District Court Vacates Micro-Captive Listed Transaction Regulation

(Parker Tax Publishing May 2026)

A district court held that the IRS exceeded its statutory authority in designating certain micro-captive transactions as listed transactions in Reg. Sec. 1.6011-10 and therefore declared the regulation unlawful and vacated it. The court found that under Code Sec. 6707A, micro-captive transactions must be presumptively tax avoidant in order to be described as listed transactions, and the IRS failed show that the transactions described in Reg. Sec. 1.6011-10(c) met that standard. Drake Plastics Ltd. Co., et al. v. IRS, 2026 PTC 87 (S.D. Tex. 2026).

Background

Captive insurance transactions allow businesses to claim payments to their affiliated insurers as an ordinary and necessary business expense under Code Sec. 162(a). If the affiliated insurer makes an election under Code Sec. 831(b), it can exclude up to $2,200,000 of its net premium income per year. Captives that elect Code Sec. 831(b) benefits are commonly called "micro-captives."

Under Code Sec. 6707A, the IRS may designate transactions as reportable transactions and as listed transactions. Under Code Sec. 6707A(c)(1), a reportable transaction is a transaction that is of a type that the IRS has the potential for tax avoidance. Under Code Sec. 6707A(c)(2), a listed transaction is a reportable transaction that the IRS has "specifically identified" as a "tax avoidance transaction for purposes of section 6011."

In 2025, the IRS issued final regulations in T.D. 10029 that identify certain micro-captive transactions as transactions of interest and certain other micro-captive transactions as listed transactions. Under Reg. Sec. 1.6011-11, micro-captive transactions that are the same as, or substantially similar to, the transactions described in Reg. Sec. 1.6011-11(c) are identified as transactions of interest. Reg. Sec. 1.6011-11(c) describes transactions where a captive that has at least 10 years of insurance transactions (1) elects Code Sec. 831(b) treatment and (2) satisfies the relationship test, the financing factor, and the loss-ratio factor (with an adjusted loss ratio of 30 percent). In Reg. Sec. 1.6011-10, micro-captive transactions that are the same as, or substantially similar to, the transactions described in Reg. Sec. 1.6011-10(c) are identified as listed transactions. The transactions described in Reg. Sec. 1.6011-10(c) are those in which a captive (1) elects Code Sec. 831 treatment, (2) satisfies the relationship test, and (3) satisfies either the financing factor or loss-ratio factor (with an adjusted loss ratio of 60 percent).

Drake Plastics Ltd. Co. (Drake Plastics) is a Houston limited liability company that specializes in extruding, injection molding, postprocessing, and machining ultra-high-performance polymers. 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 thirty other related entities. Strategic Risk Alternatives, LLC creates and manages micro-captive insurance plans for closely held businesses. Drake Plastics, Drake Insurance, and Strategic Risk Alternatives (Drake Plastics) sued the IRS to challenge the regulations identifying micro-captives as transactions of interest and listed transactions. Drake Plastics argued that the regulations exceeded the IRS's statutory authority and were arbitrary and capricious.

Analysis

The district court held that the IRS appropriately designated micro-captive transactions as transactions of interest under Reg. Sec. 1.6011-11. However, the court held that the IRS exceeded its authority in designating micro-captive transactions as listed transactions in Reg. Sec. 1.6011-10. The court therefore declared Reg. Sec. 1.6011-10 unlawful and vacated it.

With regard to Reg. Sec. 1.6011-11, the said it was clear from the administrative record that the transactions described in Reg. Sec. 1.6011-11(c) are of a type that have the potential for tax avoidance or evasion under Code Sec. 6707A(c)(1) and may not really be for insurance. The court noted that in the IRS pointed to multiple Tax Court decisions in which taxpayers in micro-captive transactions remitted amounts treated as insurance premiums for something other than insurance. These rulings, the court found, provided the facts and data necessary for the IRS to conclude that captive insurance arrangements are potentially used for tax avoidance and there is a legitimate basis to seek additional information from captives and material advisors to aid in determining whether a captive is, in fact, impermissibly avoiding tax liability.

However, with regard to Reg. Sec. 1.6011-10, the court found that when enacting Code Sec. 6707A, Congress intended listed transactions to have than a mere potential for tax avoidance. Code Sec. 6707A(c)(2) defines a listed transaction as "a tax avoidance transaction for purposes of section 6011." The court reasoned that, while the Code does not define a "tax avoidance transaction," the term and statutory structure compel the conclusion that a tax avoidance transaction has more than "a potential tax avoidance or evasion." The court said that the term "tax avoidance" supports the conclusion that a listed transaction must avoid taxes, and cannot merely have the potential to do so to be subject to the reporting requirement.

The court noted that Code Sec. 6707A(c)(2) does not include the word "potential," even though its immediate neighbor (Code Sec. 6707A(c)(1)) does. In the court's view, this difference in statutory language creates a negative inference suggesting that Congress intended the two provisions to work differently. The court also pointed out that under Code Sec. 6707A(d)(1)(A), the IRS has the discretion to rescind penalties for failure to disclose a reportable transaction, but not for a failure to disclose a listed transaction. Moreover, failures to report listed transactions may be penalized up to $200,000 ($100,000 in the case of a natural person) while failures to disclose any other reportable transaction may be penalized up to $50,000 ($10,000 in the case of a natural person). Based on these differences, the court concluded that Congress intended listed transactions to have more than a mere "potential for" tax avoidance.

The court then went on to conclude that the IRS exceeded its authority in issuing Reg. Sec. 1.6011-10 because the IRS made no finding that transactions under Reg. Sec. 1.6011-10 are presumptively tax avoidant. The IRS justified Reg. Sec. 1.6011-10, the court said, through an explanation of what typically occurs in an abusive micro-captive financing arrangement: "amounts paid as premiums have not only avoided ordinary taxation but have continued to avoid tax while back in the hands of the related parties who caused the premiums to be paid and deducted." The noted that Reg. Sec. 1.6011-10 provides a conjunctive test, requiring the presence of both the financing factor and the loss-ratio factor, so that it covers transactions that are "consistently associated with transactions that are . . . tax avoidance transactions." But the court found that this analysis addressed only half the problem. Identifying typical features of an abusive transaction, the court reasoned, does not identify transactions that are typically abusive. So the IRS's finding that Reg. Sec. 1.6011-10 covers the typical abusive micro-captive transactions was not a finding that Reg. Sec. 1.6011-10 covers presumptively abusive transactions.

The court found that this "dearth of data" was material because the IRS recognized in T.D. 10029 that Reg. Sec. 1.6011-10 will cover some legitimate transactions as well as those that are abusive. The court said that, although the IRS found that the conjunctive test in Reg. Sec. 1.6011-10 "significantly narrows the scope" of the final regulation, there was no finding that Reg. Sec. 1.6011-10 is sufficiently narrow to satisfy Code Sec. 6707A(c)(2)'s requirement of presumptive tax avoidance.

For a discussion of captive insurance arrangements, see Parker Tax ¶92,730. For a discussion of the reportable transaction rules, see Parker Tax ¶253,130.

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