Tax Court denies microcaptive insurance arrangement
Entities were not insurance companies and did not provide insurance in the commonly accepted sense, the court holds.
By Charles J. Reichert, CPA
The Tax Court held that a purported insurance arrangement involving family-owned manufacturing companies, a microcaptive insurance company, and two fronting carriers was not insurance because the fronting carriers were not bona fide insurance companies that issued insurance policies, and the reinsurance of those policies by the captive insurance company did not distribute risk. As a result, the court disallowed the manufacturing companies' deductions related to the payment of purported insurance premiums and held that the microcaptive insurance company was required to report the payments it received as gross income.
Facts: John Jacob, Michael VanLenten, and six of their relatives owned, either directly as shareholders of one or more S corporations or indirectly as trust beneficiaries, all of the stock of a group of companies known collectively as Highland Tank that manufactured above-ground and underground steel tanks. Jacob and VanLenten established Syzygy Insurance Co., a microcaptive insurance company, in December 2008. Starting in 2009, Highland Tank and Syzygy participated in a captive insurance program run by a company named Alta that used two fronting companies, U.S. Risk Associates Insurance Co. and Newport Re Inc.
Under the arrangement, from 2009 to 2011 Highland Tank paid premiums to the two fronting companies totaling $1,373,500 for coverage of various risks. The fronting companies kept a fee and then ceded the remaining $1,319,056 of the premiums and all of the insurance risk to Syzygy, which reinsured the potential claims. From 2009 to 2011, Highland Tank did not file any claims under these insurance policies but filed multiple claims with noncaptive insurance carriers.
On its 2009—2011 tax returns, Highland Tank took tax deductions for the premium payments that were passed through to the family members' individual tax returns. Also for those years, Syzygy excluded from gross income the net premium amounts it received from the fronting companies because it had elected to be a microcaptive insurance company under Sec. 831(b). After examination, the IRS determined that Syzygy did not engage in insurance transactions and Syzygy's Sec. 831(b) election was invalid. As a result, it determined the premium payments Syzygy had received were taxable and assessed deficiencies of $403,897 plus 20% accuracy-related penalties of $80,779. The IRS also disallowed the flowthrough deductions taken by the family members for the premium payments of Highland Tank, assessing deficiencies totaling $507,517 plus accuracy-related penalties totaling $101,485. Syzygy and the family members petitioned the Tax Court for relief.
Issues: An insurance company with net written premiums not exceeding $2.3 million (for tax years beginning in 2019; $1.2 million in 2009—2011) can elect under Sec. 831(b) to be taxed only on its investment income. Bona fide insurance premiums paid to these companies (microcaptive insurance companies) are deductible; however, the exclusion for the recipient company and the deduction for the payer of the premiums require the captive insurance arrangement to meet the definition of insurance. The courts have developed four criteria for judging whether an arrangement qualifies as insurance: (1) The insurer must distribute risk among its policyholders, and (2) the arrangement must involve insurable risk, (3) must shift risk to the insurer, and (4) must be insurance in the commonly accepted sense.
The IRS argued that Syzygy was not an insurance company and did not engage in insurance transactions, while Syzygy and the family members argued that Syzygy distributed risk by participating in the fronting companies' captive insurance pools and reinsuring unrelated risks.
Holding: The Tax Court found that for Syzygy to be distributing risk, as required by the third criteria for insurance, the fronting companies had to be actual insurance companies and that, under its precedent from Rent-A-Center, Inc., 142 T.C. 1 (2014), they were not bona fide insurance companies issuing insurance policies. Because they did not issue insurance policies, Syzygy's reinsurance of those policies did not distribute risk and the captive insurance arrangement was not insurance, so Syzygy could not deduct the premiums it paid.
In Rent-A-Center, Inc., the Tax Court set forth the following factors for determining whether a company is a bona fide insurance company:
Was the entity created for legitimate nontax reasons?
Was there a circular flow of funds?Did the entity face actual and insurable risk?
Were the policies arm's-length contracts?
Did the entity charge actuarially determined premiums?
Was comparable coverage more expensive or even available?
Was the entity subject to regulatory control, and did it meet statutory requirements?
Was the entity adequately capitalized?
Did the company pay claims from a separately maintained account?
Applying these factors, the Tax Court concluded that the fronting companies were not bona fide insurance companies because: The premiums charged were not actuarially determined. The contracts were not at arm's length because Highland Tank's ratio of premiums paid to loss recoverable under the policies with the fronting companies was about six times higher than its ratio for insurance policies obtained outside the captive program, and the premiums' apparent purpose therefore was to increase deductions. Also, the contracts created an apparently circular flow of funds, the court stated, since Highland Tank paid $1,373,500 of gross premiums to the fronting companies, which then transferred $1,319,056 in reinsurance premiums to Syzygy.
Although the failure to distribute risk in the arrangement was in itself enough to doom Syzygy's deductions, the court also noted that, in the alternative, it would also disallow the deductions because the transactions did not constitute insurance in the commonly accepted sense. Factors used to determine that an arrangement is insurance in the commonly accepted sense are whether the company was organized, operated, and regulated as an insurance company; the company was adequately capitalized; the policies were valid and binding; premiums were reasonable and determined at arm's length; and claims were paid.
Applying these factors, the court concluded that the arrangement was not insurance in the commonly accepted sense because Syzygy was not operated like an insurance company. According to the court, this was demonstrated by the facts that Syzygy paid only one claim that it never investigated and that may not have been covered, made troubling investment choices, and charged unreasonable premiums.
The family members argued as a contingency position that even if the payments were not insurance premiums, they were indemnification protection payments and therefore deductible as ordinary and necessary business expenses. The court stated that indemnification payments can be considered necessary (appropriate and helpful) and have a valid purpose if the indemnified party seeks indemnification for covered losses. However, Highland Tank had failed to seek indemnification for losses it said were covered; therefore, the payments were not deductible as ordinary and necessary business expenses.
The court did hold that Syzygy and the family members were not liable for the accuracy-related penalties, as they were able to show that they had relied in good faith on the advice of a qualified tax adviser.