include income derived in the active conduct of an insurance business by a QIC. Generally, to be a QIC, the foreign insurer must: (1) be a corporation that would be subject to tax under Subpart L if it were a domestic corporation and (2) have “applicable insurance liabilities” (AILs) that exceed 25 percent of its total assets, as provided in section 1297(f)(1), which is referred to as the “AIL test” in this preamble.

The commenter stated that QIC status creates a rebuttable presumption that the purported insurer is a bona fide insurance company and that applying the same QIC test to domestic insurers that have elected to be taxed under

section 831(b) should create a similar rebuttable presumption in these regulations.

The Treasury Department and the IRS have determined that QIC status is not appropriate for determining whether a micro-captive transaction is a tax avoidance transaction or has the potential to be a tax avoidance transaction. Foremost, QIC status does not create a rebuttable presumption that the foreign company is a bona fide insurance company. Rather, QIC status depends on the foreign company being a bona fide insurance company, as that is a prerequisite to satisfying the first prong of the QIC test, that it would be subject to tax under subchapter L (that is, would be taxable as an insurance company for Federal tax purposes) if it were a domestic corporation. The commenter's proposed test is unworkable because it is circular. Further, the entities identified as Captives by the proposed and final regulations claim eligibility to be taxed under section 831(b) of subchapter L and therefore would presumably take the position that they are subject to tax under subchapter L. However, as discussed more fully in parts I.E. and VI.C. of this Summary of Comments and Explanation of Revisions, litigation and audit experience demonstrate that many micro-captive transactions do not meet the requirements for taxation as insurance under the Code.

Nor is the second prong of the QIC test, the AIL test, suitable for determining whether a company is a bona fide insurance company or for identifying micro-captive listed transactions or transactions of interest. The AIL test is based on the ratio of a foreign corporation's applicable insurance liabilities to its total assets as reported on the foreign insurance company's applicable financial statement for a taxable year, as those terms are defined in § 1.1297-4.

The AIL test is appropriate in the PFIC context because the objective of the PFIC provisions generally, that is, independent of insurance considerations, is identifying foreign companies with U.S. shareholders that are predominately passive investment vehicles focused on holding investment assets and earning investment income. The AIL test achieves this objective by identifying foreign insurance companies that, though they are engaged in the active conduct of an insurance business, are nevertheless predominantly passive investment vehicles because they have a very large amount of total assets compared to their insurance liabilities. By failing the AIL test, such foreign insurance companies do not constitute QICs and therefore do not qualify for the PFIC insurance exception under section 1297(b)(2)(B).

The AIL test is not part of the determination of whether a foreign corporation would be an insurance company taxable under subchapter L if it were a domestic company. Further, a foreign insurance company that fails the AIL test would still be a PFIC even if it is a bona fide insurance company and is engaged in the active conduct of an insurance business. It is thus inappropriate to use the AIL test in determining if a company is a bona fide insurance company or to identify micro-captive listed transactions or transactions of interest. Instead, the Loss Ratio Factors are appropriate for this purpose, in part because one indicium of tax avoidance in a micro-captive transaction is excessive premium payments (which taxpayers claim are deductible to the Insured and not taxable to the Captive pursuant to the section 831(b) election) when compared to liabilities incurred for insured losses and claim administration expenses.

3. Commercial and Special Markets Comparison

Commenters compared micro-captives to commercial carriers and special markets, such as commercial E&S (excess and surplus lines) carriers. Commenters pointed out that many commercial insurance business lines and geographical locations consistently have loss ratios of less than 65 percent, and some recommended the loss ratio percentage be based on each line of coverage written by the Captive or similar coverages written by commercial carriers. One commenter identified specific commercial lines of coverage, including Boiler & Machinery, Burglary & Theft, Earthquake, Fidelity, Surety, and Other Liability-Claims Made, as examples of lines of coverage that many micro-captives offer and stated that micro-captives therefore have similar loss and loss ratio distributions to these commercial lines.

