A Texas federal judge ruled against the Internal Revenue Service in a case involving its classification of micro-captive insurance as a "listed transaction," but also ruled in favor of the IRS classifying micro-captives as "transactions of interest."
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The judge vacated the IRS's "listed transaction" designation, effectively rejecting the IRS's attempt to label such arrangements as presumptive tax shelters, while allowing a lower-tier disclosure requirement to stand, categorizing them as "transactions of interest."
"The court finds that the IRS: (1) appropriately designated micro-captive transactions as transactions of interest through 26 C.F.R. § 1.6011-11; but (2) cannot justify on the current record the designation of micro-captive transactions as listed transactions through 26 C.F.R. § 1.6011-10," the judge wrote. "The court therefore vacates 26 C.F.R. § 1.6011-10."
The ruling removes a designation that carried penalties of up to $200,000 and discouraged many small businesses from legitimately using captive insurance, while also reinforcing limits on federal agencies' ability to classify entire categories of financial activity as abusive without clear evidence. The ruling is also one of the first significant tax rulings that applies the post-Loper Bright Enterprises v. Raimondo framework after a Supreme Court ruling in 2024 curtailed deference to agencies such as the IRS and the Securities and Exchange Commission.
The IRS had already been
"Captive insurance transactions allow corporate entities to claim payments to their affiliated insurers as a business expense under 26 U.S.C. § 162(a)," wrote Judge Rosenthal. "If the affiliated insurer receives premium payments below a statutory cap, that insurer can elect tax benefits under § 831(b) of the Internal Revenue Code. Captives that elect § 831(b) benefits are commonly called 'micro-captives.' Although some micro-captives are legitimate insurers, some are not."
The court removed the IRS's most aggressive label from micro-captive insurance transactions, ruling the agency didn't have the evidence to treat them as presumptive tax fraud.
Drake Plastics is a Houston limited liability company that specializes in extruding, injection molding, postprocessing and machining ultra-high-performance polymers. Its affiliate, Drake Insurance Co., is a captive insurance entity that provides workers' compensation, product liability, errors and omissions, and other types of insurance for Drake Plastics and over 30 other related entities. Strategic Risk Alternatives LLC creates and manages micro-captive insurance plans for closely held businesses. The plaintiffs sued the IRS and federal officials to challenge the IRS's final regulations, arguing that compliance was costly and burdensome and that labeling micro-captive insurance as presumptively tax-avoidant scares clients away from using a micro-captive to achieve even legitimate tax benefits.
"The IRS finalized regulations in January of 2025 that designated 831(b) micro-captive transactions either as a transaction of interest or a listed transaction, depending on certain qualifying factors," said Dustin Carlson, president of SRA 831(b) Admin, one of the plaintiffs. "We brought the lawsuit because we believe the regulations were arbitrary and capricious, and that the IRS overreached by issuing these [regulations]. The judge last week found that they didn't have the evidence to label them as a listed transaction, because a listed transaction has with it just a presumption of you're being a tax shelter or you're being a tax cheat. They didn't have the evidence to back that up, and so the judge threw that part out and retained the transaction of interest part."
A listed transaction carries higher penalties for failure to file the disclosure, he noted, and it impacts the business as well. "Lenders don't like when you're part of a listed transaction," said Carlson. "Certain CPA firms actually won't even complete your return if you're involved with a listed transaction. It's burdensome for the taxpayer."
He noted that the transaction of interest designation is one that the micro-captive industry has dealt with for about a decade after the IRS issued
"Following this ruling, it's a little bit back to the status quo," said Carlson. "We would have liked to have seen the whole regulation tossed out, but the listed transaction part of it was definitely the worst part of it."
The IRS may decide to appeal the ruling, he acknowledged, since it had a win when a judge upheld the regulations in the Sixth District of Tennessee. "There is a split decision right now amongst the district courts," he said. CIC Services has also filed an appeal in that case, he added, and there's another pending case, Ryan LLC in the Fifth District, where Drake Plastics and SRA just won. "It is possible that the IRS appeals, but we'll wait and see what happens," he said.
In the meantime, several of his firm's clients have converted from 831(b) to 831(a) micro-captives since the IRS issued its regulations last year, while others decided to close down their insurance entity entirely.
"We had a bunch of clients that also decided just to close their company altogether and no longer participate in it," said Carlson.
There are some advantages to converting to an 831(a) from an 831(b). "Typically, an 831(b) has the premium threshold," Carlson explained. "The PATH Act made that $2.2 million, and I believe with inflation, that's up to $2.9 million this year. If you're larger than that, then you can't elect an 831(b) so you're going to file as an 831(a). But then also the difference is how you're taxed. An 831(a) is taxed as a normal insurance corporation. With an 831(b), that's where you have the income exclusion, where you're only taxed on investment gains from premiums."
Despite the Trump administration's cuts in budgets and staffing at the IRS, many other court cases are still pending.
"As far as enforcement goes, we really haven't seen much activity, or at least new activity from the IRS, but there's actually close to 1,300 cases pending in Tax Court right now related to micro-captives," said Carlson.
Others may decide to set up a micro-captive now as a result of the ruling, but he would like to see the IRS change its regulatory approach.
"I think having the worst part of it thrown out definitely makes people more comfortable with participating in it," said Carlson. "We've always said we would like to work with the IRS to get some commonsense regulations. If you look at the Tax Court record, the two qualifying factors they have — the financing factor and the loss ratio factor in the regulations — neither of those are actually ever relevant to any of the court cases the IRS has won. It always comes down to operational issues where the micro-captive wasn't issuing policies in a timely manner. They weren't adjudicating claims like an insurance company would. They were loaning money back to the operating company just within a few days of receiving premiums. None of those were addressed by these regulations, and we would love to work with the IRS to actually get to some regulations that address those issues because there are bad actors in the industry. There's people abusing it, just like any other part of the Tax Code that allows for tax deferral."
