# Micro-Captive Insurance: Section 831(b), the Court Losses and Form 8886 in 2026

> Micro-captive insurance under IRC § 831(b): why the IRS wins in court, where the listed transaction rules stand after Drake Plastics, and your Form 8886 duty.

Source: https://ridleylawoffices.com/micro-captive-insurance/

By Eric Ridley, attorney, Ridley Law. Updated October 2026.

*Part of our [strategies that backfire](https://ridleylawoffices.com/estate-planning-strategies-that-backfire/) series.*

**Who this page is for:** owners of profitable closely held businesses, usually with $1 million or more a year of taxable income, who’ve been pitched a captive insurance company, families in the $15 million to $100 million range whose adviser wants the captive owned by a trust for the children, and families with a captive already in place who need to know their filing duties and exposure. The income tax problem applies at any estate size. See [high-net-worth estate planning in California](https://ridleylawoffices.com/high-net-worth-estate-planning-california/).

**Short answer –**A micro-captive is a small insurance company owned by the same family that owns the business it insures. The business deducts the premiums, and the captive elects under IRC § 831(b) to pay tax only on its investment income, so up to $2.9 million a year in 2026 can move from a taxed business to a lightly taxed company the family controls. Real captives exist. The ones the IRS challenges charge premiums far above commercial rates for coverage that rarely pays claims, and as of April 2024 the IRS said it had won every micro-captive case decided on the merits in the Tax Court and the courts of appeals since 2017. Participants still have to file Form 8886 for a “transaction of interest” under Treas. Reg. § 1.6011-11, which three federal courts have upheld. Whether micro-captives are also listed transactions under § 1.6011-10 is split: a Tennessee court upheld that rule in March 2026, a Texas court vacated it in April 2026, and the Texas ruling is on appeal to the Fifth Circuit.

**$2.9M**

2026 premium limit for the § 831(b) election, Rev. Proc. 2025-32

**60%**

Loss ratio below which an § 831(b) captive related to its insured is a transaction of interest, Treas. Reg. § 1.6011-11 (2025)

**20x**

Premium the Caylor company paid its captive, on top of about $60,000 a year of commercial coverage (T.C. Memo. 2021-30)

**75%**

Penalty on the tax benefit for not filing Form 8886, capped at $10,000 for an individual and $50,000 for an entity for a transaction of interest, IRC § 6707A

## What a disallowed captive premium costs

A hypothetical California business owner in the top federal bracket runs $1.2 million a year of premiums through a captive for three years. If the IRS proves the arrangement isn’t insurance, the deductions go away, and the bill comes to $1,598,400 before interest and California tax.

| Item | Amount |
| --- | --- |
| Premium deducted each year | $1,200,000 |
| Federal tax saved each year at 37%, if respected | $444,000 |
| Federal tax owed for 3 years if the deduction is denied | $1,332,000 |
| 20% accuracy-related penalty on that underpayment | $266,400 |
| Total before interest and California tax | $1,598,400 |

The captive’s own return changes too: without a valid § 831(b) election, the premiums are taxable income to the captive (*Avrahami*; *Syzygy*). The family still has the cash that built up in the captive, but it gets taxed again when it comes out.

## What the pitch promises, and the election behind it

A micro-captive moves business income into a lightly taxed company the family controls, if the arrangement counts as insurance. Micro-captive insurance is an arrangement in which a business buys insurance from a small insurance company owned by the business’s owners or their family, and that insurance company elects under IRC § 831(b) to be taxed only on its investment income, not on the premiums it collects.

What the business gets is a deduction, and what the captive gets is an exclusion. In its transaction-of-interest notice, the IRS describes the arrangement this way: the business and the related captive enter into contracts the parties treat as insurance, the business deducts the premiums, and the captive excludes them from income under § 831(b). The IRS says the contracts are interpreted, administered and applied in ways that don’t fit arm’s-length insurance (Notice 2016-66). In its Dirty Dozen warnings, the IRS lists what it sees in the abusive version: implausible risks, coverage that doesn’t match the business’s needs, duplication of commercial coverage, and premiums above arm’s-length prices (IRS, 2024).

