On March 5, 2026, the United States District Court for the Eastern District of Tennessee issued its memorandum opinion in CIC Services, LLC v. Internal Revenue Service, No. 3:25-cv-00146, ultimately upholding the Treasury Department and IRS’s Final Rule on micro-captive insurance reporting requirements. For tax professionals advising clients on the IRC § 831(b) election, this ruling represents a critical development in the compliance landscape, resolving a multi-year administrative law battle regarding the IRS’s authority to classify certain captive arrangements as listed transactions and transactions of interest.

Background and the 2022 Invalidation of Notice 2016-66

To fully contextualize the 2026 decision, practitioners must look back to the earlier litigation involving the same parties, culminating in the court’s 2022 opinion. In 2016, the IRS issued Notice 2016-66, classifying micro-captive transactions as "transactions of interest" under 26 C.F.R. § 1.6011-4 and imposing severe penalties under IRC §§ 6707(a), 6707A, and 6708(a) for non-disclosure.

CIC Services originally sued to enjoin enforcement of the Notice, arguing it was a legislative-type rule that skirted the Administrative Procedure Act (APA) notice-and-comment requirements, and that it was arbitrary and capricious. On March 21, 2022, the District Court agreed, ruling that "Notice 2016-66 is a legislative rule that is invalid because the IRS failed to observe notice-and-comment procedures required by the APA". Furthermore, the court determined the IRS’s actions were arbitrary and capricious because "the administrative record fails to include relevant data and facts supporting the IRS’s decision to designate micro-captive arrangements as transactions of interest". As a result, the court elected to "vacate the Notice in its entirety" and ordered the IRS to return all documents and information produced by taxpayers and material advisors pursuant to the defective Notice.

The Final Rule and the Taxpayer’s Request for Relief

Following the 2022 defeat, the IRS engaged in formal rulemaking, publishing proposed regulations and eventually issuing a Final Rule and accompanying regulations on January 14, 2025 (90 Fed. Reg. 3534). The 2025 Final Rule designates a captive transaction electing § 831(b) taxation as a "listed transaction" if it fails three objective tests: the "20 Percent Relationship Test," the "Financing Factor," and the "Loss Ratio Factor".

CIC Services, a firm that assists small businesses in forming and managing captive insurance companies, filed a new suit on April 9, 2025. CIC alleged that its clients operated captives falling under these new designations, creating burdensome recordkeeping and reporting obligations that threatened CIC with severe financial and reputational harm, as well as potential civil and criminal liability. In its request for relief, CIC asked the court to "(1) declare that the Final Rule and accompanying regulations violate the APA; (2) order that the Final Rule and accompanying regulations be set aside; and (3) enter a permanent injunction prohibiting the Government from enforcing the Final Rule and accompanying regulations" against CIC, its clients, and affiliates.

Court’s Analysis of the Law and Application to the Facts

CIC’s challenge rested on two main arguments under the APA: first, that the IRS exceeded its statutory authority, and second, that the Final Rule was arbitrary, capricious, and a pretext to eliminate the § 831(b) election for small captives.

On the issue of statutory authority, the APA permits courts to set aside agency actions found to be "in excess of statutory jurisdiction, authority, or limitations, or short of statutory right" under 5 U.S.C. § 706(2)(C). CIC argued that the Final Rule’s objective tests imposed new, unauthorized requirements to obtain § 831 tax benefits. The court wholly rejected this argument, observing that "nothing in the Final Rule or its accompanying regulations provide that a qualifying captive taxpayer will lose §831(b) tax benefits in the event the IRS determines that the captive engaged in Listed Transactions or Transactions of Interest". Applying IRC §§ 6011 and 6707A, the court concluded that Congress expressly mandated the IRS to collect information on transactions with a potential for tax avoidance. Therefore, the Final Rule creates "disclosure requirements, not substantive rules affecting how the IRS will assess taxes," meaning the IRS acted well within its delegated authority.

Next, the court applied the APA’s arbitrary and capricious standard under 5 U.S.C. § 706(2)(A). Under this narrow standard of review, the court must "determine only whether the [agency] examined ‘the relevant data’ and articulated ‘a satisfactory explanation’ for [its] decision". In stark contrast to the hollow administrative record that doomed Notice 2016-66 in 2022, the court found the 2026 administrative record robust. The court noted that the current record includes recent Tax Court decisions—such as Avrahami, Syzygy, Caylor, Keating, Swift, Patel, and Royalty Mgmt—which provide "the ‘facts and data’ necessary for the Treasury Department and the IRS to conclude that captive insurance arrangements are potentially used for tax avoidance".

The court systematically analyzed the IRS’s application of the law to the facts for each of the Final Rule’s objective factors:

The Loss Ratio Factor: The Final Rule flags captives whose insured losses and claim administration expenses are less than 30 percent of premiums earned minus policyholder dividends. The court cited the IRS’s rationale that "[p]ricing premiums far in excess of what is reasonably needed to fund insurance operations results in a lower loss ratio and remains a strong indicator of tax avoidance," as it identifies situations where arrangements do not function as commonly accepted insurance.
The Financing Factor: This factor targets captives that convey earned premiums back to policyholders or related entities in non-taxable transactions. The court validated the IRS’s reasoning that "in a financing arrangement involving an abusive micro-captive transaction, 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 20 Percent Relationship Test: This limits the reporting trigger to captives where at least 20 percent of the entity’s voting power or assets is owned by an insured or related persons. The court accepted the IRS’s explanation that this excludes arrangements with less tax avoidance potential, such as diversified small mutual insurers.

In addressing CIC’s claims that these factors were poor proxies or overly broad, the court applied Sixth Circuit precedent, noting that "[t]hat an agency regulation might be over- or under-inclusive does not necessarily render it arbitrary and capricious".

Finally, the court addressed CIC’s argument that the Final Rule was a mere pretext resulting from the IRS’s "long-running efforts to limit captives’ use of §831(b) tax benefits". The court reviewed internal IRS communications but found that "[l]imited internal skepticism about the effects of a proposed policy decision and its underlying motivations are simply insufficient to demonstrate that the eventual policy decision is pretext for discouraging code-compliant election of §831(b) tax benefits". The court highlighted that the IRS explicitly responded to public comments by formally stating, "[t]he Treasury Department and the IRS do not intend to discourage the use of section 831(b) by entities that qualify for the election".

Conclusions

The court concluded that the IRS successfully cured the procedural and substantive defects that plagued its 2016 Notice. Finding that the IRS provided a "reasonably discerned" path for its regulatory decisions supported by a robust administrative record, the court ruled that the Final Rule and accompanying regulations were neither arbitrary and capricious nor outside the IRS’s statutory authority.

Consequently, the court ordered that "CIC’s motion for summary judgment is DENIED, and the Government’s motion for summary judgment is GRANTED". For CPAs and EAs, this means the stringent reporting mechanisms and material advisor disclosure rules enacted in the January 2025 Final Rule remain fully enforceable law.

Prepared with assistance from NotebookLM.