Tenth Circuit Upholds Tax Court; Deals Significant Blow to Microcaptives

(Parker Tax Publishing June 2022)

The Tenth Circuit affirmed the Tax Court and held that a company could not exclude from income insurance premiums paid to it pursuant to a captive insurance arrangement because the company did not qualify as a tax-exempt insurance company under Code Sec. 501(c)(15) and the payments were thus taxed at a 30 percent tax rate as U.S.-source fixed, determinable, annual or periodical income. The Tenth Circuit found no error in the Tax Court's findings that (1) the company was not an insurance company because it had not adequately distributed risk among a large number of independent insureds, and (2) the policies it issued were not insurance in the commonly accepted sense. Reserve Mechanical Corp. v. Comm'r, 2022 PTC 137 (10th Cir. 2022).

Background

In an insurance agreement known as a micro-captive transaction, a parent company forms a "captive" insurer under its control and pays premiums to the captive for insurance coverage. The tax advantages of such an agreement include: (1) a deduction by the insured parent company for the premiums as ordinary and necessary business expenses under Code Sec 162(a), and (2) an exclusion from income by the captive insurer of the premiums under Code Sec. 501(c)(15), which exempts small insurance companies from income tax if they receive no more than $600,000 a year in premiums.

From 2008 to 2010, Reserve Mechanical Corp. (Reserve) issued a number of insurance policies to Peak Mechanical Corp. (Peak), a manufacturer of underground mining equipment, in a captive insurance arrangement set up by Capstone Associated Services, Ltd. Reserve was incorporated in Anguilla, British West Indies in 2008 with an initial capital investment of $100,000. Two men, Norman Zumbaum and Cory Weikel, owned both Reserve (through Reserve's parent corporation, Peak Casualty) and Peak. Before Reserve issued those policies, Peak had limited its insurance coverage to commercial policies that cost about $100,000 a year. Peak maintained those policies, which were issued from 2008 to 2010 (the years at issue), but also paid Reserve more than $400,000 a year for supplemental insurance obtained through new policies.

Capstone, which consulted for and managed captive insurance companies, advised Zumbaum and Weikel in the creations of Reserve and handled the technical and management issues, such as preparing policies and recommending premiums. It believed that for Reserve to be a qualified insurance company it would have to receive at least 30 percent of its premiums from companies not affiliated with it. Capstone arrived at the 30 percent figure based on a Tax Court case, The Harper Group v. Comm'r., 96 T.C. 45 (1991), holding that a particular captive insurer had a sufficient pool of insureds to provide risk distribution when approximately 30 percent of the captive's business came from insuring unrelated parties.

Capstone ostensibly created diversification of risks in two ways, which together accounted for about 30 percent of the premiums received by Reserve. The first was a "quota share" arrangement under which approximately 50 captives under Capstone's management assumed liability on reinsurance policies issued to each other. The reinsurance arranged by Capstone was accomplished through PoolRe Insurance Corp., another company managed by Capstone. Through PoolRe each of the captive insurers in effect reinsured, and was reinsured by, each of the other captives, with PoolRe acting as the intermediary. The second method was a "credit coinsurance" arrangement where each captive reinsured a small percentage of risk that PoolRe assumed from coinsuring thousands of vehicle-service contracts with another insurance company. Reserve claimed to have received about 15 percent of its premiums through this arrangement. Taken together, the premiums from both these plans constituted more than 30 percent of the premiums Reserve received from Peak and PoolRe.

Peak also maintained insurance coverage with third-party commercial insurers. It held policies with third-party insurers that covered general liability, worker's compensation, commercial property, inland marine, and international risk.

On its income-tax returns for 2008 - 2010, Peak deducted the premiums it paid Reserve. While the payment of insurance premiums are generally deductible under Code Sec. 162, in Reserve's case, there was no corresponding taxable income reported. Reserve paid no income tax on the premiums it received, claiming that it qualified under Code Sec. 501(c)(15) as a tax-exempt insurance company receiving premiums under $600,000 per year.

The IRS sent Reserve a tax deficiency notice after finding Reserve was not tax exempt under Code Sec. 501(c)(15). According to the IRS, Reserve's purported insurance and/or reinsurance transactions lacked economic substance and the money it received was not paid to an insurance company and was not paid for insurance. As a result, the IRS assessed tax deficiencies for 2008, 2009, and 2010. It classified Reserve's income under Code Sec. 881(a) as fixed or determinable annual or periodical (FDAP) gains, profits, and income received from sources within the United States, but not effectively connected with the conduct of a trade or business within the United States. FDAP income is subject to a 30 percent tax rate. Reserve contested the assessment in the Tax Court, arguing that it was in fact an insurance company and that if it was not, the purported premiums it received were a nontaxable capital contribution to the company.