In the estate planning version of the pitch, the captive is owned by the children or a trust for them, so premiums the business pays build up in a company outside the parents’ estates. Congress wrote that version into the eligibility test. A captive that insures one family business and is owned by the children while the parents own the business fails both tests. The election is unavailable, and the captive is taxed on its premiums like any other insurer.

The election has a premium cap and two diversification tests, and the second one looks at the family’s ownership. A small insurance company other than a life insurer can elect to be taxed only on its taxable investment income if its net written premiums, or direct written premiums if greater, don’t exceed the limit for the year, which is $2,900,000 for taxable years beginning in 2026 (IRC § 831(b); Rev. Proc. 2025-32, sec. 4.36). The first diversification test limits any one policyholder to 20% of the captive’s premiums for the year, counting related policyholders as one (IRC § 831(b)(2)(B)). A captive that fails the first test still qualifies only if no spouse or lineal descendant of an owner of the insured business holds a percentage of the captive that is more than a de minimis amount, 2 percentage points, higher than their percentage of the business it insures (IRC § 831(b)(2)(B)).

## Why the IRS keeps winning micro-captive cases

The election only matters if the captive is an insurance company and the contracts are insurance, and that’s where the IRS wins. In April 2024 the IRS said it “has prevailed in all micro-captive Tax Court and appellate court cases decided on their merits since 2017” (IRS, Dirty Dozen 2024). The courts test whether an arrangement is insurance by asking whether it involves risk shifting, risk distribution and insurance risk, and whether it meets commonly accepted notions of insurance (*Avrahami v. Commissioner*, 149 T.C. 144 (2017)).

Most of the risk in the litigated captives comes from one family business, so there’s no pool of unrelated risks to distribute. To fix that, promoters added reinsurance pools in which captives swapped small slices of each other’s risk, and courts found those pools circular. In *Swift v. Commissioner*, the captives got back 99.59%, 98.74%, 94.98% and 98.99% of what they paid into the pool in 2012 through 2015.

### Premiums that don’t track the risk

In *Caylor Land & Development, Inc. v. Commissioner*, T.C. Memo. 2021-30, the construction company paid its captive $1.2 million, the § 831(b) limit then, the day after the captive was formed, before any policy had been underwritten or issued. Its commercial premiums ran about $60,000 a year, and the court found no insurance. In *Keating v. Commissioner*, T.C. Memo. 2024-2, total premiums on the captive coverages “always hovered around $1.2 million, the section 831(b) limit,” and the average rate-on-line was more than ten times that of comparable commercial policies. The court denied the deductions.

Premiums that arrive with no claims, or on top of coverage the company already had, tell the same story. In *Avrahami*, the family’s businesses deducted insurance premiums of $1,090,000 for 2009 and $1,170,000 for 2010, largely paid to a captive owned by Mrs. Avrahami, and no claims were filed under the captive’s direct policies in either year. The court held the payments weren’t insurance premiums and the § 831(b) election was invalid. In *Syzygy Insurance Co. v. Commissioner*, T.C. Memo. 2019-34, the insured company already carried between 11 and 13 commercial policies with premiums of $981,882 to $1,471,042 a year. The captive arrangement wasn’t insurance, and the deductions were denied.

In *Caylor* the family company paid its captive $1,200,000 on top of the $59,917 a year it paid commercial carriers, about 20 times as much, and in *Reserve Mechanical* the insured paid its captive $448,127 in 2009 while keeping commercial policies that had cost $95,828 in 2007, as the opinions report. These multiples compare spending, since the captive coverage came on top of the commercial policies. The like-for-like measure is *Keating*‘s: a rate-on-line more than ten times that of comparable commercial policies.

| Case | Commercial premiums | Premiums to the captive | Multiple | Result |
| --- | --- | --- | --- | --- |
| Caylor Land & Development, T.C. Memo. 2021-30 | $59,917 (Aug. 2007 to Aug. 2008) | $1,200,000 (Dec. 2007) | 20.0x | Not insurance, deductions denied, penalties applied |
| Reserve Mechanical Corp., 34 F.4th 881 (10th Cir. 2022) | $95,828 (2007) | $448,127 (2009) | 4.7x | Not an insurance company, Tax Court affirmed |

### Risk that isn’t shared with anyone

In *Reserve Mechanical Corp. v. Commissioner*, 34 F.4th 881 (10th Cir. 2022), the Tenth Circuit affirmed that the captive wasn’t an insurance company: virtually all its risk was from one affiliated insured, the pool it joined didn’t distribute risk, and the premiums weren’t the result of arm’s-length dealing. The premiums it received were taxed at the 30% rate of § 881(a).

