IRS Audits of Micro-Captive Insurance Companies: Litigation, Disclosure, and Compliance Trends

At the 2025 CICA International Conference, the session titled "IRS Audits—Now and the Future" examined how micro-captive insurance companies that elect 831(b) tax treatment are being assessed amid evolving regulatory guidance and recent tax court rulings. Panelists Charles "Chaz" Lavelle (Dentons Bingham Greenebaum), Kacie N. Dillon (Woolston & Tarter), and Eryn Brasovan (Womble Bond Dickinson) outlined key litigation outcomes, updated Internal Revenue Service (IRS) disclosure requirements, and emerging compliance expectations for micro-captive owners and advisers. 

This summary is based on the panel's presentation materials, which highlight both emerging risks and best practices in navigating the current enforcement environment. 

Recent tax court decisions—including Royal Management, Caylor, and Keating—underscore the need for captives to operate in a manner that aligns with long-established insurance principles. These rulings highlight the importance of issuing policies in a timely manner, ensuring that coverage addresses genuine business risks, and setting premiums through sound actuarial analysis. Courts have been clear: Insureds must understand the protection they are purchasing, and documentation should establish a legitimate, non-tax business purpose for forming and operating the captive insurance company.  Inconsistent or boilerplate policy language, inadequate claims administration, and overly aggressive investment strategies have all drawn judicial scrutiny. 

At the same time, the courts have not always fully appreciated the structural and operational differences between small captives and large commercial insurers. According to one slide, "courts still do not appreciate" key distinctions in policy design, investment allocation, and the use of pooling arrangements. The infrastructure and staffing expectations placed on small captives are often unrealistic when compared to the scale and resources of traditional insurers. As the presentation reminded attendees: "CAPTIVES ARE A GOOD RISK MANAGEMENT TOOL." 

Captive insurance companies must be formed and operated with a clearly defined business purpose that goes beyond tax planning. Risk coverage should reflect the enterprise's actual exposures, supported by a documented rationale that demonstrates sound underwriting intent. Engaging experienced, independent service providers is essential—not only to meet technical requirements but to ensure the captive benefits from meaningful insurance expertise. These advisers should contribute actively to program design and oversight rather than simply carrying out administrative tasks. 

Under final regulations issued on January 14, 2025, the IRS now classifies certain micro-captive arrangements as either listed transactions or transactions of interest. These classifications apply when a captive elects 831(b) tax treatment, reinsures or issues contracts treated as insurance under federal law, and is at least 20 percent owned by the insured or a related party. 

Two key hallmarks determine classification status. A low loss ratio—below 30 percent over a rolling 10-year period—and the presence of a financing transaction within the past 5 years, such as a loan or other payment to a related party, are considered indicators of heightened IRS concern. If both hallmarks are present, the arrangement is treated as a listed transaction and subject to the agency's most rigorous disclosure and enforcement protocols. If only one is present, the arrangement may be considered a transaction of interest. In either case, disclosure is required on IRS Forms 8886 (by participants) and 8918 (by material advisers). The statute of limitations for listed transactions is extended to 1 year after the required disclosure is filed. 

Disclosure remains required in a variety of scenarios, even if the captive insurance structure appears legitimate or has previously undergone IRS review. These include situations involving commercial fronting arrangements, amended tax returns, revoked 831(b) elections, or prior no-change letters issued by the IRS. While some exceptions exist—for example, captives writing at least 95 percent unrelated party business or those that revoked their election before April 14, 2025—these carve-outs are narrowly defined. Rev. Proc. 2025–13 outlines the procedure for revoking an election for both current and prior tax years by submitting written notice to the IRS. 

For each open tax year involving a listed or reportable transaction, disclosure is mandatory. In cases where the insured is a pass-through entity, the individual owners may also be responsible for filing unless the entity formally notifies the IRS that it will report on their behalf. Material advisers must file unless they have not made a tax statement relating to the transaction within the past 6 years. The deadline for filing was April 14, 2025—90 days after publication of the final regulations in the Federal Register. 

The IRS's disclosure requirements reflect a broader enforcement focus on transactions that may lack economic substance. Under IRC § 7701(o), a transaction is considered to have economic substance only if it results in a meaningful change in the taxpayer's economic position (apart from federal income tax effects) and is undertaken with a substantial purpose beyond tax. Penalties for failing this test are 20 percent under IRC § 6662(b)(6), increasing to 40 percent under IRC § 6662(i) if the transaction is not properly disclosed. Filing Form 8886 is the standard method of disclosure and, when timely and accurately completed, may satisfy the requirement for adequate disclosure. 

In Patel v. Commissioner, the tax court concluded that the taxpayers were not entitled to deduct premiums paid to their captive insurer. However, the court has yet to decide whether penalties apply under the economic substance doctrine. According to the slides, the court is still evaluating whether IRC § 7701(o) includes a relevancy threshold and whether Congress's statutory authorization of captive-related tax benefits has any bearing on the doctrine's application. Oral arguments were held on February 12, 2025, and a further opinion is pending. 

As of March 2025, eight tax court cases involving 831(b) captive insurance companies had reached a decision. Two were under appeal while four were fully briefed and awaiting resolution. Several additional cases are scheduled for trial later this year. Patel may also proceed to appeal once the court rules on the outstanding penalty issues. Despite the steady stream of litigation, the slides noted, "We have not seen an uptick on IRS audits of 831(b) captives." 

To maintain defensibility, premiums should be actuarially determined and reflect current market data rather than tax thresholds. Captive insurers must meet established risk distribution standards and avoid the use of notional pooling structures—arrangements that simulate risk-sharing without the actual transfer of risk among participants. Claims processes should follow documented procedures and be subject to meaningful oversight. Governance must comply with statutory and domicile-specific requirements, including the involvement of independent directors. Investment activity should be guided by a formal, documented policy that aligns with regulatory expectations. As the presentation concluded, "Captives with multiple service providers independently advising them are more well-informed and well-protected."