Generally, commercial E&S carriers cover risks that are too uncommon, too large, or too unquantifiable to be insured by admitted carriers. In a commercial E&S market, multiple financial backers, grouped in syndicates, come together to pool and spread diversified risks that are placed with the syndicates through authorized brokers. Certain Captives may share some similarities with a commercial E&S carrier, but as a general matter, a typical micro-captive does not comport itself consistently with insurers operating in the commercial E&S market. For example, the risks covered by a micro-captive are often those of relatively few insureds who are concentrated in a small geographic region.
See, e.g., Caylor,
T.C. Memo. 2021-30, at *38 (risks were concentrated in a group operating in a specific geographic location);
Swift,
T.C. Memo. 2024-13, at *31 (risks were concentrated in a specific industry in a small geographical area). Commenters did not explain what aspect of a commercial E&S carrier's loss ratio is substantially comparable to the average loss ratio for a typical micro-captive or how a more reliable metric to identify tax avoidant micro-captives can be derived from a commercial E&S carrier's loss ratio. Thus, loss ratio comparisons between micro-captives and commercial E&S carriers would not constitute an improvement over the current Loss Ratio Factors.

With respect to comments suggesting alternatives based on comparable commercial lines, the Treasury Department and the IRS have determined sufficient relief is afforded by the reductions to the Loss Ratio Factors for both Micro-captive Listed Transactions and Micro-captive Transactions of Interest, as discussed further in parts II.C. and II.D. of this Summary of Comments and Explanation of Revisions. With respect to comments suggesting comparison to certain business lines, the Treasury Department and the IRS are not persuaded that the few specific lines identified by the commenters better represent the variety of lines offered by micro-captives than the case law and national averages for property and casualty companies (excluding certain consumer and business lines), as discussed further in parts II.C. and II.D. of this Summary of Comments and Explanation of Revisions. The final regulations do not adopt any changes based on these recommendations.

4. County Mutual Insurance Company Comparisons

A commenter suggested comparing micro-captives to county mutual insurance companies, which the commenter said have loss ratios of 40 percent and frequently make section 831(b) elections. Like commercial E&S and special markets, county mutual insurance companies are similarly inappropriate for comparison. Although they may also cover risks concentrated in a small geographical area, county mutual insurance companies are subject to different incentives and constraints compared to micro-captive insurance companies because they are wholly owned by their many unrelated policyholders in a manner that does not

resemble the closely held nature of micro-captive insurance companies. For example, if premiums collected by a county mutual insurance company are not used to pay claims, the unrelated policyholders would expect that the county mutual insurance company will reduce future premiums or return some portion of the excess funds to the owners as a dividend or return premiums. Micro-captive insurance companies, on the other hand, face no such expectation. The final regulations do not adopt any changes based on this recommendation. However, for the reasons described in part II.C. of this Summary of Comments and Explanation of Revisions, and consistent with the request by commenters regarding the loss ratios of county mutual insurance companies, the final regulations lower the Loss Ratio Factor for purposes of identification as a listed transaction under § 1.6011-10 to 30 percent.

5. Variations for Regions or States

Some commenters recommended establishing variations of the Loss Ratio Factors for specific regions or States. Accounting for disparities in loss experience from region to region would not be administrable, and, within a given region, different coverages would be subject to different disparities, which would further complicate the analysis. The final regulations do not adopt any changes based on this recommendation because the Treasury Department and the IRS have determined that sufficient relief is afforded by the changes to the Loss Ratio Factors described in parts II.C. and II.D. of this Summary of Comments and Explanation of Revisions.

F. Inclusion of Policyholder Dividends in Loss Ratio Factor Computation

Commenters expressed concerns about the inclusion of policyholder dividends in the computation, indicating that issuance of policyholder dividends may require regulatory approval and is not a common practice of micro-captives, thereby situating a micro-captive to fail the test for insurance in the commonly accepted sense. The Loss Ratio Factors are modified loss ratios, determined for Federal tax purposes, and the inclusion of policyholder dividends in the computation is intended to afford taxpayers a means of correcting inappropriately accumulated premiums, thereby avoiding characterization of their micro-captive arrangements as “transactions of interest” or “listed transactions.” The Loss Ratio Factors have no other purpose or relevance and do not in any way affect or impede the functioning of a Captive. Further, removing policyholder dividends from the computation would unfairly disadvantage Captives that choose to use policyholder dividends to correct overpriced policies. The Treasury Department and the IRS are not persuaded that the issuance of policyholder dividends by itself would cause a transaction to fail the commonly accepted sense prong of the four-prong test for insurance for Federal tax purposes described in part I. of the Background of this Preamble. Courts consider many factors to determine whether an arrangement constitutes insurance in the commonly accepted sense, including whether policies are valid and binding, whether premiums were reasonable and the result of arm's length transactions, and whether claims were paid, and no one factor within the commonly accepted sense prong is dispositive.
See, e.g., Avrahami,
149 T.C. at 191-97;
Caylor,
T.C. Memo. 2021-30, at *41-48; and
Keating,
T.C. Memo. 2024-2, at *53-64. The final regulations do not modify the Loss Ratio Factors in response to these comments.