The Fifth Circuit reached the same result in *Swift v. Commissioner*, 144 F.4th 756 (5th Cir. 2025). It affirmed that neither the direct policies nor the reinsurance pools achieved risk distribution, and the Tax Court’s findings of “unreasonable, reverse-engineered premiums” and “similar commercial coverage at a fraction of the cost” supported the result. It also affirmed 20% penalties.

### Penalties now follow the losses

Relying on a promoter’s opinion doesn’t count, because “reliance may be unreasonable if the adviser is a promoter of the transaction” (*Keating*, quoting *Neonatology*). In 2017 and 2019 the Tax Court excused penalties because the law was unsettled and the taxpayers relied on advisers, and by 2021 and after, with *Avrahami* on the books, courts imposed them.

*Avrahami* didn’t impose accuracy-related penalties except on amounts it treated as dividends or interest, citing the taxpayers’ good-faith reliance on professional advice and the lack of precedent. *Syzygy* imposed none, because the family relied in good faith on a CPA who wasn’t a promoter. In *Caylor* the family got no actual advice about the captive, and penalties applied in the cases where the IRS had met its supervisory-approval requirement. *Keating* imposed accuracy-related penalties, and *Swift* affirmed 20% penalties.

## What a legitimate captive looks like

The Tax Court has found real insurance in captives on the right facts, in *AMERCO*, *Harper Group* and *Rent-A-Center*, as *Avrahami* recounts. *Avrahami* lists the questions the court asks about whether a captive is a bona fide insurance company: whether it was created for legitimate nontax reasons, whether there’s a circular flow of funds, whether it faces actual and insurable risk, whether the policies are arm’s-length contracts, whether premiums are actuarially determined, whether comparable coverage was more expensive or even available, whether it’s regulated and adequately capitalized, and whether it pays claims from a separately maintained account.

| Issue | What holds up | What failed in court |
| --- | --- | --- |
| Reason for the captive | A real coverage gap commercial carriers won’t fill at a sensible price | Coverage that duplicates commercial policies, a red flag on the IRS’s Dirty Dozen list (IRS, 2024) |
| Premiums | Priced by an independent actuary from the risk | Hovering at the § 831(b) limit every year (*Keating*), or 20 times commercial cost (*Caylor*) |
| Claims | Claims filed and paid in the ordinary course | No claims filed under the direct policies (*Avrahami*) |
| Risk distribution | Many unrelated insureds or a large number of independent risks | One affiliated insured plus a pool that returned nearly every dollar (*Reserve*, *Swift*) |
| Use of the captive’s money | Reserves held to pay claims | Loans and transfers back to the family (*Avrahami*). Financing to related parties is also a § 1.6011-11 trigger |
| Ownership | Owned in the same proportions as the insured business | Owned by children or their trusts while parents own the business, which fails § 831(b)(2)(B) |

**Don’t do this:** don’t form a captive to deduct premiums set at the § 831(b) limit for risks your commercial policies already cover, and don’t put it in your children’s names to move value out of your estate. *Avrahami*, *Caylor*, *Keating* and *Swift* all denied the deductions, and the later cases added penalties. If you’re already in one, the Form 8886 duty under § 1.6011-11 applies now.

## What to do instead of a captive

Buy the coverage your business needs from commercial carriers, and price any gap with an independent broker before anyone mentions a captive. If a captive still makes sense, it should be built by insurance professionals with no stake in the tax result, priced by an independent actuary, regulated, and run like an insurer that pays claims. For moving business value to the next generation, use tools built for that, such as gifts of business interests appraised and reported on a Form 709. See [estate planning strategies compared](https://ridleylawoffices.com/estate-planning-strategies-compared/) and [asset protection in California](https://ridleylawoffices.com/asset-protection-california/).

