The Tax Court Hands the IRS Another Win in its Campaign Against Small Captive Insurance Arrangements

The IRS prevailed in another challenge against a small captive insurance arrangement in the case of Reserve Mechanical Corp. v. Comm’r, decided by the Tax Court on June 18, 2018. This is the second case decided in the IRS’ favor involving a small captive, the first being Avrahami v. Commissioner decided last year.  As the IRS seeks to build on these judicial victories, taxpayers would be well advised to look closely at their captive insurance programs to make sure they are not at risk for suffering the same fate as these taxpayers.  

The captive insurance company at issue, Reserve, was formed by two business owners to insure the risks of their co-owned businesses.  Reserve was formed under foreign law, but made an election under Section 953(d) to be treated as a US person.  This election paved the way for Reserve, based on certain other qualifying conditions, to be treated as a small insurance company under Section 501(c)(15), thereby permitting Reserve to treat its income as exempt from income tax.   Reserve was managed  by Capstone, a third party captive management company.    

Reserve issued policies insuring three businesses, the primary one being Peak Mechanical.   Reserve retained some of the risk of loss under those policies and reinsured the remainder through a reinsurance pool.  The reinsurance pool was also managed by Capstone and served as a reinsurer for many other Capstone clients.   At the same time, Reserve assumed liability for a portion of the totality of risks managed by the reinsurance pool.   Stated differently, Reserve traded a portion of the risk of loss under the Peak policies for a portion of the blended risk of loss under the pool’s entire insurance portfolio.  These reinsurance transactions were designed to achieve “risk distribution” – a legal necessity to establish Reserve as an insurance company.  

The Tax Court invalidated Reserve and its insurance transactions on two legally-independent grounds. 

First, the Tax Court held that Reserve failed as an insurance company because its arrangements did not achieve risk distribution.   Among the findings cited by the Court in support of its holding were:

• The reinsurance pool did not have any claims.
• The transaction between Reserve and the reinsurance pool was seemingly not arm’s length.   The amounts that Reserve paid to the reinsurance pool to reinsure the Peak policies were exactly equal to the amounts that the reinsurance pool paid to Reserve to assume liability for a portion of the pool’s overall portfolio, despite there being different risks involved on each side of the transaction. 
• Reserve was only liable on claims made on the Peak policies after a substantial claims threshold was exceeded, which, based on Peak’s history of losses and other commercial coverages, rendered the risk of loss too remote.

Second, the Tax Court held that the transactions between Reserve and Peak did not constitute insurance in the commonly accepted sense.   The Court noted that Reserve met the formalities of an insurance company in its formation, licensing, capitalization, and the keeping of books and records, but the Court found that Reserve did not operate as an insurance company.   Among the Court’s supporting findings were:

• The feasibility study (prepared by Capstone) provided no information on the probability of a covered loss event nor explain in detail how the policies would supplement Peak’s existing coverages.
• Other than the feasibility study, there was no evidence that any due diligence was performed for the policies issued by Reserve. 
• Although Capstone calculated premiums using objective criteria with actuarial support, there was no real business purpose for the policies.    Peak and its affiliates did not have a significant history of losses, and all of the captive policies provided “excess” coverage that, based on Peak’s low loss history and commercial policy limits, would likely never be needed. 
• The insurance policies Capstone drafted and used with its clients including Reserve were “cookie cutter” and in many instances not reasonably suited for the needs of the insured. 
• While a claim was filed by Peak with Reserve, the evidence showed no effort to substantiate or verify the claim. 
• Peak fully maintained its commercial coverages, which Peak testified were insufficient to cover its risks, while thereafter paying roughly 400% more for captive insurance.  The Court found that “no unrelated party would reasonably agree to pay Reserve the premiums that Peak and the other insureds paid for the coverage provided by the direct written policies.”

Because Reserve did not qualify as an insurance company, the Tax Court held that it was ineligible to make a Section 953(d) election, thereby making it a foreign corporation.  And as a foreign corporation with income from U.S. sources (namely the premiums Reserve received from Peak), Reserve was subject to a 30% income tax.   Its further worth noting that in reaching its conclusions, the Tax Court dismissed 39 favorable determination letters that the IRS had issued to other unrelated taxpayers involving captive insurance arrangements similar to the arrangements involving Reserve.

For a copy of the Mechanical Reserve decision follow this link: https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11678. For commentary on the IRS’ prior win in the Avrahami case also involving a small captive insurance company, follow this link: https://www.meadowscollier.com/?t=40&an=68340&format=xml&p=7664. For practice tips for assessing and evaluating small captive insurance arrangements, follow this link: https://www.meadowscollier.com/?t=40&an=69644&format=xml&p=7664.

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 adaddino@meadowscollier.com.