G. Solvency Concerns

Some commenters protested that establishing a minimum loss threshold by application of the Loss Ratio Factors would negatively impact solvency for captives, by requiring artificially low premiums or imprudent issuance of policyholder dividends. This concern is misplaced. Captive insurers would avoid insolvency in the same way they always have; that is, by insuring risks that are selected and duly reserved for in accordance with sound business judgement and the regulatory requirements of their domicile. Nothing in these regulations requires, encourages, or allows micro-captives to make contractual promises that exceed risk-bearing capabilities. The final regulations do not modify the Loss Ratio Factors in response to these comments.

H. Clarifications Regarding Computation of Loss Ratio Factors

Commenters argued that it may not be possible to calculate a loss ratio applicable to a given taxable year because losses under a policy may not be resolved for years (for example, long-tail coverage), and sought some clarification in the computation of the Loss Ratio Factors. For example, commenters asked whether the “liabilities incurred for insured losses” amount used in the Loss Ratio Factors computations includes losses incurred through participation in pooling arrangements, reinsurance agreements, and retrocession agreements, how micro-captives should compute the applicable loss ratio for long-tail coverage, and whether the current taxable year is included in the number of years being counted for the Computation Periods.

The Computation Periods of ten years for Micro-captive Listed Transactions and up to ten years for Micro-captive Transactions of Interest, respectively, are intended to accommodate the existence of potential long-tail coverage. These commenters appear to contemplate situations in which a Captive incurs losses but for which claims have not been reported (incurred but not reported, or IBNR) or are undergoing further development (incurred but not enough reported, or IBNER). To clarify, the Loss Ratio Factor is computed using the amount of liabilities incurred for insured losses as such term is applied under the relevant accounting method used by the participant taxpayer, as of the end of the relevant taxable year(s).
See, e.g.,
§ 1.446-1(c)(1)(ii) (defining when a liability is considered incurred for accrual method taxpayers). The final regulations do not adopt any changes based on these comments.

With respect to whether the Loss Ratio Factors include losses incurred through pooling arrangements, reinsurance agreements, and retrocession agreements, the final regulations place no limitation on the source of losses incurred by the Captive. The Computation Periods as set forth in §§ 1.6011-10(b)(2)(i) and (ii) and 1.6011-11(b)(2)(i) and (ii) include the most recent concluded taxable year in accordance with § 1.6011-4(e)(2), Rev. Proc. 2005-26, 2005-17 I.R.B. 965, and the Instructions to Form 8886.

III. Comments and Changes Relating to the Financing Factor as Described in Proposed § 1.6011-10(c)(1)

A few commenters argued that the Financing Factor should be removed as a factor for identifying listed transactions and transactions of interest. As proposed, such commenters assert that the Financing Factor fails to consider the circumstances for the financing, suggesting that a better measure of a transaction's potential for tax avoidance is whether the financing reflects an overconcentration in illiquid assets. One commenter stated that nothing in the Code or existing precedent treats related-party financing that is arm's length as abusive. Commenters noted that State regulators generally must approve financing in related-party transactions, and if approved by the State, financing should not be of concern to the IRS.

One of the key abuses seen in micro-captive transactions is the indefinite deferral of tax. Such abuses may be compounded by the use of tax-deferred income for the personal benefit of the related persons involved.
See, e.g., Avrahami,
T.C. 149 at 169-71 (portions of premiums paid made available as loans to related real estate holding company);
Swift,
T.C. Memo. 2024-13, at *18-19 (portions of premiums paid made available to invest in real estate and limited liability companies for the direct or indirect benefit of petitioners); and
Patel,
T.C. Memo. 2024-34, at *11 (portions of premiums paid made available to invest in life insurance for the direct or indirect benefit of petitioners). In an abusive micro-captive transaction, an Insured entity deducts amounts paid directly or indirectly to the Captive that the parties treat as insurance premiums in an arrangement that does not constitute insurance for Federal tax purposes. Captives then exclude those amounts from taxable income under section 831(b). When a financing arrangement is involved, such Captives return some portion of those tax-deferred amounts directly or indirectly to the Insured or related parties via a loan, capital contributions to a special purpose vehicle, or other financing arrangement for which a current tax does not apply. Thus, in a financing arrangement involving an abusive micro-captive transaction, amounts paid as premiums have not only avoided ordinary taxation but have continued to avoid tax while back in the hands of the related parties who caused the premiums to be paid and deducted. This deliberate, continuing avoidance of income tax using benefits to which the participants are not entitled is abusive and identifying transactions with similar fact patterns as listed transactions is consistent with the IRS's pronouncements with respect to micro-captives since before the publication of Notice 2016-66.
See, e.g.,
“Captive Insurance,” IR-2015-19 (Feb. 3, 2015),
https://www.irs.gov/newsroom/abusive-tax-shelters-again-on-the-irs-dirty-dozen-list-of-tax-scams-for-the-2015-filing-season
(last visited Jan. 6, 2025.)