## If you already have a captive, what you have to file

Find out whether your captive meets the § 1.6011-11 description, whether every participant has filed, and how its loss ratio and any related-party loans look. A captive can also stop being a transaction of interest if it requests consent to revoke its § 831(b) election before the disclosure deadline, which the regulation addresses for years ending before 2026 (Treas. Reg. § 1.6011-11(h)(1)).

As of October 2026, participants in a micro-captive that elects § 831(b), is related to its insured under a 20% ownership test, and has either a loss ratio under 60% or loans or other financing to related parties must disclose it on Form 8886 as a transaction of interest under Treas. Reg. § 1.6011-11, effective January 14, 2025 (T.D. 10029). The rule applies to a captive that elects § 831(b), is related to the insured by at least 20%, and either provides financing to related parties or has a loss ratio below 60% over its most recent ten years (or all its years if it’s younger). The Eastern District of Tennessee upheld the 2025 rules in March 2026 (*CIC Services, LLC v. IRS*, No. 3:25-cv-00146). The Southern District of Texas upheld § 1.6011-11 in April 2026 (*Drake Plastics*), and the Northern District of Texas upheld it in June 2026, calling the designations “solely disclosure requirements” (*Ryan, LLC v. IRS*).

The transaction-of-interest filing applies either way, and the listed-transaction rule is the one a court has vacated. *Drake Plastics Ltd. Co. v. IRS*, No. 4:25-cv-02570 (S.D. Tex. Apr. 15, 2026), held the IRS exceeded its authority in designating micro-captives as listed transactions under § 1.6011-10 and vacated that section, staying the vacatur until May 1, 2026, while stating that “Eliminating § 1.6011-10 does not affect a taxpayer’s obligation to report under § 1.6011-11.” The companies appealed on May 4, 2026 and the government cross-appealed on June 15, 2026 (5th Cir. No. 26-20219). The government’s brief is due October 23, 2026.

The captive, the insured business and its owners can each be participants, and each year of participation needs the form attached to the income tax or information return, including amended returns. An exact copy of the first one is filed with the IRS Office of Tax Shelter Analysis (Instructions for Form 8886).

The penalty for not filing is 75% of the tax decrease from the transaction, with a minimum of $5,000 for an individual. For a reportable transaction that isn’t listed, the cap is $10,000 for an individual and $50,000 for an entity, per failure (IRC § 6707A(b)). An understatement tied to an undisclosed reportable transaction can carry a 30% accuracy-related penalty instead of 20% (IRC § 6662A(c)).

The IRS first named micro-captives a transaction of interest in Notice 2016-66, and more than 100,000 micro-captive disclosures have been filed under it, according to *Ryan, LLC v. IRS* (N.D. Tex. 2026). After the Supreme Court held in 2021 that the Anti-Injunction Act didn’t bar a suit challenging that notice, because the reporting requirement is not a tax (*CIC Services, LLC v. IRS*, 593 U.S. 209 (2021)), a district court on remand set the notice aside in 2022 for skipping notice-and-comment rulemaking. Treasury responded with the January 2025 regulations (T.D. 10029).

## Where California changes the picture

A disallowed deduction costs California tax too, at rates up to 12.3% plus the 1% surcharge on taxable income over $1 million (FTB 2025 rate schedules; R&TC § 17043). California has no estate tax, so a captive owned by children saves only federal estate tax, and it does that only if it’s insurance, which the cases above say it usually isn’t.

California follows the federal disclosure rules and can add its own. Section 6011 applies for California tax, and the Franchise Tax Board can identify its own reportable and listed transactions (R&TC § 18407). California has its own nondisclosure penalty that tracks § 6707A with lower caps: $15,000 for a non-listed reportable transaction ($5,000 for a natural person) and $30,000 for a listed one ($15,000 for a natural person), and it applies only to taxpayers with taxable income over $200,000 (R&TC § 19772). California also has a reportable transaction accuracy penalty patterned on § 6662A (R&TC § 19164.5).

