Captive Insurers are an Acceptable Means to Avoid Tax

Post number 5328

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In Drake Plastics Ltd. Co., et al. v. Internal Revenue Service, et al., Civil Action No. H-25-2570, United States District Court, S.D. Texas, Houston Division (April 15, 2026) Plaintiffs (Drake Plastics Ltd. Co.; Drake Insurance Co., a captive insurer; and Strategic Risk Alternatives, LLC, a micro-captive manager/advisor) challenged Treasury/IRS’s January 14, 2025 final rule imposing disclosure requirements for certain micro-captive transactions. The Final Rule created two disclosure categories with different criteria and penalty consequences:

1. micro-captive “transactions of interest” (26 C.F.R. § 1.6011-11) and
2. “listed” micro-captive transactions (26 C.F.R. § 1.6011-10).

The plaintiffs moved for vacatur of the Final Rule; a declaratory judgment; a permanent injunction barring the defendants from enforcing the Final Rule against the plaintiffs, their clients, and affiliates; and a permanent injunction requiring the defendants to destroy or return all materials provided in response to the Final Rule
CAPTIVE INSURANCE AND THE INTERNAL REVENUE CODE

The common-law definition of “insurance” is based on the traditional characteristics of an insurance transaction. Those are: risk-shifting; risk-distribution; insurance risk; and whether an arrangement looks like commonly accepted notions of insurance.

Captive insurance transactions allow corporate entities to claim payments to their affiliated insurers as a business expense. If the affiliated insurer receives premium payments below a statutory cap, that insurer can elect tax benefits of the Internal Revenue Code. Captives that elect § 831(b) benefits are commonly called “micro-captives.”

The rule uses objective criteria, including a Relationship Test (related ownership), a Financing Factor (funds returned to insured/related parties without taxable gain), and a Loss-Ratio Factor (modified loss ratio thresholds, generally 60% for transactions of interest and 30% for listed transactions; listed status also requires at least ten years).

Plaintiffs argued the rule exceeded statutory authority and was arbitrary and capricious and they sought vacatur and injunctive relief.

LAW

Courts set aside agency action that is in excess of statutory jurisdiction, authority, or limitations, or arbitrary [or] capricious.

Taxpayers must file returns/statements required by Treasury regulations. Civil penalties apply for failure to disclose “reportable transactions” and “listed transactions.”

The Reportable transaction standard is a transaction “of a type” the Secretary determines has a potential for tax avoidance or evasion.

The Listed transaction standard is a reportable transaction specifically identified as a tax avoidance transaction carrying higher penalties than other reportable transactions.

Insurance tax backdrop: premium payments may be deductible only if really for insurance and sham/non-insurance arrangements do not qualify for the tax benefits.

ANALYSIS / DISCUSSION

Statutory authority—transactions of interest (§ 1.6011-11):

The court held Treasury/IRS acted within § 6707A(c)(1) because the agency may require disclosure for transactions “of a type” with a potential for tax avoidance/evasion, even if some covered transactions are legitimate. The administrative record (including multiple tax court decisions and the agency’s explanation of how certain features resemble self-insurance or circular cashflows) supported the conclusion that the covered category may not be “really for insurance.”

Statutory authority—listed transactions (§ 1.6011-10):

The court held Treasury/IRS exceeded § 6707A(c)(2) because listed transactions must be presumptively tax-avoidant (more than mere “potential”), and the Final Rule/record lacked a statutorily required finding (and supporting data) that the transactions captured by § 1.6011-10 are more often than not tax-avoidance (i.e., presumptively not “really for insurance”). Identifying “typical features” of abuse was not enough without evidence that the rule predominantly captures abusive transactions.
Arbitrary-and-capricious challenge (§ 1.6011-11):

The court rejected plaintiffs’ claim that the Financing Factor and Loss-Ratio Factor were impermissibly overinclusive. It accepted the agency’s explanation that administrable, objective factors can reasonably “overshoot” in a prophylactic disclosure regime, particularly given the relatively low reporting burden. The court found the Relationship Test, Financing Factor, and Loss-Ratio Factor were reasonably explained and supported by the record.
Remedy:

Because § 1.6011-10 was codified separately and operated independently from § 1.6011-11, the court severed and vacated only § 1.6011-10, declared it unlawful, and remanded to the agency. The court denied broad injunctive relief as unnecessary given vacatur and because § 1.6011-11 remained in force.

CONCLUSION

Captive-insurance arrangements pose a potential for abuse because they combine the separate benefits that Congress enacted in §§ 162(a) and 831(b). The insured party can deduct its premium payments as business expenses, and the insurer can exclude up to $2.2 million of those premiums from its own taxable income.” The result is that the money does not get taxed at all and can be reused by the insurer for the insured’s financial benefit.

Plaintiffs received partial summary judgment: the court vacated and declared unlawful the “listed transaction” regulation for exceeding statutory authority (lack of required showing that covered transactions are presumptively tax-avoidant). The court upheld the “transaction of interest” regulation as within statutory authority and not arbitrary/capricious. Vacatur of § 1.6011-10 was stayed until May 1, 2026; the case was remanded for further agency action consistent with the opinion.

The court granted in part the plaintiffs’ motion for summary judgment and a permanent injunction and grants in part the defendants’ cross-motion for summary judgment. The defendants:

1. appropriately designated micro-captive transactions as transactions of interest through 26 C.F.R. § 1.6011-11; but
2. exceeded their statutory authority in designating micro-captive transactions as listed transactions through 26 C.F.R. § 1.6011-10.

The court declared unlawful 26 C.F.R. § 1.6011-10 and vacated it.

ZALMA OPINION

Captive insurance is not like insurance companies that seek to profit from the business of insurance. It is the creation of a insured owned and operated insurance designed to avoid tax by allowing the insured to deduct the premiums paid and the captive insurer also pays little in the way of tax. The Insured and its captive insurer won part of its claims and lost some. The USDC teaches that a captive insurer can challenge the IRS and win and save reporting and paying some taxes.

(c) 2026 Barry Zalma & ClaimSchool, Inc.

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