Several commenters noted that related-party financing such as the arrangements described by the Financing Factor can be subject to substantial scrutiny, to the extent that State insurance regulators will permit such financing only after an extensive approval process.
See, e.g., Avrahami,
149 T.C. at 170 (“Insurance regulators often raise bureaucratic eyebrows at related-party dealings.”). Even so, the IRS has seen multiple transactions for which approval was required but not sought, or for which approval may have been granted but, nevertheless, the parties' treatment of the financing arrangement did not comport with industry standards. Based on its experience, the IRS maintains that, in transactions structured as described in the proposed regulations, financing arrangements that create a tax-deferred circular flow of funds are indicative of tax avoidance.

One commenter argued that inclusion of specific factors, such as the Loss Ratio Factor and the Financing Factor, improperly assumes insurance company status can be determined by reference to a single factor. However, the proposed regulations neither define insurance for Federal tax purposes nor identify transactions by a single factor. As discussed more fully in part I.E. of this Summary of Comments and Explanation of Revisions, these regulations do not presume to define insurance for Federal tax purposes; rather, the regulations identify fact patterns that are consistently associated with transactions that are or may be tax avoidance transactions. Regarding commenters' suggestions that the liquidity of a captive is a better measure than the Financing Factor, the commenters did not specify what potential measure of liquidity (such as the character of assets, amount of assets, or comparison of assets to Captive's liabilities) would better identify micro-captive transactions that are or may be tax avoidance transactions. Further, regardless of the specific measure of liquidity used, determinations thereof would be too fact-specific (and dependent upon individual policy terms and jurisdictional requirements) to be administrable. The use of amounts paid as premiums in a tax-preferred manner, and the return of such amounts directly or indirectly to the related parties who benefitted from the original tax deduction, is the tax avoidance addressed by the Financing Factor. While some participants may have obtained regulatory approval to issue the related-party financing, from a Federal tax perspective, the approval of a regulatory body does not answer the question of whether the transaction as a whole should be respected for Federal tax purposes. The final regulations therefore retain the Financing Factor.

However, the Treasury Department and the IRS agree that the presence of related-party financing in a micro-captive transaction by itself may not rise to the level of tax avoidance, as it may be that such financing was determined at arm's length or otherwise treated as a bona fide financing arrangement between the related parties.
See Avrahami,
149 T.C. at 199-204 (finding that the economic reality of the related-party financing at issue, while a close question, could be treated as a bona fide debt obligation, notwithstanding the court's determination that the Avrahami's captive transaction was not insurance for Federal tax purposes). The concern with respect to financing arrangements is the continuing deferral of tax. 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 have revised 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 § 1.6011-10(c)(1), in conjunction with the Loss Ratio Factor as described in § 1.6011-10(c)(2), are identified as listed transactions in the final regulations. 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.

Because the potential for tax avoidance still exists when there is related-party financing, the final regulations include the Financing Factor in the identification of a Micro-captive Transaction of Interest. Taxpayers who are engaged in a transaction described by the regulations that meets the Financing Factor as described in § 1.6011-11(c)(1), the Loss Ratio Factor as described in § 1.6011-11(c)(2), or both, are identified as participating in a transaction of interest in the final regulations. The Financing Computation Period for Micro-captive Transactions of Interest is the same as the Financing Computation Period for Micro-captive Listed Transactions.

