How does captive insurance work, and why does the IRS target micro-captives?

What it is

A captive is an insurance company owned by the business it insures or by people related to that business. Large companies have used captives for decades to insure hard-to-place risks. A "micro-captive" is a small captive that elects under IRC §831(b) to be taxed only on its taxable investment income, so the premiums it receives are not taxed to the captive.

The operating business deducts the premiums it pays. If the arrangement is real insurance, the deduction and the §831(b) election work together. If it is not, the IRS disallows the deduction, can tax the captive's income, and can impose penalties.

What the law says

Section 831(b) lets a qualifying small insurance company elect to be taxed on its taxable investment income. The statutory premium limit of $2,200,000 is indexed for inflation. Section 4.36 of Rev. Proc. 2025-32 sets the 2026 limit at $2,900,000 of net written premiums, or direct written premiums if greater. Section 831(b)(2)(B) adds diversification requirements, which generally limit how much premium can come from one policyholder, or require that owners' interests in the captive track their interests in the insured business.

Premiums are deductible under IRC §162 only if the arrangement is insurance for federal tax purposes. The courts look for risk shifting, risk distribution, and insurance in the commonly accepted sense, including arm's-length, actuarially determined premiums and real claims handling.

In T.D. 10029 (published January 14, 2025), Treasury finalized Treas. Reg. §1.6011-10, which identifies micro-captive listed transactions, and Treas. Reg. §1.6011-11, which identifies micro-captive transactions of interest.

Requirements and tests

Under the final regulations, both categories start with a captive that has made the §831(b) election and at least 20% related ownership between the insured business, its owners, and the captive. The regulations then apply two factors over a computation period of up to 10 years:

• Listed transaction: the captive has a financing factor, such as a loan or other transfer of its funds back to a related party that was not taxed to the recipient, AND a loss ratio below 30%.
• Transaction of interest: a financing factor OR a loss ratio below 60%.
• The loss ratio compares insured losses and claim administration expenses with premiums earned, less policyholder dividends, over the computation period.
• There is an exception for certain consumer coverage arrangements.
• Disclosure: participants file Form 8886 with the return and send a copy to the IRS Office of Tax Shelter Analysis. Material advisors have their own reporting duties.

How it works

A legitimate captive starts with a risk study: which real exposures the business carries that commercial coverage does not handle well. An independent actuary sets premiums for those risks. The captive is licensed and capitalized as required by its domicile's insurance regulator, pools or reinsures enough unrelated risk to achieve risk distribution, pays valid claims, and invests its reserves conservatively.

The business deducts the premiums, the captive is taxed on its investment income under §831(b), and the owners pay tax when funds come out as dividends or on liquidation. Every year, the participants apply the loss-ratio and financing tests and file Form 8886 if either category applies.

Risks and IRS scrutiny

Micro-captives have been on the IRS enforcement list for years and have appeared on its annual "Dirty Dozen" list of abusive schemes. The Tax Court disallowed premium deductions in Avrahami v. Commissioner, 149 T.C. 144 (2017), and in later cases, including Syzygy Insurance Co. v. Commissioner (T.C. Memo. 2019-34) and Caylor Land & Development v. Commissioner (T.C. Memo. 2021-30). The Tenth Circuit affirmed the Tax Court in Reserve Mechanical Corp. v. Commissioner (2022).

The patterns that failed include premiums priced to hit a target deduction, risks that were unlikely to produce claims, circular reinsurance pools, very few claims, and money lent back to the owners. Consequences include loss of the deduction, tax on the captive's receipts, the 20% or 30% reportable-transaction accuracy penalty under IRC §6662A, and disclosure penalties under IRC §6707A.

Who it is not for

This is not for any business without real, significant, insurable risks; for anyone whose premium was set to match a desired deduction; for anyone planning to borrow the captive's funds; or for anyone who will not pay for an independent actuary, a licensed insurance manager, and the annual disclosure work. If a promoter leads with the tax savings, treat that as a warning sign.

How ebotCPA helps

We review an existing or proposed captive against the §831(b) rules, the insurance case law, and the T.D. 10029 loss-ratio and financing tests. We prepare the required Form 8886 disclosures and tell you plainly when the facts do not support the arrangement, including exit options. We coordinate with your attorney, who drafts the legal documents. We also work with the captive's actuary and insurance manager.

Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.

Primary sources

1. 26 U.S.C. §831(b). Alternative tax for certain small insurance companies.

   “the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $2,200,000”

   Allows an eligible small insurer to elect tax on taxable investment income only, subject to a premium limit and diversification requirements.

2. Rev. Proc. 2025-32, §4.36. 2026 inflation adjustments.

   “the amount of the limit on net written premiums or direct written premiums (whichever is greater) is $2,900,000”

   Sets the 2026 §831(b) premium limit at $2,900,000.

3. Treas. Reg. §§1.6011-10 and 1.6011-11 (T.D. 10029). Micro-captive listed transactions and transactions of interest.

   Identifies micro-captive listed transactions (financing factor and loss ratio below 30%) and transactions of interest (financing factor or loss ratio below 60%).

4. 26 U.S.C. §6707A. Penalty for failure to disclose a reportable transaction.

   Sets the penalty at 75% of the tax decrease, capped at $100,000 for individuals and $200,000 for others for listed transactions.

5. IRM 20.1.13. Material advisor and reportable transaction penalties.

   Describes how the IRS administers the reportable-transaction disclosure penalties.

6. Avrahami v. Commissioner, 149 T.C. 144 (2017). Micro-captive premiums not deductible.

   Held that the captive arrangement was not insurance, so the premiums were not deductible.

Frequently asked questions