Payments to Microcaptive Insurance Company by Family Business Aren't Deductible

(Parker Tax Publishing March 2021)

The Tax Court held that a family-owned construction business could not deduct payments to a microcaptive insurance company that it owned because the microcaptive failed to distribute risk and didn't conduct business as an insurer commonly would. The court also upheld penalties for the substantial understatement of tax after rejecting the taxpayer's arguments that its reliance on its accounting and business advisers was reasonable. Caylor Land and Development, Inc. v. Comm'r, T.C. Memo. 2021-30.

Background

Bob Caylor and his son Robert Caylor II (Rob) are entrepreneurs who built a thriving construction business. Though it began as a sole proprietorship, it has since grown into an empire of many separate subsidiaries and affiliates (Caylor entities). And like all businesses, the Caylor entities needed insurance. Prior to 2007, the entities long had traditional insurance, which typically cost the group around $60,000 each year. Beginning in 2007, however, the Caylor entities increased their insurance bill by taking out policies from a related microcaptive insurer at a cost of $1.2 million annually. At the same time, consulting payments between the Caylor entities grew by about $1.2 million.

Rob ran the Caylor entities primarily through Caylor Construction Company (Caylor Construction). The fortunes of the Caylor entities were closely tied to the fortune of Caylor Construction as it paid substantial "consulting fees" to Caylor Land & Development Company (Caylor Land), which then paid "consulting fees" to numerous Caylor entities. In addition, while the Caylor entities had traditional insurance, such insurance didn't cover every loss that the Caylor entities faced over the years. From 1997-2007, the Caylor entities had $500,000 of losses that were not covered by their traditional insurance - roughly $50,000 a year.

In early 2007 an acquaintance of Rob's introduced him to the idea of a captive insurance company. Rob, along with his father and Richard Kennedy, his longtime accountant, went to a lunch presentation on captive insurance that was put on by Tribeca - an insurance-management company located in Arizona that specialized in managing captive insurance companies. The presentation was a primer on captive insurance and emphasized microcaptives and their potential tax benefits. Rob was convinced after the presentation that the Caylor entities could benefit from such an arrangement. Kennedy, however, was less convinced, and thought the pitch for a microcaptive "too good to be true." Rob asked Kennedy and Greg Gadarian, his longtime tax and business attorney, to look into captive insurance. Neither could find anything negative about Tribeca and concluded that captive insurance, if done correctly, had potential. But both also acknowledged that they were not experts in the area and could not determine if Tribeca's specific program satisfied the Code's requirements and if Tribeca's program would be able to deliver on the promised tax benefits.

Rob decided to go forward in setting up a captive insurance company with Tribeca as its third-party manager. He began the process by answering a general questionnaire that Tribeca sent him. He signed an engagement letter with Tribeca in September 2007. The letter stated that the captive needed to meet certain "risk shifting" and "risk distribution" tests. Within a month, Tribeca prepared a feasibility study for Caylor Construction. The study concluded that Caylor Construction was suitable for a captive insurance company. The Caylors' captive insurance company, named Consolidated, Inc., was incorporated under the laws of Anguilla and licensed as an Anguilla insurance company. It was owned by Rob. Tribeca filed the articles of incorporation for Consolidated on December 20, 2007. On December 21, Consolidated elected under Code Sec. 953(d) to be treated as a domestic U.S. corporation for tax purposes and elected under Code Sec. 831(b)(2)(A)(ii) to be taxed solely on investment income so long as its annual premiums did not exceed $1.2 million - which is what made Consolidated a microcaptive. That same day Caylor Construction paid Consolidated $1.2 million, which it deducted as an insurance expense on its 2007 tax return. The Caylor entities also continued to carry traditional commercial insurance. From August 2008 to August 2011, Caylor Construction paid roughly $55,000 per year for this traditional insurance. And just as in 2007 and 2008, on paper, the Caylor entities supplemented their insurance through Consolidated in 2009 and 2010.