IV. Comments and Changes Relating to the Consumer Coverage Exception as Described in § 1.6011-10(d)(2)

A “Consumer Coverage Arrangement” as described in the proposed regulations includes certain arrangements in which a service provider, automobile dealer, lender, or retailer (“Seller”) sells contracts that the parties treat as insurance contracts (“Contracts” as defined in proposed § 1.6011-10(b)(3)) either issued or reinsured by a Captive

related to the Seller (“Seller's Captive”) to its Unrelated Customers (as defined in proposed § 1.6011-10(b)(11)) in connection with the products or services being sold. As noted in the preamble to the proposed regulations, as a general matter, participation in this type of reinsurance arrangement is neither a Micro-captive Listed Transaction nor a Micro-captive Transaction of Interest under the proposed regulations because the insured is not sufficiently related to the Seller's Captive. Generally, in a Consumer Coverage Arrangement, the Insureds under the Contracts that are issued or reinsured by the Seller's Captive are Unrelated Customers of Seller, and these Unrelated Customers, their owners, and persons related to the Unrelated Customers or their owners do not directly or indirectly own at least 20 percent of the voting power or value of the outstanding stock of any entity issuing or reinsuring the Contract.

Nonetheless, the proposed regulations would provide relief from identification as either a Micro-captive Listed Transaction or as a Micro-captive Transaction of Interest under §§ 1.6011-10(d)(2) and 1.6011-11(d)(2) (“Consumer Coverage Exception”) for certain Consumer Coverage Arrangements that would otherwise be Micro-captive Listed Transactions or Micro-captive Transactions of Interest. The proposed exception would apply to arrangements in which the following criteria are met: (1) the arrangement involves a Seller's Captive (meaning a Captive related to Seller as defined in proposed § 1.6011-10(b)(10)); (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: (a) 50 percent; or (b) 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). Proposed § 1.6011-10(d)(2)(iv)(B) is referred to as the “Unrelated Commissions Test”; proposed § 1.6011-10(d)(2)(iv)(A) and (B) are collectively referred to as the “Commissions Test.”

As further discussed in this part IV. of the Summary of Comments and Explanation of Revisions, commenters expressed appreciation for the inclusion of the Consumer Coverage Exception but requested clarification of the Consumer Coverage Exception provisions and recommended changes to the exception, particularly with respect to the Commissions Test.

A. The Commissions Test

Several commenters recommended that the Commissions Test be eliminated from the Consumer Coverage Exception. One commenter recommended that if the Commissions Test is not eliminated from the Consumer Coverage Exception altogether, it should at least be eliminated for commercial insurers acting as Intermediaries (as such term is defined in proposed § 1.6011-10(b)(5)). Several commenters specifically requested the elimination of the Unrelated Commissions Test set forth at proposed § 1.6011-10(d)(2)(iv)(B), expressing concern about the ability of taxpayers to comply with the provision as written.

To explain why the Commissions Test should be eliminated, one commenter argued that commissions seemingly have no applicability to the validity of the insurance arrangement. Two commenters remarked on the lack of a basis for the 50 percent threshold in the Commissions Test, as set forth in proposed § 1.6011-10(d)(2)(iv)(A). The commenters suggested that use of this percentage to determine “abusiveness” of the transactions does not necessarily have any substantive connection to the economic realities of the transaction, which is negotiated at arm's length between customers and Sellers. Commenters noted that customers negotiate the purchase price of consumer coverage with Sellers without regard to the tax implications of Sellers' participation in the underwriting profit of the consumer coverage, and Sellers sometimes agree to lower prices and lower commissions, not for any tax-motivated reason, but because otherwise the customer will not buy the product. One of these commenters said that, as a result, the Commissions Test sets an “arbitrary” standard. The other commenter suggested that the proposed regulations would injure consumers by essentially requiring Sellers to caution their salespeople not to offer discounts, for fear of losing the Consumer Coverage Exception and triggering “transaction of interest” status. A third commenter noted that, for standard types of coverage written by commercial insurers, such as automobile service contracts, the market is strongly competitive, and the effect of the proposed regulations would be to reduce that competition by requiring consumers to pay a commission mark-up on consumer coverage of at least 100 percent of the net premium charged by the insurer.

One of the commenters remarked that the 50 percent threshold in the Commissions Test would only make sense if the IRS had reason to believe that the sale of products at a lower rate is an indication of a non-market driven effort to artificially transfer otherwise taxable revenue to the micro-captive. The commenter asserted that, in over 30 years, the commenter had never seen this issue raised in examination, read cases of this happening, or heard that the IRS has actual evidence that it in fact occurs. The commenter further asserted that Consumer Coverage Arrangements “have already been examined, and deemed not to justify listed transaction treatment,” as evidenced by the listing of certain consumer coverage transactions in Notice 2002-70, 2002-2 C.B. 765, and subsequent “de-listing” of those transactions in Notice 2004-65, 2004-2 C.B. 599. The commenter distinguished Consumer Coverage Arrangements from the micro-captive transactions determined by the Tax Court in recent cases not to be insurance for Federal tax purposes. To the extent the IRS has had successful Tax Court outcomes in the micro-captive area, the commenter asserted, those cases all concerned enterprise risk; none were concerned with unrelated third-party consumer risk arrangements.

