On January 14, just days before the end of the Biden Administration, the US Treasury continued its multi-decade-long attacks on Congressionally-authorized captive insurance arrangements by issuing a new final regulation relating to 831(b) small captive insurance companies: https://public-inspection.federalregister.gov/2025-00393.pdf.
Unfortunately, the new rule very much resembles the originally proposed rule that received overwhelmingly negative feedback from the captive insurance industry, from CPAs, from attorneys, and even from state insurance regulators. In short, the new rule appears to be every bit as arbitrary and capricious as the old IRS Notice 2016-66 was, and even more so. As you may recall, our firm successfully challenged Notice 2016-66 in court and had it overturned as arbitrary and capricious (after a five-year battle that involved a 9-0 judgment in our favor from the Supreme Court of the United States).
The final rule made a few changes to the previously proposed rule, but those changes do not address the most important criticisms that the IRS received, comments that made clear that the regulation is unwise, arbitrary, capricious, and illegal.
WHAT THE NEW RULE SAYS
The new final regulation designates any captive insurance company that makes an election under section 831(b) as either a Listed Transaction or a Transaction of Interest depending on the circumstances:
Listed Transactions The rule identifies any captive that has made the 831(b) election as a Listed Transaction if:
- Within the prior five taxable years (or all taxable years if the captive has been in existence for less than five taxable years) the captive entered into a financing transaction with an insured that did not result in taxable income or gain to the recipient, such as a guarantee or a loan of premium income
AND
- The captive has existed for ten or more years and has a loss ratio of less than 30%.
(If the captive has not been in existence for at least ten years then it’s not considered to be a “Listed Transaction” but may still be a Transaction of Interest.)
Transactions of Interest The rule identifies any 831(b)-electing captive as a Transaction of Interest if:
- Within the prior five taxable years (including the most recent concluded taxable year), the captive entered into a financing transaction with an insured that did not result in taxable income or gain to the recipient, such as a guarantee or loan of premium income OR
- Within the prior ten taxable years (or in the case of a captive that has been in existence for less than ten taxable years then for all of the captive’s taxable years) the captive has a loss ratio of less than 60%.
However if the captive in question has revoked its section 831(b) election, taxpayers who participated in a Listed Transaction or a Transaction of Interest, including insureds, owners and intermediaries, will not be considered participants in the transaction for any taxable year in which such revocation is effective, provided that a successor captive has not been established. Also, taxpayers who finalized a settlement agreement with the IRS with respect to a captive transaction occurring in a prior year, in examination or litigation, will be treated as having made the required disclosures for years subject to that agreement.
The practical distinction between a Transaction of Interest and a Listed Transaction isn’t that great. Both require taxpayer and material advisors to make essentially the same disclosures to the IRS, informing the IRS of their participation in the transaction (as was previously required by Notice 2016-66) and some select details. The primary difference is that a Listed Transaction is generally considered by the IRS to be per se abusive while Transactions of Interest merely may be abusive.
PROBLEMS WITH THE RULE
The legal and practical problems with the new rule are too plentiful to count. First, captive insurance companies that have not made the 831(b) election are not targeted by the rule at all. This means that if we have two insurance companies operating in exactly the same way—with the same premiums, policies, insureds, and loss histories and the only difference being that one made the Section 831(b) election—only the one that filed the Section 831(b) election can be a Listed Transaction or Transaction of Interest under the new rule.
And that makes absolutely no sense. How can the IRS rationally consider a loss ratio exceeding a certain threshold (30% or 60%), or a particular financing transaction, to be all but conclusive evidence that the transaction is “abusive”, or that the entity isn’t a valid insurance company, while also considering that the exact same type of entity that hasn’t elected to be taxed under 831(b)—an entity with the exact same policies, insureds and loss ratios, etc.—isn’t per se abusive and is presumed to be a legitimate insurance company?
The irrationality of this position makes the IRS’s real purpose clear. The IRS isn’t actually targeting “abusive” arrangements or “illegitimate” insurance companies but rather continues to improperly target a Congressionally-authorized tax incentive that it has long resented, with which it has long disagreed, that it has long pressed Congress to revoke and that it has long sought to illegally suppress. As a matter of proper law, an insurance company doesn’t become per se “illegitimate”, and a transaction doesn’t become per se abusive, simply because of the way the entity elects to be taxed.