A captive that isn’t admitted in California raises a premium tax question. California imposes a 3% gross premium tax when an insured whose home state is California places property and casualty coverage with a nonadmitted insurer under the surplus line chapter, unless a surplus line broker already paid it (R&TC § 13210; Ins. Code §§ 1760.1, 1775.5). If a captive isn’t admitted in California, ask in writing whether this tax applies and who pays it.

## Working with Ridley Law

I review captive arrangements as part of an estate plan: who owns the captive, how it fits the § 831(b) ownership test, what it means for the estate, and how to wind it down if that’s the answer. I work alongside your CPA and, where the matter calls for it, co-counsel. Work at this level is built for each family and quoted in writing before any drafting starts. For an IRS examination or a Tax Court case, I’ll help you find tax controversy counsel.

The first call is free and runs 30 minutes, by phone or Zoom. [Book my 30-minute call](https://ridley.click/eric-30) or call 805-244-5291.

## Frequently asked questions

### Is micro-captive insurance legal?

Yes. Section 831(b) is in the tax code, and a captive that provides real insurance at arm’s-length prices can use it. The IRS challenges arrangements that don’t distribute risk or charge premiums far above commercial rates.

### Is a micro-captive still a listed transaction?

The courts are split. The Eastern District of Tennessee upheld § 1.6011-10 in March 2026, the Southern District of Texas vacated it in April 2026, and the Texas ruling is on appeal to the Fifth Circuit. Whether to file under § 1.6011-10 is a question for your tax adviser. The transaction-of-interest rule, § 1.6011-11, applies either way.

### Who has to file Form 8886 for a micro-captive?

Participants in a transaction described in § 1.6011-11, which can include the captive, the insured business and its owners. The form goes with the return and, the first time, to the Office of Tax Shelter Analysis.

### What is the 2026 premium limit for an 831(b) captive?

$2,900,000 of net or direct written premiums for taxable years beginning in 2026 (Rev. Proc. 2025-32).

### Can my children own the captive?

Not if the captive gets more than 20% of its premiums from one policyholder and the children’s share of the captive is more than 2 percentage points above their share of the insured business. The § 831(b) election then fails (IRC § 831(b)(2)(B)).

### What happens if the IRS disallows the premiums?

The business loses the deductions, the captive’s election fails so its premiums become taxable, and penalties are likely in a case filed today. *Keating* and *Swift* imposed 20% penalties.

This page is general information about California and federal law as of its update date. It isn’t legal, tax, insurance or investment advice for your situation, and reading it doesn’t create an attorney-client relationship. The worked example is hypothetical.

**Related reading:** [estate planning strategies that backfire](https://ridleylawoffices.com/estate-planning-strategies-that-backfire/); [syndicated conservation easements](https://ridleylawoffices.com/syndicated-conservation-easement/); [money myths](https://ridleylawoffices.com/money-myths/); [ultra-high-net-worth estate planning](https://ridleylawoffices.com/ultra-high-net-worth-estate-planning-california/).