Another commenter called the Commissions Test “vague, unworkable, anti-consumer and anti-competitive,” asserting that the IRS should not be requiring, or even encouraging, payment of high commission rates as a condition of the exception. The commenter observed that the Commissions Test seems to be based upon section 482 of the Code transfer-pricing concerns rather than failure of risk transfer and risk distribution and lack of arm's-length dealing and sound business practices, the issues identified by the preamble to the proposed regulations as the focus of the proposed regulations. The commenter asserted that the real concern of the regulations should be to ensure that the net premiums paid to the Captive are not excessive. The commenter observed that commercial insurers writing consumer coverage for sale through dealers typically specify a schedule listing various products and the applicable net premium for each (that is, after the dealer's withheld commission) payable to the insurer for each, and that these net premiums are set by the commercial insurer based upon actuarial analysis of the risks to be covered. The commenter further

observed that the gross amount paid by the customer (including the amount above the specified net premium that the dealer retains as a commission) is subject to negotiation by each customer, and the commercial insurer may not be informed of the commission or who earns it.

To address this commercial insurer scenario, the commenter proposed a safe harbor from material advisor and participant status for commercial insurers acting as Intermediaries (as defined in proposed § 1.6011-10(b)(5)) in transactions that do not involve the payment of excessive premiums to the captive. However, because the proposed safe harbor would be for any commercial insurer acting as an Intermediary in a micro-captive transaction, unless the commercial insurer (or related company) retrocedes risks with respect to consumer products and pays a reinsurance premium in excess of an arm's length amount, the effect of this safe harbor would not be limited to Consumer Coverage Arrangements. Because the proposed safe harbor has implications beyond Consumer Coverage Arrangements, it is discussed in part V.B. of this Summary of Comments and Explanation of Revisions.

Commenters also remarked that elimination of the Commissions Test would make application of the Consumer Coverage Exception more streamlined and efficient and less burdensome. One of the commenters expressed concern that not all Sellers capture information about sales and commissions in a way that will facilitate calculation of “the fee, commission, or other remuneration earned by any person or persons, in the aggregate, for the sale of the Contracts, described as a percentage of the premiums paid by the Seller's customers.” The commenter asserted that this additional cost and effort is not justified “to guard against a theoretical abuse in an industry where the Service has already found that insufficient evidence of abuse exists to justify listed transaction treatment.”

After careful consideration of the comments received generally requesting the elimination of the Commissions Test and specifically requesting the elimination of the Unrelated Commissions Test, the Treasury Department and the IRS are persuaded that elimination of the Commissions Test in the Consumer Coverage Exception is appropriate. The tax avoidance or potential for tax avoidance that the Commissions Test intended to identify is distinguishable from the closely held arrangements associated with the fact patterns identified in §§ 1.6011-10(a) and 1.6011-11(a); for example, the ultimate policyholders are commonly Unrelated Customers in Consumer Coverage Arrangements. Accordingly, the Commissions Test is eliminated from the Consumer Coverage Exception in the final regulations.

One commenter also sought clarification of certain aspects of the Commissions Test. However, because the Commissions Test is eliminated from the Consumer Coverage Exception in the final regulations, no further explanation is necessary.

B. Restricting Consumer Coverage Arrangements Identified as Reportable Transactions Through Clarification of Defined Terms

The definition of “Insured” set forth in proposed § 1.6011-10(b)(4) and incorporated in proposed § 1.6011-11(b)(4) is “any person that conducts a trade or business, enters into a Contract with a Captive or enters into a Contract with an Intermediary that is directly or indirectly reinsured by a Captive, and treats amounts paid under the Contract as insurance premiums for Federal income tax purposes.” One commenter on the Consumer Coverage Exception recommended that the final regulations clarify that this definition is not intended to include someone who is only covered by the policy for a momentary period of time during which the underlying sales transaction is being finalized. The commenter noted that the preamble appears to indicate that guaranteed asset protection (GAP) products are an example of a “dealer obligor” arrangement in which a Seller could be considered the Insured for a short transitory time period occurring between the time the covered product is delivered to the Unrelated Customer of Seller and the financing to purchase the product is finalized for the Unrelated Customer. The commenter asserted that such situations should not trigger a reporting obligation since this is a temporary condition arising solely from an administrative need to allow third parties to process paperwork.

