Notice 2016-66: Is Your Micro-Captive a Transaction of Interest?

In January 2025, the Treasury Department and the Internal Revenue Service (IRS) issued final regulations for micro-captive insurance arrangements. These regulations establish new rules for identifying and reporting transactions with potential for tax avoidance, creating two categories of reportable arrangements: “listed transactions” and “transactions of interest.” This framework does not automatically classify these arrangements as improper. Instead, it requires participants to disclose their involvement, allowing the IRS to gather information to determine if a captive is being used for risk management or tax avoidance.

New Reporting Classifications for Micro-Captives

A micro-captive is a small, closely held insurance company that insures the risks of an affiliated business. Under Internal Revenue Code Section 831(b), these captives receive tax benefits if their annual net written premiums do not exceed a certain limit, which is $2.85 million for 2025. This allows the captive to be taxed only on its investment income, while the affiliated business deducts the premiums paid as a business expense. This structure is intended for genuine risk management purposes.

The 2025 regulations target transactions with characteristics suggesting they are not legitimate insurance. An arrangement must be reported if it meets a 20% ownership test, where the business paying premiums, or its owners, directly or indirectly holds at least 20% of the captive’s voting power or stock. If this test is met, the transaction is then classified as a “listed transaction” or a “transaction of interest” based on other factors.

Listed Transaction

A micro-captive arrangement is identified as a listed transaction, a category for structures the IRS considers to have a high potential for tax avoidance, if it meets two conditions. First, the captive provided financing or conveyed its capital to a related party within the last five years. Second, the captive has existed for at least 10 years and has a loss ratio of less than 30% over the most recent 10-year period. Both conditions must be met.

Transaction of Interest

An arrangement is a transaction of interest, a category for structures requiring further scrutiny, if it meets one of two conditions. The first condition is that the captive provided financing to a related party as described above. The second condition is that the captive’s loss ratio over the most recent 10-year period is less than 60% but is 30% or higher. Meeting either of these conditions classifies the arrangement as a transaction of interest.

Required Disclosures and Filings

If a micro-captive arrangement is a listed transaction or a transaction of interest, disclosure obligations are triggered for all involved parties. Participants required to file disclosures include the business paying the premiums, the captive insurance company, and any “material advisors” who provided advice on the transaction for a fee.

The disclosure is made using Form 8886, Reportable Transaction Disclosure Statement. This form must be filed for each taxable year of participation and provide a description of the arrangement, its features, its expected tax consequences, and the identification of all parties involved.

A completed Form 8886 must be attached to the participant’s federal income tax return for each year of participation. A separate copy of the same form must also be mailed to the IRS Office of Tax Shelter Analysis (OTSA). This dual-filing requirement ensures the information is reviewed by the specialized office responsible for tracking these transactions.

Penalties for Non-Compliance

Failing to comply with these disclosure requirements carries financial penalties under Internal Revenue Code Section 6707A. These penalties apply directly to the failure to disclose and are separate from any underlying tax liability if the transaction is later determined to be improper.

The penalty is 75% of the tax decrease resulting from the transaction. The law also sets minimum and maximum penalties. For individuals, the penalty is at least $5,000 and at most $100,000. For entities, the penalty is at least $10,000 and at most $200,000.

Following court decisions that invalidated prior IRS guidance on procedural grounds, the IRS stopped enforcing penalties based on that guidance. However, the final regulations issued in January 2025 re-establish a firm legal basis for these disclosure requirements and the associated penalties. This framework is designed to encourage adherence to the reporting rules. Material advisors are subject to separate penalties for failing to meet their own disclosure and list maintenance obligations.