A coalition representing captive insurance, banking, and related sectors is seeking the repeal of an Internal Revenue Service rule that targets microcaptive arrangements, arguing that it imposes undue regulatory burdens on small businesses.
The rule, finalized in January 2025 after a development period that began in 2023, classifies a microcaptive transaction as a “transaction of interest” under specific conditions. These include situations in which the insured holds at least 20% of the captive’s voting power or value, and either the captive’s loss ratio falls below 60% or no taxable income was generated for fund recipients over the prior five years.
Although the rule took effect in January, the IRS announced in April it would not impose penalties on microcaptives that fail to meet the disclosure requirement if they file by July 31. The original deadline was in April but was extended in response to difficulties filers faced during tax season.
In a letter to the IRS and the US Department of the Treasury, organizations including the 831(b) Institute requested that the rule be repealed ahead of the new filing deadline. While the final rule contained revisions reflecting some industry feedback, the coalition maintains that it still undermines the purpose of Section 831(b) of the tax code.
Section 831(b) was enacted by Congress nearly four decades ago to help small and mid-sized businesses manage risk through captives, particularly when access to commercial insurance was limited or unaffordable.
Proponents argue that the IRS’s current approach conflicts with that original legislative intent and imposes compliance obligations that many smaller firms are ill-equipped to manage.
That section allows certain small and medium-sized businesses to exclude premiums from federal income taxes if specific criteria are met. According to the letter, the provision was designed to help businesses that have trouble obtaining insurance through conventional markets or face high costs for coverage.
Why are captives becoming more popular?
In recent years, rising premiums, increased deductibles, and shrinking coverage capacity in the commercial insurance market have led many small businesses to explore alternative risk financing strategies, including microcaptives.
These entities have become a more accessible option for firms facing challenges in securing adequate or cost-effective protection in traditional insurance markets.
The IRS began a nationwide audit initiative targeting microcaptives in 2008, citing concerns that many were being used for tax avoidance. The stakeholder groups noted that although more than 1,100 small captive audit cases are pending, only 10 had gone to trial as of June 16.
Of those cases, more than 27% resulted in settlements of 10% or less of the amounts initially assessed by the IRS.
One notable case – spotlighted earlier this month – involved a settlement between the IRS and Bruce Molnar over microcaptive structures used between 2005 and 2012. The IRS questioned the level of risk distribution and premium pricing in the structures, ultimately leading to a negotiated outcome rather than full litigation.
The IRS has also listed microcaptive transactions among its annual “Dirty Dozen” tax schemes, a designation that signals the agency’s view that such structures may be used to improperly shield income.
Critics of the classification argue that it paints all microcaptives with the same brush, regardless of whether the arrangement meets legitimate risk management criteria.
If implemented as written, the rule would remove a key risk management option for small businesses, said Dustin Carlson (pictured above), president of the 831(b) Institute.
“Commercial insurance is often insufficient, unavailable, or unaffordable to many small businesses; by further restraining access to alternative plans with wide-sweeping and ill-informed regulations, the IRS threatens the continued existence of our nation’s small businesses,” Carlson said in a report from AM Best.
Carlson also said that the rule undermines small business resilience by introducing broad and misinformed restrictions. He said that it reflects a misunderstanding of captive insurance and that such actions are becoming central to policy debates.
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