Another commenter asked that the final regulations clarify that a Seller that only directly or indirectly reinsures Contracts that ultimately benefit Unrelated Customers, such as GAP contracts, is not an Insured, even if the Seller is technically a transitory or residual obligor under the contract. The commenter suggested that if this recommendation is not adopted, the definition of “Captive” set forth in proposed § 1.6011-10(b)(1) and incorporated in proposed § 1.6011-11(b)(1), should be modified to exclude any entity that only issues Contracts to Insureds, where the ultimate beneficiaries of such contracts are Unrelated Customers, to the extent that the total percentage of issued and reinsured GAP and similar Contracts provided to Insureds of such entity do not exceed 25 percent of the total issued and reinsured Contracts for such entity. The commenter noted that this definition would remove burdensome compliance data collection from what is essentially a minority of the entity's contracts and would permit the IRS to focus on situations where there is greater potential for tax avoidance.

The final regulations make no change to the definitions of Insured and Captive in response to these comments. A Seller is an Insured only if it “enters into a Contract with a Captive or enters into a Contract with an Intermediary that is directly or indirectly reinsured by a Captive.” A Seller is not an Insured if it facilitates an Unrelated Customer entering into a Contract with Seller's Captive or an Intermediary but is not itself a party to the Contract. A Seller is an Insured only if it treats amounts paid under the Contract as insurance premiums for Federal tax purposes. To the extent a Seller receives and makes payments under a Contract as an agent of a party or parties to the Contract, the Seller would not treat amounts paid under a Contract as insurance premiums for Federal tax purposes. As a general matter, therefore, a Seller that only facilitates the direct or indirect insurance or reinsurance of Contracts that ultimately benefit Unrelated Customers, such as GAP contracts, and does not reflect the tax benefits of participating in a purported insurance transaction in its filed returns, will not be an Insured that is a participant under these regulations. A Seller that satisfies all the requirements of the definition of Insured is appropriately considered an Insured. However, in recognition of concerns expressed by commenters that such situations could potentially arise, the final regulations retain the Consumer Coverage Exception, which may prevent a Consumer Coverage Arrangement in which a Seller (or related person) is an Insured from being identified as a Micro-captive Listed Transaction or Micro-Captive Transaction of Interest.

C. Revising Definition of Seller To Permit De Minimis Sales to Related Persons

The definition of “Seller” set forth in proposed § 1.6011-10(b)(9) and incorporated in proposed § 1.6011-11(b)(8) is “a service provider, automobile dealer, lender, or retailer that sells products or services to

Unrelated Customers who purchase insurance contracts in connection with those products or services.” A commenter recommended modification of this definition to prevent an occasional sale of an automobile and insurance contract to a related party from disqualifying a Seller's Captive from the Consumer Coverage Exception. The commenter also stated it is important to clarify that it is not a requirement for all purchasers of insurance contracts to be Unrelated Customers for the dealer to be a Seller. The commenter asserted that there is a low risk of tax avoidance if a majority of the Contracts being insured or reinsured by a Seller's Captive are either directly sold to an Unrelated Customer or are for the ultimate benefit of an Unrelated Customer. The commenter suggested a de minimis exception for related party sales by establishing a five percent threshold for such transactions.

In response to these comments, § 1.6011-10(b)(9) of the final regulations clarify that a Seller 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 §§ 1.6011-10(d)(2) and 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 § 1.6011-10(b)(8) of the final regulations) to the Seller.

D. Other Requests for Clarification

A commenter asked for clarification of whether the Consumer Coverage Exception applies when the Seller's Captive neither assumes reinsurance from an unrelated fronting company, nor cedes reinsurance to an unrelated insurer. The Consumer Coverage Exception set forth in proposed § 1.6011-10(d)(2) and incorporated in proposed § 1.6011-11(d)(2) requires that “Seller's Captive issue or reinsure some or all of the Contracts sold to Unrelated Customers in connection with the products or services being sold by the Seller,” that “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 the Seller,” and that the Commissions Test set forth in proposed § 1.6011-10(d)(2)(iv) is met with respect to “the Contracts issued or reinsured by the Seller's Captive.” The involvement of an unrelated fronting company or other unrelated insurer is not required.