In 2009 and 2010, 12 Caylor entities paid a total of $1.2 million in premiums to Consolidated. From 2007 to 2010, Consolidated collected $4.8 million. However, in all that time, Consolidated paid only four claims - two in 2008 and two in 2009 - that together amounted to only $43,000. And, these claims were made on policies that Consolidated didn't issue until after the policy years had closed. The first claim in 2009 was for $13,000 in legal fees that Caylor Construction incurred to collect a debt. Tribeca requested additional support for the claim - such as an invoice or proof of payment - but none was ever submitted. Instead Rob and his wife, Paula, in their capacities as Consolidated's owners overruled the captive managers at Tribeca and ordered that the claim be paid. A similar situation occurred with the second claim.

For both 2009 and 2010, Caylor Construction deducted payments that it made to Caylor Land as consulting expenses. Payments by other entities to Consolidated were reported as a combination of deductible insurance expenses, legal fees, accounting fees, and management fees. Consolidated reported itself as a microcaptive, and therefore did not include the $1.2 million in premiums as taxable income for either year.

For both 2009 and 2010, Kennedy - who is a licensed CPA in Arizona - prepared the tax returns for almost all of the Caylor entities. The Caylors didn't provide, and Kennedy did not ask for, any documents to support the large consulting fees between Caylor Construction and Caylor Land - he simply reported the information that was given to him. He was unaware that many of the Caylor entities were paying nearly 100 percent of their gross receipts from consulting on insurance premiums to Consolidated.

The IRS audited the 2009 and 2010 tax returns of the Caylor entities and challenged the deductibility of the consulting payments from Caylor Construction to Caylor Land and the deductibility of the insurance expense payments from the Caylor entities to Consolidated. The IRS also assessed accuracy-related penalties for substantial understatements of tax under Code Sec. 6662(b)(2) or negligence under Code Sec. 6662(b)(1). The Caylors argued that they relied on professionals to advise them on how to report the consulting fees and insurance payments.

Analysis

The Tax Court denied the deductions for the consulting fees and the insurance. Both the testimony and exhibits in the case caused the court to find it more likely than not that the "consulting" consisted of nothing more than conversations that Rob and his dad had over breakfast. The court noted that neither one could say what this consulting concerned, what subjects were discussed, or the amount of time spent talking business instead of the ordinary subjects fathers and sons talk about. For a father and son to have a warm and loving relationship that helps sustain and grow the family business is admirable, the court said, but it's not deductible.

With respect to the deductibility of insurance, the court noted that neither the Code nor the regulations define the term "insurance." Thus, the court looked to the case law and began by noting that the Supreme Court has stated that insurance is a transaction that involves "an actual insurance risk." Additionally, Helvering v. Le Gierse, 312 U.S. 531 (1941) provides that, historically and commonly, insurance involves risk-shifting and risk-distributing. The line between nondeductible self-insurance and deductible insurance, the court said, is blurry. The court tried to clarify it by looking to four nonexclusive criteria: risk-shifting; risk-distribution; insurance risk; and whether an arrangement looks like commonly accepted notions of insurance.

The court found there was no geographic diversity or industry diversity in the entities that Consolidated insured as all the entities in one way or another were a part of the real-estate industry. Because Consolidated failed to distribute risk and was not selling insurance in the commonly accepted sense, the court found that it need not decide whether its transactions involved insurance risk or risk shifting. In analyzing whether Consolidated's arrangement looked like insurance, the court found that the writing and delivering of insurance policies after a claim period was abnormal as was the refusal to submit documentation, as was requested by Tribeca, for paying a claim. The court thus concluded that the premiums paid to Consolidated and deducted by the Caylor entities were not "insurance" for federal tax purposes because Consolidated failed to distribute risk and didn't act as an insurer commonly would.

The court rejected the Caylors' reasonable-cause-and-good-faith defense and found that they were liable for substantially understating their taxes for the years at issue. According to the court, the Caylor entities had no reasonable cause for their tax positions and did not take their positions in good faith. Neither Kennedy nor Gadarian advised Rob that the microcaptive was established and operated correctly, the court said. And, the court said, Caylor Construction was negligent in failing to keep adequate records of its deductions for "consulting" payments.

For a discussion of captive and microcaptive insurance arrangements, see Parker Tax ¶92,730.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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