District Court Rejects APA Challenge to Final Microcaptive Regulations

(Parker Tax Publishing April 2026)

In a lawsuit brought by a manager of captive insurance companies seeking to set aside the final regulations issued in T.D. 10029 that identify certain micro-captive transactions as listed transactions or transactions of interest, a district court upheld the final regulations under the Administrative Procedure Act and granted summary judgment for the government. The court held that the final regulations are not contrary to law or arbitrary and capricious because they do not prevent qualifying captive insurance companies from obtaining the tax benefits of Code Sec. 831(b) and the IRS reasonably explained its rationale for issuing the regulations. CIC Services, LLC v. IRS, 2026 PTC 55 (E.D. Tenn. 2026).

Background

A micro-captive transaction is typically an insurance agreement between a parent company and a captive insurer under its control. The Code provides the parties to such an agreement with tax advantages. The insured party can deduct its premium payments as business expenses under Code Sec. 162(a), and the insurer can exclude up to $2.2 million of those premiums from its own taxable income under Code Sec. 831(b).

In Notice 2016-66, the IRS classified micro-captive transactions as transactions of interest for the purposes of Reg. Sec. 1.6011-4 and Code Secs. 6011 and 6012. The IRS issued the Notice because it was concerned that certain taxpayers were structuring captive insurance companies to claim tax benefits under Code Sec. 831 without providing real insurance to the parent company. Based on this classification, the Notice required certain taxpayers and material advisors to provide information to the IRS in connection with these transactions.

CIC Services, LLC (CIC) is a Knoxville-based firm that helps small businesses form and manage a captive insurance company. In 2017, CIC filed a lawsuit requesting that the court set aside the Notice and issue an injunction prohibiting enforcement, arguing that issuance of the Notice violated rulemaking requirements under the Administrative Procedure Act (APA) and that the Notice constituted an arbitrary and capricious rule under the APA. In CIC Services, LLC v. IRS, 2022 PTC 402 (E.D. Tenn. 2022), the district court invalidated Notice 2016-66, finding that the IRS failed to follow notice-and-comment procedures required by the APA and that the Notice was arbitrary and capricious under the APA.

After the court invalidated and set aside Notice 2016-66, the IRS proposed new regulations and invited public comment. In 2025, the IRS finalized the regulations in T.D. 10029. Under Reg. Sec. 1.6011-10 of the final regulations, a captive transaction qualifies as a listed transaction if it elects Code Sec. 831(b) taxation and fails three tests: (1) the 20 Percent Relationship Test, (2) the Financing Factor, and (3) the Loss Ratio Factor. A captive fails the 20 Percent Relationship Test if at least 20 percent of the entity's assets or the voting power or value of its outstanding stock or equity interests is directly or indirectly owned, individually or collectively, by an Insured, an Owner, or persons Related to an Insured or an Owner. A captive fails the Financing Factor requirement if the captive made available as financing or otherwise conveyed to a policyholder, a policyholder's owners, or related entities, in a transaction that did not result in taxable income or gain, any portion of the amounts the captive earned from insurance contracts. Finally, a captive fails the Loss Ratio Factor if the amount of liabilities incurred for insured losses and claim administration expenses is less than 30 percent of the amount equal to premiums earned by the captive minus policyholder dividends during the relevant period. Additionally, Reg. Sec. 1.6011-11 of the final regulations designates captive transactions as transactions of interest if the captive elects Code Sec. 831 treatment, fails the 20 Percent Relationship Test, and fails either the Financing Factor or Loss Ratio Factor with an adjusted loss ratio of 60 percent. A taxpayer that engages in listed transactions or transactions of interest must file reports with the IRS describing their transactions and the parties involved.

In April of 2025, CIC initiated an action in a district court asserting that the final regulations must be set aside because they violate the APA as contrary to law and arbitrary and capricious agency action. CIC argued that the IRS exceeded its statutory authority because the final regulations impose new requirements to obtain the tax benefits of Code Sec. 831. Specifically, CIC argued that a captive that meets the requirements of Code Sec. 831 but does not pass the tests in the final regulations may lose congressionally approved Code Sec. 831 tax benefits. CIC further contended that final regulations are arbitrary and capricious because (1) the administrative record lacked facts or data to support the regulations' conclusions; (2) the final rules were not reasonably explained; (3) the final regulations rely on impermissible factors; and (4) the IRS's abuse-detection rationale is pretext for eliminating small captives' ability to claim Code Sec. 831(b) tax benefits.

Analysis

The district court granted summary judgment for the government and held that the IRS did not exceed its statutory authority by issuing the final regulations and the final regulations do not constitute arbitrary and capricious agency action.

In the court's view, the IRS did not exceed its authority in issuing the final regulations because the final rules do not threaten the tax benefits available to a captive that meets the requirements of Code Sec. 831(b). Nothing in the final rules, the court found, provide that a qualifying captive taxpayer will lose Code Sec. 831(b) tax benefits in the event the IRS determines that the captive engaged in listed transactions or transactions of interest. To the contrary, the court noted that the final regulations specify that captives who engage in listed transactions or transactions of interest are subject to recordkeeping and reporting requirements. The court reasoned that a captive can qualify for and maintain access to Code Sec. 831(b) tax benefits by meeting the congressionally mandated statutory requirements and, at the same time, be subject to recordkeeping and reporting requirements under the final regulations.

In rejecting CIC's contention that the final regulations are arbitrary and capricious, the court found that numerous recent Tax Court decisions, in which taxpayers in micro-captive transactions remitted amounts treated as insurance premiums for something other than insurance, provided a legitimate basis for the IRS to seek additional information from captives and material advisors to aid in determining whether a captive is impermissibly avoiding tax liability. Accordingly, the court found that the administrative record contained sufficient facts and data to support the IRS's conclusion that captive transactions can be used to escape tax liability. The court also found that the IRS provided a reasonable explanation for the final regulations, in light of recent Tax Court decisions explained how captive insurance arrangements could be used to for tax avoidance. For example, in Swift v. Comm'r, T.C. Memo. 2024-13, the Tax Court applied a four-factor test to distinguish between permissible insurance and impermissible self-insurance. The district court found that, similarly seeking to differentiate between acceptable captive arrangements for insurance and captive arrangements for tax avoidance, the IRS explained in the preamble to the final regulations that the transactions described in the regulations resemble self-insurance and therefore, more information is needed to determine if the taxpayers involved in such transactions are, in substance, engaged in self-insurance.

The court also rejected CIC's argument that the final regulations are a pretext for the IRS's long-running effort to limit captives' use of Code Sec. 831(b) tax benefits. It was clear to the court that the IRS has been concerned about captives being used for tax avoidant purposes since 2015, when the IRS identified captives in its Dirty Dozen list of tax scams, and certainly since 2016, when it issued Notice 2016-66. The court noted that the IRS responded to comments to the proposed regulations on the possibility that the final rules would inhibit the use of Code Sec. 831(b) by stating that the IRS did not intend to discourage the use of Code Sec. 831(b) by entities that qualify for the election, nor should the regulations be construed as intending to discourage the use of Code Sec. 831(b) by such entities. The court also noted that under Atrium Medical Center v. U.S. Dept. of Health and Human Services, 766 F.3d 560 (6th Cir. 2014), the IRS was required to provide only a "reasonably discerned" path for its decision from the administrative record, and the court concluded that the IRS satisfied that obligation.

For a discussion of captive insurance arrangements, see Parker Tax ¶92,730.

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