A captive insurance company is an insurer owned by, or related to, the business it insures. If the arrangement is genuine insurance, the operating business may deduct the premiums. Small captives that elect special tax treatment under IRC §831(b), often called micro-captives, have drawn sustained IRS attention, and certain micro-captive arrangements are now listed transactions or transactions of interest.
How a Captive Works
The operating business buys insurance policies from a related insurance company and pays premiums to it. The captive must operate as a real insurer: it issues binding policies, maintains adequate capital, is regulated in its domicile, and pays covered claims. The operating business can deduct the premiums only if the arrangement is insurance for federal tax purposes.
The Section 831(b) Election
Under IRC §831(b), a property and casualty insurance company whose net written premiums (or direct written premiums, if greater) do not exceed a statutory limit, $2.2 million adjusted for inflation, and that meets diversification requirements may elect to be taxed only on its taxable investment income. The premiums it receives are then not taxed to the captive. The diversification rules generally require that no more than 20% of premiums come from any one policyholder, or that ownership meet an alternative test aimed at family ownership. Once made, the election can be revoked only with IRS consent.
To make the election, the captive must be an insurance company, which means more than half of its business must be issuing insurance contracts or reinsuring risks.
What Counts as Insurance
Courts look at four elements: risk shifting, risk distribution, insurance risk, and whether the arrangement is insurance in the commonly accepted sense. The Supreme Court held in Helvering v. Le Gierse, 312 U.S. 531 (1941), that both risk shifting and risk distribution must be present. The risk must be an insurance risk, not merely an investment or business risk.
In Avrahami v. Commissioner, 149 T.C. 144 (2017), the Tax Court listed factors it considers in deciding whether an arrangement is insurance in the commonly accepted sense, including whether the company was organized, operated, and regulated as an insurer; whether it was adequately capitalized; whether the policies were valid and binding; whether premiums were reasonable and set at arm’s length; whether claims were paid; whether the policies covered typical insurance risks; and whether there was a legitimate business reason to buy insurance from the captive.
The deduction depends on whether the captive provides real insurance, with arm’s-length premiums, genuine risk, and claims that are actually paid. Tax savings alone do not make an arrangement insurance.
Micro-Captive Listed Transactions and Transactions of Interest
Final regulations published January 14, 2025 (Treasury Regulations §§1.6011-10 and 1.6011-11) identify certain micro-captive arrangements as listed transactions and others as transactions of interest. The regulations use objective factors, including whether the insured business, its owners, or related persons own at least 20% of the captive, whether the captive’s funds are used for financing to related parties, and whether the captive’s loss ratio (claims and related costs compared with premiums) falls below 30% over a ten-year computation period for a listed transaction or below 60% for a transaction of interest.
Participants and material advisors in these transactions must file disclosure statements. The IRS’s earlier identification of micro-captive transactions in Notice 2016-66 was set aside by a federal district court in CIC Services, LLC v. IRS (E.D. Tenn. 2022) for failure to follow notice-and-comment procedures; the 2025 regulations were issued through formal rulemaking.
Consequences When a Captive Fails
If an arrangement is not insurance, the operating business loses its premium deductions, and the captive may lose the benefit of its §831(b) election. The taxpayer owes the additional tax plus interest and may face a 20% accuracy-related penalty. For reportable transactions, the penalty under IRC §6662A is 20%, or 30% if the transaction was not disclosed, and a separate penalty under IRC §6707A applies for failing to file a required disclosure.
When a Captive May Make Sense
A captive is more likely to hold up when the business has real, insurable risks that are costly or unavailable in the commercial market; premiums are set by an independent actuary based on those risks; the captive is adequately capitalized and regulated; claims are filed and paid in the ordinary course; and the captive’s funds are not lent back to the owners. The costs of formation, regulation, actuarial work, and administration should be weighed against the risk-management benefits.
The Bottom Line
Captive insurance can be a legitimate risk-management tool, but the tax treatment depends on whether the arrangement is genuine insurance. Owners of existing micro-captives should review whether the 2025 regulations require disclosure, and anyone considering a captive should evaluate it on its insurance merits first.
Questions about a captive insurance arrangement?
Tax attorney Cassra Minai, Esq. can review your situation in a confidential consultation.