The IRS just won its third consecutive battle in its war against Section 831(b) microcaptive arrangements with the Tax Court’s decision in Syzygy Ins. Co., et al vs. Commissioner released on April 10, 2019. Although the Tax Court refused to impose penalties, it otherwise handed a landslide victory to the IRS, sustaining the tax deficiency against the insured businesses based on disallowed premium deductions while at the same time taxing those identical premiums as income to the microcaptive. This decision will serve to embolden an already-confident IRS in its audit campaign against microcaptives, increasing the importance of early strategizing with trial counsel. Will your client’s current, or proposed, microcaptive arrangement pass muster?
In a typical Section 831(b) captive arrangement, the insuring business incurs, and deducts for income tax purposes, insurance premiums paid to the captive. The captive, in turn, will retain part of the earned premiums and use the remainder to reinsure the risks of the policies through a third-party reinsurance arrangement. When done correctly, the captive is entitled to exclude the premium monies from income (up to certain amount, historically $1.2 million) and only pays taxes on investment returns. Thus when the dust settles, the insuring business gets to deduct 100% of the premium payments and the captive gets to exclude 100% of the premiums received from income – pretty powerful tax planning. Of course this tax benefit is only available for true risk management plans, and the IRS has identified ,and actively pursued, various captive arrangements which it believes are more akin to tax plays rather than insurance transactions.
Enter the Jacob family, which owned and operated Highland Tank and its related companies engaged in the steel-tank business. Through captive management company Alta Holdings, LLC, the Jacoby family formed Syzygy, a Delaware company, in 2008 and made an election under Section 831(b) to be taxed as a small insurance company. For the next five years, Highland Tank and its affiliates purchased captive insurance policies whereby 49% of the premium was ceded to Syzygy and the remaining 51% was ceded to a reinsurance pool insuring policies of 40-50 unrelated companies. Syzygy agreed to insure its quota-share percentage of the losses of the reinsurance pool, i.e., ratio of Highland Tank premiums to the total premiums of the pool. The risk of loss under the Highland Tank policies, however, was not shared equally across these two “layers” of insurance. Under the first layer, borne solely by Syzygy, the captive was responsible for the first $250,000 of losses. Losses above that, up to policy limits – i.e., the second layer, was borne by the reinsurance pool. The IRS raised the usual challenges to this captive arrangement, arguing that (i) Highland Tank’s payments were not deductible insurance premiums, (ii) Syzygy’s Section 831(b) election was not valid because it was not an “insurance” company”, and (iii) the premiums received by Syzygy were taxable income. The IRS also proposed accuracy-related penalties on the resulting income deficiencies.
The Tax Court ruled in favor of the IRS on the underlying income tax deficiencies. This had the effect of double taxing the captive participants, as the Tax Court held that the premiums paid by Highland Tank and its affiliates were not deductible, and those same premiums when received by Syzygy were income taxable to it. [Practice Note: This arguable whipsaw creates a heightened risk exposure for taxpayers participating in microcaptive insurance arrangements.] Among the factual findings underlying the Tax Court’s holdings were:
- The risk borne by Syzygy for the first $250,000 of losses entitled it to more than 49% of the premium, and that 49% was used simply to satisfy an IRS safe harbor provision on risk distribution.
- The insurance policies issued to Highland Tank were not commercially reasonable, containing several unique terms such as no-refund of premiums upon cancellation and an unreasonably short time limit to report claims. Further, the policies were typically issued after the time period that the policies purported to cover.
- The premiums for the policies were not actuarially determined nor otherwise calculated on a reasoned basis.
- Highland Tank incurred losses that were covered by the captive insurance policies, and yet did not file any claims.
- The reinsurance pool addressed only a single claim over a five year period, which as not properly investigated and settled based on questioned merits.
- Syzygy invested a large portion of its reserves in split dollar insurance arrangements on the lives of Jacob family members.
Despite these harsh findings on the underlying tax issues, the Tax Court was more forgiving on penalties. The Court found that the Jacob family’s reliance on their outside CPA – who was independent, participated in meetings with Alta, and advised the Jacob family that the arrangement complied with relevant tax laws – was reasonable and in good faith. Therefore accuracy-related penalties did not apply.
While some of the facts presented in Syzygy are unique and aspects of the Court’s decision distinguishable on that basis, there is no question that risks associated with Section 831(b) microcaptives continue to increase. It is therefore critical for tax practitioners to visit with their clients that have Section 831(b) captive insurance arrangements to evaluate the merits of the planning, analyze the potential risks of litigation, and explore ways to fortify potential defenses. Consideration should also be given to the level of captive insurance coverage and whether it should be adjusted based on claims experience and other factors, as well as the covered risks and whether policies should be discontinued or otherwise replaced based on changing business risks.
To learn more about microcaptives and the IRS’ enforcement campaign against them, see the following:
- For a copy of the Syzygy decision, follow this link: https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11907
- For commentary on the IRS’ win in the 2018 microcaptive case of Mechanical Reserve, follow this link: https://www.meadowscollier.com/the-tax-court-hands-the-irs-another-win-in-its-campaign-against-small-captive-insurance-arrangements
- For commentary on the IRS’ win in the 2017 microcaptive case of Avrahami, follow this link: https://www.meadowscollier.com/in-the-first-case-emeverem-decided-involving-irc-section-831b-microcaptive-insurance-planning-the-tax-court-delivers-the-irs-a-critical-first-win
- For practice tips for assessing and evaluating small captive insurance arrangements, follow this link: https://www.meadowscollier.com/weathering-the-storm-18-tips-for-assessing-your-clients-section-831b-microcaptive-insurance-planning-following-the-avrahami-decision
- For information on annual reporting requirements applicable to microcaptives, follow this link: https://www.meadowscollier.com/irs-mandates-disclosure-of-small-captives-before-january-30-2017
If you have any other questions about this blog post or captive insurance, please do not hesitate to contact me at (214) 749-2464 or firstname.lastname@example.org.