We can see the wrongness, and scariness, of the IRS’s position on this point by applying the same (non)logic in a different context. Suppose that we have an individual taxpayer with two investment accounts—one an ordinary taxable account and one an IRA. By making one an IRA, the taxpayer has elected special tax treatment and rules (similar to electing Section 831(b)). Otherwise, the accounts are exactly the same—they were opened at the same time, have the same broker, have always held exactly the same stocks and bonds, etc. The taxpayer has taken no distributions from either account to date.
Now suppose that the IRS were to decide that taxpayers are “abusing” the tax code by accumulating more in their retirement plans than the IRS deems they “need” for “legitimate” retirement reasons. The IRS notes that many taxpayers who have retired “unfairly dodge taxes” by declining to take distributions from their accounts. And others even continue to *add* to their accounts and take additional deductions for doing so.
And so the IRS creates a new regulation saying that any retirement account that is an IRA, that is owned by a person aged 55 or older, and that doesn’t distribute at least “X” percent of its assets each year in a taxable transaction to its owner, is “abusive” and a Listed Transaction or Transaction of interest. Going back to our hypothetical taxpayer above with two retirement accounts, one an IRA and one not, how is it rational to say that the IRA one is “abusive” and reportable while the other isn’t? That position only makes sense if the real goal isn’t to prevent actually abusive investment arrangements but instead is to thwart and disincentivize participation in a Congressionally-endorsed tax incentive.
But there are other problems too: In the example above, how did the IRS come up with the “X” percent IRA distribution requirement? Why and how did the IRS conclude that distributions of at least “X” percent each year render the arrangement non-abusive but distributions of “X-1” percent do not? If the IRS cannot give a rational explanation to that question, then differentiating between legitimate and illegitimate arrangements based in large part on “X” is the very definition of “arbitrary and capricious”, and arbitrary and capricious rules are illegal.
The same logic applies when we look at the 30% and 60% claims ratios that the IRS uses to differentiate between supposedly nonabusive captive 831(b) arrangements and abusive ones. Where did the IRS come up with those percentages? It offers no rational explanation for them. They are the very definition of arbitrary and capricious. And so should be illegal.
The accounting firm Ryan, LLC has already filed a lawsuit in Texas challenging the legality of this new IRS rule regarding 831(b)-electing insurance companies. Other firms, perhaps ours, are sure to follow suit shortly. One way or another, we are confident that illegal, overreaching, arbitrary, and capricious this rule will eventually be overturned by the courts. The main question is: How much cost and hassle will taxpayers have to absorb in the meantime?
In addition, it’s possible that Congress might neuter the rule by taking action under the Congressional Review Act. Or that the Trump Administration will revoke the rule or issue a superseding one that is more rational and targeted. Though it’s a bit unclear, it seems that the effective date of this new rule may already be delayed as a result of Trump’s executive order postponing the effective date of Biden’s last-minute rule-making attempts.
Regardless, in the (we think) unlikely event that the rule is upheld and becomes the law of the land indefinitely, it’s significantly less burdensome on taxpayers and material advisors than the old Notice 2016-66 (which designated nearly all 831(b) captives as Transactions of Interest before it was overturned by the courts). We doubt that those who didn’t abandon their captive in the face of Notice 2016-66 will be any more inclined to do so in the face of this new rule, a rule that we believe to be even more arbitrary and capricious than before.
None of this is tax advice. Readers should consult their own tax professionals to determine the effective date of the new regulation (taking into account any relevant impact of Trump’s executive order), whether it applies to them, and how to comply. To the extent that disclosure is indeed required by a given CIC Services client, CIC Services will provide all relevant data from its records that may be necessary to make the proper disclosures.
We will keep you posted on developments. In the meantime, please let your Senator and Congressperson know your dissatisfaction with this latest attempt by the IRS to undermine and supersede the will of Congress by targeting Section 831(b), and ask them to intervene legislatively (by passing safe harbor definitions of “insurance” and “insurance company” for captives making the 831(b) election.
Sean King, JD, CPA, MAcc | Principal