Sources

- [U.S. Tax Court, Avrahami v. Commissioner, 149 T.C. 144 (2017)](https://www.courtlistener.com/opinion/4563553/avrahami-v-commr/) (2017-08-21)
- [U.S. Supreme Court, CIC Services, LLC v. IRS, 593 U.S. 209 (2021)](https://www.courtlistener.com/opinion/4883695/cic-servs-llc-v-irs/) (2021-05-17)
- [U.S. District Court, E.D. Tenn. (via GovInfo), CIC Services, LLC v. IRS, No. 3:25-cv-00146 (Mar. 5, 2026)](https://www.govinfo.gov/content/pkg/USCOURTS-tned-3_25-cv-00146/pdf/USCOURTS-tned-3_25-cv-00146-0.pdf) (2026-03-05)
- [U.S. Tax Court, Caylor Land & Development, Inc. v. Commissioner, T.C. Memo. 2021-30](https://www.courtlistener.com/opinion/9505588/robert-c-caylor-ii-margo-d-caylor/) (2021-03-10)
- [U.S. District Court, S.D. Tex., Drake Plastics Ltd. Co. v. IRS, No. 4:25-cv-02570 (Apr. 15, 2026)](https://www.courtlistener.com/docket/70455154/drake-plastics-ltd-co-v-internal-revenue-service/) (2026-04-15)
- [U.S. Court of Appeals, 5th Cir., Drake Plastics v. IRS, No. 26-20219 (docket)](https://www.courtlistener.com/docket/74205880/drake-plastics-v-irs/) (docket through 2026-09-28)
- [U.S. Tax Court, Keating v. Commissioner, T.C. Memo. 2024-2](https://www.courtlistener.com/opinion/9457365/terence-j-keating-janet-d-keating/) (2024-01-04)
- [U.S. Court of Appeals, 10th Cir., Reserve Mechanical Corp. v. Commissioner, 34 F.4th 881 (2022)](https://www.courtlistener.com/opinion/6468507/reserve-mechanical-corp-v-cir/) (2022-05-13)
- [U.S. District Court, N.D. Tex., Ryan, LLC v. IRS, No. 3:25-cv-00078 (June 26, 2026)](https://www.courtlistener.com/docket/69536678/ryan-llc-v-internal-revenue-service/) (2026-06-26)
- [U.S. Court of Appeals, 5th Cir., Swift v. Commissioner, 144 F.4th 756 (2025), No. 24-60270](https://www.ca5.uscourts.gov/opinions/pub/24/24-60270-CV0.pdf) (2025-07-16)
- [U.S. Tax Court, Syzygy Insurance Co. v. Commissioner, T.C. Memo. 2019-34](https://www.courtlistener.com/opinion/4608743/syzygy-insurance-co-inc-v-commissioner/) (2019-04-10)
- [IRS, Dirty Dozen 2024 wrap-up](https://www.irs.gov/newsroom/dirty-dozen-bogus-tax-avoidance-strategies-schemes-with-an-international-element-wrap-up-annual-taxpayer-awareness-campaign) (2024-04)
- [IRS, Instructions for Form 8886 (Rev. October 2022)](https://www.irs.gov/pub/irs-pdf/i8886.pdf) (2022-10)
- [IRS, Notice 2016-66](https://www.irs.gov/pub/irs-drop/n-16-66.pdf) (2016-11-01)
- [IRS, Rev. Proc. 2025-32](https://www.irs.gov/pub/irs-drop/rp-25-32.pdf) (2025-10-09)
- [Treasury and IRS, T.D. 10029, 90 Fed. Reg. 3534 (Jan. 14, 2025)](https://govinfo.gov/content/pkg/FR-2025-01-14/pdf/2025-00393.pdf) (2025-01-14)
- [Franchise Tax Board, 2025 California tax rate schedules](https://www.ftb.ca.gov/forms/2025/2025-540-tax-rate-schedules.pdf) (2025)
- [U.S. Congress (via Cornell LII), 26 U.S.C. § 6662A](https://www.law.cornell.edu/uscode/text/26/6662A) (current)
- [U.S. Congress (via Cornell LII), 26 U.S.C. § 6707A](https://www.law.cornell.edu/uscode/text/26/6707A) (current)
- [U.S. Congress (via Cornell LII), 26 U.S.C. § 831](https://www.law.cornell.edu/uscode/text/26/831) (current)
- [California Legislature (via DingDuff), Ins. Code § 1760.1](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=INS&sectionNum=1760.1) (current)
- [California Legislature (via DingDuff), Ins. Code § 1775.5](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=INS&sectionNum=1775.5) (current)
- [California Legislature (via DingDuff), Rev. & Tax. Code § 13210](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=13210) (current)
- [California Legislature (via DingDuff), Rev. & Tax. Code § 17043](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=17043) (current)
- [California Legislature (via DingDuff), Rev. & Tax. Code § 18407](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=18407) (current)
- [California Legislature (via DingDuff), Rev. & Tax. Code § 19164.5](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=19164.5) (current)
- [California Legislature (via DingDuff), Rev. & Tax. Code § 19772](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=19772) (current)