Loper Bright May Pose Roadblocks for Microcaptive Final Rules

The Treasury Department’s final regulations on microcaptive transactions may have gone astray from what Congress intended when it passed Section 831(b) of the tax code, which allows small insurance companies known as microcaptives to pay tax only on investment income,

Congress created Section 831(b) for small insurers, allowing them to exclude part of their income from tax so small businesses could obtain coverages for cheaper than (or unavailable) on the commercial market. Companies are entitled to benefits under Section 831(b) when the owner of an insured business holds an interest in the insurer no greater than their interest in the operating business.

While Tax Court victories have allowed the IRS to aggressively enforce what it claims are abusive arrangements, the US Supreme Court’s ruling overturning Chevron deference has potentially changed regulatory analysis of these final rules.

Final Regulations

The final regulations come on the heels of recent IRS losses in various listing notice cases. The regulations make captive arrangements—specifically small insurance companies who make Section 831(b) elections—into listed transactions if there is a financing arrangement and the average loss ratio is less than 30% over 10 years.

Arrangements are instead considered transactions of interest if a financing arrangement exists or the average loss ratio over the past 10 years is less than 60%. The difference between the two designations is the penalty involved for failing to properly disclose the transaction.

These loss ratios are huge. Commercial carriers may easily have loss ratios exceeding 70% or 80%. Large captives also may have high ratios, albeit less than commercial carriers. But most small captives don’t have similar ratios and, based on their scale, they can’t afford them. Comparing loss ratios of microcaptives to much larger insurers simply doesn’t work.

Consider a medical practice that uses a captive insurance company as its medical malpractice and stop-loss insurer and has qualified actuaries determine premiums. This isn’t the same situation as a small business that spends hundreds of thousands of dollars on terrorism insurance that doesn’t even provide coverage.

With a 50% medical malpractice loss ratio, the captive would be a transaction of interest. Upon filing Form 8886, used to report what the IRS views as an abusive transaction, there would be a significant chance of audit, since the IRS likely would want more information. And based on the IRS’s one-sized-fits-all approach, the IRS likely will conclude that the arrangement doesn’t qualify as insurance for tax purposes, so deductions will be disallowed and the IRS will impose tax at the captive level.

This surely can’t be what Congress intended with Section 831(b). After the IRS publicly announced its concerns about abusive captive insurance arrangements, Congress increased the premium limit allowed and created a diversification requirement to address estate planning abuses. Amid allegations of abuse, Congress expanded Section 831(b) and curtailed what it thought the abusive practices focused on.

Now, with bright-line rules of what the IRS deems as acceptable and unacceptable transactions, it seems that the IRS has legislated limits on Section 831(b) that don’t exist in that section of the tax code.

Contrast that with the October 2024 final regulations on conservation easements, where the Treasury Department adopted the same hurdle added by Congress to tax code Section 170(h). With those regulations, the Treasury simply created reporting parameters related to the contribution limits Congress created.

There is a notable exception to the microcaptive disclosure requirements: captives that sell insurance contracts exclusively to unrelated parties, such as auto warranty insurers that serve third-party customers. The IRS rightly understands that these captives aren’t the ones to focus on.

Unfortunately, the exceptions end there. While creating simple rules for when a captive must report may be a nearly impossible task, the alternative is worth consideration. Leave it to Congress.

Regulatory Shift

The Supreme Court’s 2024 rulings in Loper Bright Enterprises v. Raimondo and Corner Post Inc. v. Board of Governors shifted the playing field of regulatory construction. Agencies no longer enjoy sweeping deference to their interpretation of laws that existed under the Chevron doctrine, especially when Congress hasn’t expressly delegated its authority.

In such situations, the question is what’s the “single, best meaning” of the statute. Section 6707A authorizes the IRS to designate transactions as transactions of interest or listed transactions. But it is difficult to read this grant of authority by itself.

If that were the case, then the IRS could choose to designate every code section to be a listed transaction. Such a result is realistically improbable, but surely Congress meant only abusive transactions. And how can Congress or a court know if a transaction is abusive without analyzing the operable code section (in this case, Section 831(b))?

That brings us back to the IRS creating bright-line rules that aren’t in the statute or legislative history of Section 831(b). Congress didn’t ask the Treasury to do that.

Section 831(d) explicitly grants Treasury the authority to require reporting specific to how a taxpayer meets diversification requirements. Yet Congress hasn’t expressly granted authority to the Treasury to promulgate regulations on any other part Section 831(b).

Without an express delegation of authority, a court would have to look at whether the regulations are the best meaning of Section 6707A and Section 831(b). A court may lean on Section 6707A’s authority to find that the Treasury acted properly. It also may find the requirements imposed by the new regulations violate congressional intent with Section 831(b).

While only a court can answer these questions, we know Loper Bright changed the analysis. The Treasury’s regulations clearly implicate non-abusive captives. Whether this inclusion is a violation of congressional authority to the Treasury could be tested soon.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Meeren Amin is partner with Fox Rothschild, focusing on assisting businesses and individuals in finding solutions to complex tax controversies.

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