The IRS has finalized proposed regulations (REG-109309-22) that identify transactions that are “the same as, or substantially similar to,” certain micro-captive transactions as listed transactions, and certain other micro-captive transactions as transactions of interest. (TD 10029, 1/10/2025)
Abusive micro-captive insurance transactions.
According to the IRS, in an abusive micro-captive insurance transaction, an insured entity that owns at least 20% of the voting power or value of a captive insurance company deducts “insurance premiums” paid to the captive in an arrangement that does not constitute insurance for federal tax purposes. The captive then excludes those amounts from taxable income under Code Sec. 831(b).
When a financing arrangement is involved, the captive returns some portion of those tax-deferred amounts to the insured or related parties via a loan or other financing arrangement to which a current tax does not apply. Thus, the “premiums” avoid ordinary taxation in the hands of the captive and continue to avoid tax when back in the hands of the related parties who caused the premiums to be paid and deducted.
Proposed micro-captive listed transaction regs.
Under the proposed regs, a “micro-captive listed transaction” is a transaction in which an owner of an insured holds the necessary interest (the “20 Percent Relationship Test”) in a captive insurance company and
- the captive provides certain financing (the “financing factor”) over the financing computation period, or
- has less than a 65% loss ratio (the “loss ratio factor”) over the loss ratio computation period.
On the other hand, a “micro-captive transaction of interest” is a transaction in which an owner of an insured holds the necessary interest in a captive insurance company and the captive has less than a 65% loss ratio determined over the transaction of interest computation period.
The proposed regs would require participants in either a micro-captive listed transaction or transaction of interest and their material advisors to file disclosure statements.
Final regs adopt proposals with modifications.
The final regulations adopt the proposed regulations with certain modifications. Most of these modifications clarify issues raised by comments on the proposed regulations.
The final regulations incorporate non-substantive changes to the description of the election under Code Sec. 831(b) to better reflect the text of the statute.
The final regs also provide more clarity on when a transaction is considered “substantially similar” to an identified transaction. The term “substantially similar” has also been defined in the final regs by cross-reference to Reg §1.6011-4(c)(4).
Under the final regs, the definition of a “micro-captive listed transaction” is narrowed so that micro-captive transactions are listed transactions only if both the financing factor and the loss ratio factor tests are met.
In addition, the final regs lower the loss ratio factor percentage for both micro-captive listed transactions and micro-captive transactions of interest and extend the transaction of interest computation period from nine to 10 years.
Also, when a transaction hasn’t existed for 10 years, the transaction may only be designated as a transaction of interest rather than a listed transaction.
Collectively, these changes narrow the scope of the regs.
In response to comments about the consumer coverage exception, the final regs eliminate the proposed commissions test because “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 micro-captive fact patterns in the proposed regs.”
Additionally, for purposes of the consumer coverage exception, the final regs clarify that a “seller” is a service provider, dealer, lender, wholesaler, or retailer that sells products or services to customers who purchase insurance contracts for those products or services provided that 95% of all its sales to customers who purchase insurance are to unrelated customers.
Effective and applicability dates.
These regulations are effective on January 14, 2025, and generally apply to transactions that are the same, or substantially similar to, the transactions identified in the final regs as of January 14, 2025. The regs contain more information about the final regs’ applicability, including to captives that have asked permission to revoke their 831(b) election and taxpayers who have filed disclosures with the Office of Tax Shelter Analysis before January 14, 2025.
For more information on micro-captive transactions as transactions of interest, see Checkpoint’s Federal Tax Coordinator ¶S-4445.6.
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