Microcaptive Insurance: Tax and Formation Requirements

A microcaptive is a small insurance company established by a parent company to insure its own risks, often providing customized coverage for things like supply chain disruptions that may be unavailable or unaffordable commercially. While these entities serve a risk management purpose, they also offer tax advantages that have attracted significant scrutiny from the Internal Revenue Service (IRS). The IRS is concerned that many microcaptives are created primarily for tax avoidance rather than legitimate insurance needs, leading to increased audits and specific reporting requirements.

The Tax Framework for Microcaptives

The defining tax feature of a microcaptive is an election under Internal Revenue Code Section 831(b). This allows it to be taxed differently than a traditional insurer. To qualify, the company’s net written premiums must not exceed an inflation-adjusted annual limit, which for 2025 is $2.85 million.

With a valid 831(b) election, the microcaptive is not taxed on its underwriting profit from premium income, only on its net investment income. The parent company can generally deduct the premium payments as a business expense. This allows the captive to build a surplus from untaxed premiums, which can be invested to generate taxable returns.

The captive must also meet diversification requirements, preventing it from receiving more than 20% of its premiums from any single policyholder. The election must be made by the tax return due date for the first effective year. A simplified procedure now provides for automatic consent to revoke the election.

Core Insurance Requirements

For a microcaptive to be respected by the IRS, it must function as a genuine insurance company based on two principles from case law: risk shifting and risk distribution.

Risk Shifting

Risk shifting requires transferring the economic impact of a potential loss from the insured business to the captive. If a covered loss occurs, the captive is financially responsible for the claim. The captive must be adequately capitalized with enough funds to cover claims beyond its collected premiums, or courts may view it as a self-funded reserve.

Risk Distribution

Risk distribution is spreading risk across multiple, independent exposures. A captive can achieve this by insuring many distinct risks from its parent, such as hundreds of vehicles. Another method is participating in a risk pool, where captives cede risk to a larger pool and assume a portion of the pool’s risk in return. The IRS examines these pools to ensure a genuine sharing of risk.

Information and Analysis for Formation

A formal feasibility study is the first step, assessing if a captive is a sound decision. It involves a risk assessment to identify insurable risks not covered commercially and projects the captive’s financial performance, including premiums, claims, and costs.

An actuarial analysis is a component of the feasibility study. An independent actuary must determine appropriate premium amounts based on the risks insured. Premiums must be priced at arm’s length, similar to what a commercial insurer would charge, to show regulators and the IRS the captive is a legitimate insurance business.

Finally, the initial capitalization required to fund the captive is determined. This capital is separate from premiums and serves as the financial backstop to pay claims. The amount needed depends on the policies being written and must meet the minimum requirements of the chosen jurisdiction.

The Establishment Process

A primary decision is selecting the captive’s domicile, the jurisdiction where it will be licensed and regulated. Domiciles can be onshore in the United States or offshore. Each has its own laws and capital requirements, so the choice depends on the parent’s business structure, risks insured, and costs.

Next, a formal insurance license application is submitted to the domicile’s regulator. This application includes the business plan, pro forma financials, and actuarial analysis. The regulator reviews this to ensure the captive is financially sound and has a legitimate business purpose.

Upon license approval, the final step is to fund the captive. This involves transferring the predetermined initial capital from the parent company to the captive entity. This capital must be deposited before the captive can begin writing policies and accepting premiums.

Ongoing Operational and Reporting Duties

After formation, a microcaptive must be managed as an active insurance company with ongoing duties. These responsibilities are necessary to maintain its regulatory standing and substantiate its treatment as an insurer for tax purposes.

Operational management involves formal underwriting to evaluate risks and issue policies. The captive must also have a claims management process to handle and pay claims. Furthermore, its assets must be managed according to an investment policy that balances growth with the need for liquidity.

For tax compliance, the microcaptive must file an annual Form 1120-PC to report its taxable investment income. The IRS also has specific disclosure requirements. An arrangement may be classified as a “Listed Transaction” or a “Transaction of Interest,” both of which require filing Form 8886, Reportable Transaction Disclosure Statement. Failure to file can result in significant penalties.