The commenter also asked if the Consumer Coverage Exception is intended to apply if Seller's Captive directly insures an entity related to or affiliated with Seller for certain contracts described in the proposed regulations but without fronting or reinsurance attached. The Consumer Coverage Exception set forth in the proposed regulations would not apply in these circumstances because the Seller's Captive is insuring an entity related to or affiliated with Seller (rather than Unrelated Customers of Seller). This would be the case whether or not a fronting company or reinsurer were involved. However, as discussed in part IV.C. of this Summary of Comments and Explanation of Revisions, under §§ 1.6011-10(d)(2)(iv) and 1.6011-11(d)(2) of the final regulations, the Consumer Coverage Exception may apply when a Seller's Captive issues or reinsures Contracts purchased by persons other than Unrelated Customers in connection with products or services sold by the Seller or persons related to Seller, provided that no more than five percent of the Seller's Captive's business is issuing or reinsuring such Contracts. Accordingly, the Consumer Coverage Exception set forth in the final regulations would potentially apply in the circumstances described by the commenter.

A commenter suggested that “coverage for incurring diminished value” should be considered a type of consumer coverage. The preamble to the proposed regulations explains that a “Consumer Coverage contract generally provides coverage for repair or replacement costs if the product breaks down or is lost, stolen, or damaged; coverage for the customer's payment obligations if the customer dies or becomes disabled or unemployed; coverage for the difference between all or a portion of the value of the product and the amount owed on the product's financing, including a lease, if the product suffers a covered peril; or a combination of one or more of the foregoing types of coverage.” However, this is a non-exclusive list. The Consumer Coverage Exception may apply when a Seller's Captive issues or reinsures Contracts in connection with the products or services being sold by the Seller. Such Contracts could include those providing coverage for incurring diminished value.

Another commenter noted that warranty products are also widely sold and reinsured outside the automotive space and often in the business-to-business environment, suggesting that this should be taken into account when drafting terminology in the final regulations related to consumer products and seller captive concepts. The description of the Consumer Coverage Exception and related definitions use generic terms intended to encompass a broad range of products and services, not limited to automotive products and services. Nonetheless, in response to this commenter's apparent concern that the Consumer Coverage Exception as proposed may exclude arrangements “in the business to business environment,” the final regulations clarify that the term Seller includes a wholesaler that sells products or services to customers who purchase insurance contracts in connection with those products or services.

Finally, one commenter asked that the final regulations apply prospectively to Seller's Captives, meaning reporting would be required with respect to Seller's Captives only for taxable years subsequent to the effective date of the final regulations, because otherwise a number of legitimate captives would be subjected to very burdensome information gathering, testing, and reporting for a very small amount of premium income per captive. The commenter suggested that changes such as a 50 percent commission threshold should be applied on a prospective basis only to provide notice to taxpayers. As discussed in the preamble to the proposed regulations, as a general matter, participation in Consumer Coverage Arrangements is neither a Micro-captive Listed Transaction nor a Micro-captive Transaction of Interest because the insured is not sufficiently related to the insurer or any reinsurer. The proposed regulations were not intended to change this, but nonetheless provide a potential exception for taxpayers considered to be participating in a reportable Consumer Coverage Arrangement. The clarifications and changes to the proposed regulations described in this part of the Summary of Comments and Explanation of Revisions are only intended to provide further reassurance that Consumer Coverage Arrangements generally do not give rise to a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest. Further, if the Consumer Coverage Exception for Seller's Captives applied only to taxable

years after the regulations are effective as suggested by the commenter, then the exception would not apply to otherwise open taxable years for which reporting would be required. This would disadvantage taxpayers who otherwise may have qualified for the Consumer Coverage Exception in open taxable years. Consequently, the final regulations do not adopt any changes in response to this comment.

V. Comments and Changes Relating to Identification as Reportable Transactions and Reporting Requirements

A. Comments Relating to Safe Harbors From Identification as Reportable Transactions

1. Proposed Safe Harbors for Amended Returns

A commenter requested a change to the proposed regulations that would allow taxpayers who file amended returns that remove tax benefits previously recognized from participation in the micro-captive transaction to not be designated as participating in a Micro-captive Listed Transaction or a Micro-captive Transaction of Interest. Taxpayers who file amended returns after the due date,

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2025-00393. Public record. Not legal advice.