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Microcaptive Insurance Arrangement Fails to Pass Muster in Tax Court

(Parker Tax Publishing February 2024)

The Tax Court held that transactions conducted by an S corporation through a purported microcaptive insurance arrangement did not constitute insurance for federal income tax purposes and therefore, the S corporation's payments for premiums and fees were not deductible as ordinary and necessary business expenses under Code Sec. 162(a) or as losses under Code Sec. 165. The court found that the affiliated captive insurance company and other entities were not operated as insurance companies because insurance transactions were completed after the fact rather than prospectively and underwriting was disproportionately influenced by meeting target premiums near the $1.2 million limit under Code Sec. 831(b) for the years at issue, regardless of the coverage being provided. Keating v. Comm'r, T.C. Memo. 2024-2.


Terence Keating and Arthur Candland were shareholders of Risk Management Strategies, Inc. (RMS), an S corporation in the business of acting as a sole employer for its clients, which were primarily banks administering special needs trusts. RMS assumed the employer liability resulting from the employment of caregivers who worked for special needs trusts, handled payroll, and generally carried out the responsibilities of being an employer to caregivers and other employees that would have otherwise fallen on its clients.

RMS had contracts with its bank clients in their capacities as trustees. Under these contracts, RMS was required to maintain workers' compensation benefits, unemployment insurance, and commercial general liability insurance. No other insurance coverage was specifically required by the contracts.

RMS was also the insured on several purported insurance policies maintained through a captive insurance program. RMS's captive insurance program was implemented by Tribeca Strategic Advisors, LLC (Tribeca). In 2008, Tribeca formed a captive insurer called Risk Retention. The business plan stated that Risk Retention would "underwrite highly customized policies carefully tailored to the specific needs of its insured," but it also repeatedly referred to Risk Retention's intended insured erroneously as "GTI" rather than RMS. Risk Retention obtained an insurance license from the Anguilla Financial Services Commission. Risk Retention had no employees.

Under the captive insurance program, RMS participated in a risk pool with other insureds of captive insurers managed by Tribeca and later Artex Risk Solutions, Inc. (Artex) when it acquired Tribeca in 2010. The insureds purchased (1) a primary (or direct) layer of purported insurance coverage for each insured risk directly from their respective captive insurer and (2) an excess (or quota-share) layer of purported insurance coverage for each same risk from Provincial Insurance, PCC (Provincial), an Anguilla insurer. An agent collected payment from the insured, retained a 2.5 percent administrative fee, and transmitted to the captive insurer and Provincial the net amounts owed to them. RMS paid premiums approximating $1.2 million for each year at issue. For years 2012-2014, RMS deducted the premiums and fees as ordinary and necessary business expenses under Code Sec. 162(a).

In 2012, Risk Retention paid Candland and Keating dividends of $500,000 each. In April 2014 Risk Retention paid Candland and Keating dividends of $200,000 each. In October 2014 Risk Retention paid Candland and Keating additional dividends of $300,000 each. On their personal income tax returns, Candland and Keating reported the dividends they received from Risk Retention as qualified dividends.

The IRS disallowed the deductions and determined that the dividends paid to Candland and Keating were not qualified dividends and therefore should be taxed at ordinary income rates. The IRS also applied accuracy-related penalties under Code Sec. 6662(a). Keating and Candland took their case to the Tax Court. They argued that the premiums and fees were deductible as ordinary and necessary business expenses under Code Sec. 162(a). Alternatively, they contended that the payments were deductible as losses under Code Sec. 165 based on the characterization of Risk Retention as a mere reserve or account of RMS.

Taxation of Microcaptive Arrangements

Under Code Sec. 831(a), insurance companies (other than life insurance companies) are generally taxed on their income in the same manner as other corporations. However, Code Sec. 831(b) provides an alternative taxing structure for certain small insurance companies. During the years at issue, an insurance company with net written premiums (or, if greater, direct written premiums) that did not exceed $1.2 million for the year could elect to be taxed under Code Sec. 831(b). Under Code Sec. 831(b)(1), a small insurance company that makes a valid Code Sec. 831(b) election is subject to tax only on its investment income and is not subject to tax on its earned premiums. When a captive insurance company makes a Code Sec. 831(b) election, it is commonly referred to as a microcaptive insurance company.