Tax Court's Decision

In T.C. Memo. 2018-86, the Tax Court agreed with the IRS that Reserve was not an insurance company and that Reserve's purported premiums were properly characterized as U.S.-source FDAP income. The Tax Court applied four criteria in deciding whether an arrangement constitutes insurance, examining whether: (1) the arrangement involved insurable risks; (2) the arrangement shifted the risk of loss to the insurer; (3) the insurer distributed risk among its policy holders; and (4) the arrangement was insurance in the commonly accepted sense. In the view of the Tax Court, Reserve's policies failed to satisfy requirements (3) and (4).

The Tax Court found that Reserve's arrangement with PoolRe was not a bona fide insurance arrangement. Among other factors, the Tax Court found that the amounts that PoolRe was to pay Reserve under the quota share arrangement were not determined at arm's length or using objective criteria, the quota share premiums were not actuarially determined; and PoolRe was not created or operated for legitimate nontax reasons. With respect to the credit-coinsurance arrangement, the Tax Court said there was no evidence that the underlying risk existed because Reserve failed to produce the vehicle service contracts. On the issue of whether Reserve provided insurance in the commonly accepted sense, the Tax Court found that although Reserve had observed the necessary formalities in incorporating in Anguilla, it was not operated as an insurance company. Among other reasons, the Tax Court noted that Reserve had no employees of its own, was managed entirely by Capstone, and. performed no due diligence with respect to the reinsurance agreements it executed with PoolRe. The Tax Court also noted that Zumbaum - Reserve's 50 percent owner, president, and chief executive officer - knew virtually nothing about its operations.

Analysis

The Tenth Circuit affirmed the Tax Court. The court derisively noted that many of the "insurance" policies were executed with what the court escribed as "singular carelessness." For example, two of the policies erroneously listed certain businesses as the insureds. And although the directors-and-officers policy stated that it covered the specific officers and directors listed in an attachment to the policy, that attachment did not list a single insured person, so the policy provided no coverage. Also, in the apparent rush to issue the policies (and pay premiums that would be deductible in 2008), Peak paid for three policies that apparently were deemed unnecessary after further consideration, as they were dropped in 2009, after being in place for less than one month.

In addition, the court noted, Peak did not appear to get much in return for its $400,000 annual payment to Reserve. Reserve handled only one claim from Peak, a claim under a special-risk policy for partial loss of a major customer, and there were numerous irregularities in Reserve's handling of the claim, the court said. The essence of the Tax Court's ruling, in the view of the Tenth Circuit, was that Reserve's insurance policies issued to Peak did not provide true insurance, even though Reserve complied with some of the customary formalities for insurance companies and went through some of the motions associated with pricing insurance premiums. The Tenth Circuit found that no experience, expertise, or studies supported the need for Peak to obtain the policies, and the premiums for the additional insurance were not supported by any study of similar commercially available policies or careful analysis of Peak's risks of loss.

The Tenth Circuit agreed with the Tax Court that Reserve's premiums were unreasonable and not negotiated at arm's length and were based on a number "questionable features" of Reserve's policies, the most important of which was Reserve's utter failure to explain how it calculated the risks covered by the policies. Regarding whether Reserve operated as an insurance company in the commonly accepted sense, the Tenth Circuit noted that the Tax Court did not criticize Reserve simply because it was managed by Capstone. Instead, the Tax Court observed that Reserve's operations were irregular because it had no employees, it maintained an address in Anguilla without ever doing business there, and Zumbaum "knew virtually nothing about its operations." Moreover, the Tenth Circuit found that Zumbaum's lack of knowledge about Reserve and Capstone's management of Reserve contradicted a feasibility study performed by Capstone which emphasized that a prerequisite to forming a captive was "wholehearted top management support" and "strong internal oversight." The Tenth Circuit said that it was one thing to seek technical and administrative assistance from professionals; it was quite another to abandon all responsibility for how your company is handling $400,000 of insurance and simply believe everything Capstone said. The Tenth Circuit also agreed with the Tax Court that Reserve's unprofessional handling of its only claim was further evidence that it was not operated as an insurance company in the commonly accepted sense.

The Tenth Circuit also affirmed the Tax Court's holding that Reserve's purported premiums were subject to tax at a 30 percent rate as U.S.-source FDAP income. The Tenth Circuit acknowledged the IRS's ruling in Rev. Rul. 2005-40 that an arrangement which purports to be an insurance contract but lacks the requisite risk diversification may be recharacterized as a deposit arrangement, a loan, a contribution to capital, an indemnity arrangement that is not an insurance contract, or otherwise. However, the Tenth Circuit reasoned that Rev. Rul. 2005-40 does not declare that when an ostensible insurance arrangement fails to adequately distribute risk it must be recharacterized as a contribution to capital. The court explained that whether an alternative characterization is appropriate depends upon both the objective facts of the transaction and the subjective intent of the parties. The burden was on Reserve to prove that Peak intended to make a capital contribution and the court concluded that there was no evidence of such an intent.

For a discussion of micro-captive 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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