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The IRS has extended penalty relief for non-disclosure of certain micro-captive insurance transactions while formalizing stricter criteria for classifying these arrangements as "listed transactions" or "transactions of interest." These classifications determine reporting obligations and potential penalties under the 2025 final regulations.

In Notice 2025-24, published on April 11, 2025, the IRS stated that individuals and entities who failed to file mandatory disclosure forms for specific micro-captive arrangements can avoid penalties if they submit the required documentation by July 31, 2025. This includes Form 8886 for participants and Form 8918 for material advisors, both of which must be filed with the Office of Tax Shelter Analysis (OTSA).

The relief applies to penalties under sections 6707A(a) and 6707(a) of the Internal Revenue Code, which address failures to disclose reportable transactions. However, it does not extend to other reporting obligations, such as filing disclosures with tax returns or maintaining client lists, which remain in effect.

This development follows the IRS's finalization of regulations in January 2025 that designated certain micro-captive insurance arrangements as "listed transactions" or "transactions of interest." These classifications impose stringent disclosure and recordkeeping requirements, with significant penalties for noncompliance.

Micro-captive transactions have been flagged by the IRS as potential tax avoidance schemes and have appeared on its "Dirty Dozen" list for several years. The agency continues to challenge arrangements it deems abusive and has disallowed related tax benefits during audits and litigation.

Criteria for Micro-Captive Classifications

Listed Transactions

To qualify as a listed transaction – considered abusive tax avoidance – a micro-captive must meet all of these requirements:

1. Ownership threshold: The insured or related party owns ≥20% of the captive's voting power, stock value, or equity

2. Loss ratio: <30% average over 10 consecutive tax years (entire existence if younger)

3. Financing factor: Provided loans/guarantees to related parties without generating taxable income within the past 5 years

Example: A 12-year-old captive with 25% parent company ownership, 28% loss ratio since inception, and $2M in tax-free loans to subsidiaries would be classified as listed.

Transactions of Interest

These potentially questionable arrangements require disclosure if both conditions exist:

1. Ownership threshold: Same ≥20% requirement as listed transactions
2. Either:
   • Loss ratio <60% over 10-year period (or lifetime if younger)
   • Existence of financing factor (as defined above)

Key exceptions:

• Consumer Coverage Arrangements (CCAs) insuring unrelated third parties
• Employee benefit captives
• Entities with loss ratios above thresholds

Regulatory Evolution

The final regulations tightened previous proposals by:

• Lowering loss ratio thresholds from 65% to 30% (listed) and 60% (interest)
• Requiring both financing and loss factors for listed status
• Extending computation periods from 9 to 10 years
• Implementing conjunctive rather than disjunctive criteria

Taxpayers must file Form 8886 for either classification and Form 8918 for material advisors, with disclosures due to OTSA.  The IRS maintains authority to challenge arrangements meeting these criteria through audits and litigation, particularly those appearing on its annual "Dirty Dozen" list of tax avoidance schemes.

The information provided is for general informational purposes only and should not be construed as legal, tax, or insurance coverage advice. It is not intended to replace consultation with qualified professionals in these fields. For specific advice tailored to your circumstances, please consult with a licensed attorney, tax advisor, or insurance professional.