Typically, amounts paid for insurance are deductible under Code Sec. 162(a) as ordinary and necessary expenses paid or incurred in connection with a trade or business. Code Sec. 162(a) does not prohibit deductions for microcaptive insurance premiums. When such a deduction is available, an insured may be able to deduct a premium payment to its affiliated microcaptive insurance company without a corresponding inclusion of the premium in income by the microcaptive insurance company.

Nonetheless, the deductibility of insurance premiums depends on whether they were truly payments for insurance. Neither the Code nor the regulations define insurance. In Avrahami v. Comm'r, 149 T.C. 144 (2017), the Tax Court looked to four criteria in deciding whether an arrangement constituted insurance: (1) the arrangement involves an insurance risk; (2) the arrangement shifts the risk of loss to the insurer; (3) the insurer distributes its risk among its policyholders; and (4) the arrangement is insurance in the commonly accepted sense. To determine whether an arrangement constitutes insurance in the commonly accepted sense, the court looks at numerous factors including: (1) whether the insuring company was organized, operated, and regulated as an insurance company; (2) whether it was adequately capitalized; (3) whether the policies were valid and binding; (4) whether premiums were reasonable and the result of arm's-length transactions; and (5) whether claims were paid.


The Tax Court held that RMS's microcaptive arrangement was not insurance in the commonly accepted sense, and therefore was not insurance for federal income tax purposes.

The court found that, apart from generally observing the requisite corporate formalities, Risk Retention and Provincial were not operated as insurance companies. In the court's view, Risk Retention and Provincial operated during the years at issue in a manner in which only "unthinking" insurance companies would operate. The court observed that insurance transactions, including premium pricing, premium payments, and claims approval, were completed after the fact, even though in a typical insurance program they would be completed prospectively. The court also found that the captive policies were not valid and binding; RMS's captive policies were issued midway through their coverage periods, rather than after, and in the court's view the late issuances created substantial doubt about the validity and binding effect of the policies.

In addition, the court determined that Provincial's premiums were not reasonable or the result of an arm's length transaction. The court found that Candland provided Artex with an amount he was willing to pay or a target premium for all policies purchased regardless of coverage, and Candland's target premiums played an outsized role in Artex's purported underwriting. The court noted that Provincial's policies were not objectively rated by evaluating the risk and magnitude of loss on a prospective basis informed by detailed underwriting. Further, the process by which Risk Retention and Provincial paid claims was, in the court's view, abnormal. The court found it was unusual for claims approval to occur after claims payment. The court also found that Artex effectively allowed RMS to manage its own claims and failed to place proper controls on RMS's insistence that it be allowed to directly manage the claims process as though no formal captive insurance program were in place.

The court concluded that RMS's premium payments were not deductible under Code Sec. 162(a) because they were not for insurance and thus not ordinary. The court noted that RMS's clients did not require RMS to obtain the captive coverages, even though they required RMS to maintain certain insurance coverage. The court also found that businesses similar RMS did not typically rely on the types of coverages provided by Artex, on the terms provided by Artex, for their coverage needs. In addition, the court found that the fees paid to Artex and PRS were not normal, usual, or customary in RMS's line of business.

The court rejected the characterization of Risk Retention as a mere reserve or account of RMS. The court noted that Risk Retention was incorporated and therefore a separate entity and found that a taxpayer generally may not deduct another person's expense or loss. There was no dispute, the court reasoned, that RMS shifted risks to Risk Retention, a separate taxable entity, in exchange for making premium payments. The dispute was whether the arrangement by which it did so was insurance or was otherwise a deductible expense or loss, but the court found no factual basis for a finding that RMS retained the liabilities it shifted to Risk Retention or incurred the losses when they came due.

The court further found that Risk Retention's distributions to Keating and Candland in 2012 and 2014 were not qualified dividends and therefore should be taxed at ordinary income rates. The court reasoned that, given its conclusion that the captive arrangement did not constitute insurance, and Risk Retention had no other business that constituted insurance, Risk Retention was not an insurance company for the years at issue and its Code Sec. 953(d) elections were therefore invalid.

Finally, the court upheld the imposition of penalties after finding that Keating and Candland did not take any substantial steps to ascertain their proper tax liability. The court noted that there was not written tax opinion or other contemporaneous documentary evidence concerning any tax advice regarding the microcaptive arrangement. The court also found that the novel issues involved in this case did not excuse Keating and Candland from penalties in the absence of any efforts on their part to ascertain their correct tax liabilities or apply well-settled principles of taxation to their situation.

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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