Captive Insurance

Among the structures pitched aggressively to profitable business owners is the so-called “micro-captive” under IRC §831(b), “Tax on insurance companies other than life insurance companies”, in which the business sets up a small insurance company, pays it tax-deductible premiums, and the captive itself elects to be taxed only on investment income (premiums up to a statutory cap, $2,900,000 for tax years beginning in 2026 and indexed, are excluded from the captive’s taxable income). In the legitimate application — a business with a genuine and otherwise-uninsurable risk profile, arm’s-length actuarial pricing, and real claims activity — the structure is sound and useful. That application is rare. The promoted version, where a profitable business buys “coverage” it will never claim against from a captive owned by the same family trust, has been on the IRS “dirty dozen” list for over a decade and has lost in the Tax Court repeatedly ( Avrahami, Reserve Mechanical, Caylor Land, others).

The disclosure regime has been rewritten twice and is still being litigated, so readers working from older material will have the wrong citation. The IRS originally designated these arrangements transactions of interest in Notice 2016-66; that notice was set aside as procedurally invalid for skipping notice-and-comment rulemaking (CIC Services, LLC v. IRS, E.D. Tenn. 2022). The agency redid the work properly: final regulations issued as T.D. 10029, effective January 14, 2025, classified the worst-designed arrangements as listed transactions under Treas. Reg. §1.6011-10 and the rest as transactions of interest under Treas. Reg. §1.6011-11, with mandatory disclosure by participants and material advisors and the extended statute of limitations and penalties that attach to reportable transactions.

Only half of that survived. In Drake Plastics Ltd. Co. v. IRS (S.D. Tex. April 2026) the court vacated Treas. Reg. §1.6011-10, holding that the IRS had never found the transactions it described to be presumptively tax-avoidant and so could not list them. The transaction-of-interest half was upheld two months later in Ryan LLC v. IRS (N.D. Tex. June 2026), which found the loss-ratio and financing criteria reasonable indicators of tax-avoidance potential. The practical position for 2026: the listed designation and its $200,000-scale penalties are off the table while the vacatur stands, the disclosure obligation under Treas. Reg. §1.6011-11 is fully in force, and an appeal or a re-done administrative record could restore the listing. Nothing about that changes the underlying audit exposure — the substantive cases the promoters lose are decided on whether the arrangement constitutes bona fide insurance, not mere disclosure compliance.

The regulations draw the line on two objective factors, and you can compute both from your own records instead of waiting for a promoter’s opinion letter:

The loss ratio factor

The captive’s liabilities for insured losses and claim administration expenses, divided by premiums earned less policyholder dividends, measured over the computation period — for the transaction-of-interest test, the most recent ten taxable years, or every year of the captive’s existence if it has been in business less than ten. A captive that collects premiums and pays almost no claims fails here, which is precisely the design promoters sell.

The financing factor

The captive made capital available to the owner, the insured, or a related party — a loan, a guarantee, or any other transfer — in a way that produced no taxable income to the recipient, at any point in the prior five taxable years.

The two factors combine as follows. A captive that has either a loss ratio below 60% or the financing factor is a transaction of interest — the live designation. The vacated listing rule required both a loss ratio below 30% and the financing factor, measured over ten completed years; compute it anyway, because it is the profile the examiner is trained on and the one the government will try to restore. Either designation requires the participant to file Form 8886, “Reportable Transaction Disclosure Statement” with the return for every year of participation, and obliges every material advisor to file Form 8918, “Material Advisor Disclosure Statement”. Failure to disclose carries the IRC §6707A penalty, which is assessed per year and is not proportional to any tax benefit you actually claimed — you can owe it on a transaction that saved you nothing. If you already own a captive and want out, Rev. Proc. 2025-13 establishes a streamlined automatic-consent procedure for revoking the IRC §831(b) election. Promoters continue to sell the structure, and the recent taxpayer wins are procedural — on the merits of whether the arrangement is insurance, the litigation still favors the IRS. Unless your business has the risk profile that genuinely requires captive coverage — and the underwriting work to prove it on audit — decline the pitch.