Tenth Circuit on Captive Micro Insurance Company and Tax Exemptions

On May 13, 2022, in Reserve Mechanical Corporation v. Commissioner,^[1] the United States Court of Appeals for the Tenth Circuit upheld a Tax Court ruling that a micro-captive insurance company was not eligible for the income tax exemption in as a small insurance company under IRC § 501(c)(15). Therefore, the alleged bonus payments the company received constituted fixed, determinable, annual, or periodic (FDAP) income taxable at a rate of 30% under IRC § 881(a). The IRS reviews micro-captive transactions because of their potential for tax evasion. For purposes of disclosure requirements, the IRS has identified certain micro-captive transactions as “listed transactions” in Notice 2016-66. A court recently invalidated opinion 2016-66 for non-compliance with the law on administrative procedure;^[2] however, Reserve Mechanical shows that micro-captive trades remain vulnerable on the bottom.

Facts

In Reserve Mechanical, two shareholders owned and operated a mining company, Peak Mechanical Corp. (Peak). Prior to the years at issue, Peak had commercial insurance and paid annual premiums of $100,000. In 2008, the two shareholders consulted Capstone Associated Services, Ltd. (Capstone) on creating a micro-captive insurance company. Capstone promised to provide shareholders with a feasibility study; however, shareholders proceeded to form Reserve Mechanical Corp. (Reserve) in the British West Indies before reviewing this information. The reserve had no employees. Capstone provided management services to Reserve, including policy preparation and premium determination. One of the shareholders testified that he was unhappy with his commercial insurance policies, but Peak continued to maintain commercial coverage after Reserve was established.

From 2008 to 2010, Reserve issued 13 direct policies to Peak and two affiliates in exchange for annual premiums of $400,000. There were several issues with direct policies, including multiple policies listing the wrong insured and other policies overlapping Peak’s existing commercial coverage. Capstone advised Reserve that it would need to receive at least 30% of its premiums from companies not affiliated with it to qualify as an insurance company. To this end, Reserve participated in a quota-share reinsurance policy with PoolRe, a risk pool involving 50 captive insurance companies managed by Capstone. Under this agreement, Reserve and other Capstone entities have agreed to assume some of the risks assumed by PoolRe. The policy has been structured so that the commissions Reserve receives from PoolRe are equal to the commissions PoolRe receives from Peak. Additionally, Reserve has entered into a credit co-insurance agreement with PoolRe involving CreditRe. There is no evidence that Reserve received any premiums under the credit co-insurance agreement.

Peak claimed the insurance premiums it paid to Reserve as a business expense on its federal tax returns. Because Reserve received premiums of less than $600,000 each year, it concluded that it was a tax-exempt insurance company under IRC § 501(c)(15) and only paid no tax on premium payments she received from Peak. The IRS determined that Reserve had no right to exclude bonuses from taxation and proposed assessments for each year.

Legal analysis

IRC § 501(c)(15)(A)(i) provides that insurance companies are exempt from tax where: (i) gross receipts for the year do not exceed $600,000; and (ii) more than 50% of gross receipts consist of bonuses. The central issue in Reserve Mechanical was whether Reserve was an insurance company such that it could benefit from the tax exemption provided by section 501(c)(15).^[3] Insurance is not defined by the Internal Revenue Code. Courts have adopted a four-part framework for evaluating insurance contracts: (i) the contract must involve insurable risks; (ii) the arrangement must transfer the risk of loss to the insurer; (iii) the insurer must spread the risk of loss among its policyholders; and (iv) the arrangement must constitute insurance in the commonly understood sense.^[4]

Applying this framework, the Tax Court found that the reserve arrangement was deficient for two reasons: (i) it failed to spread risk because direct policies involved too few policyholders and PoolRe did not was not a bona fide insurance company; and (ii) it was not insurance in the commonly accepted sense because Reserve was not operated as an insurance company and the premiums were unreasonable and not actuarially determined. The Tenth Circuit upheld the Tax Court’s decision on both grounds. Each pattern is discussed below.

(i) The reserve mechanism did not provide for risk spreading

On appeal, Reserve did not challenge the Tax Court’s finding that the direct policies issued to Peak did not result in an allocation of risk. Instead, he argued that the reinsurance and co-insurance agreements with PoolRe resulted in sufficient risk spreading for Reserve to be a valid insurance company. Reserve claimed the Tax Court misapplied the risk allocation test by focusing on whether PoolRe was a bona fide insurance company. The Tenth Circuit recognized that, in theory, an arrangement that provided for the allocation of risk could constitute insurance even in the absence of an insurance company. However, PoolRe’s product was not insurance. According to the court, the reinsurance agreement was nothing more than a circular flow of funds without a significant distribution of risk. Moreover, there was no evidence that the co-insurance agreement with PoolRe even existed because it received no premiums or paid any claims during the 2008-2010 period. But, even if the co-insurance existed, Reserve did not assume any significant risk. According to the Tenth Circuit, the Tax Court downplayed evidence that PoolRe was a sham. The Tenth Circuit noted that the Tax Court’s decision did not come to a conclusion on the legitimacy of risk pooling generally. But it was clear that PoolRe’s risk pooling did not lead to risk spreading.

(ii) The reserve arrangement was not insurance in the commonly accepted sense

On appeal, Reserve argued that the Tax Court erred: (i) in incorrectly characterizing the policies as excess coverage policies; (ii) concluding that the bonuses were unreasonable and not negotiated at arm’s length; and (iii) considering that Reserve was not operating as an insurance company because it was managed by Capstone. The Tenth Circuit disagreed. First, she found that the Tax Court did not misinterpret the direct policies Reserve issued to Peak. It was clear that direct policies applied only after all other insurance coverage had been exhausted. Second, the Tax Court correctly concluded that the premiums for the policies were unreasonable and not arm’s length negotiated because the premiums were four times higher than the commercial policies of Peak and Reserve provided no explanation of how she calculated the risks. Finally, the Tax Court was justified in finding that Reserve was not operating as an insurance company because it had no employees; never did business in Anguilla; its president knew nothing of its operations; and he failed to investigate the one claim he received before paying around $340,000. Therefore, it was clear that the Reserve policies were not insurance in the commonly accepted sense.

Conclusion

Reserve’s direct policies and PoolRe’s risk pool involved many defects specific to this case. But Reserve Mechanical could bolster the IRS’ resolve to end abusive micro-captive trading. Although the court said it was not ruling on the legitimacy of risk pooling in general, the case sets a very high bar for micro insurance captives to establish risk pooling. Taxpayers who participate in micro-captive transactions may wish to consult their tax advisor to understand how Reserve Mechanical affects them.

NOTES

[1] 129 AFTR 2d 2022-1804 (10th Cir. 2022).

[2]CIC Services, LLC c. IRS, Case No. 3:17-cv-110 (ED Tenn. March 21, 2022). SeeGT alert, court strikes down micro-captive trading notice 2016-66, the second time an IRS notice has been struck down this month.

[3] TC Memorandum 2018-86 (2018).

[4]Harper Group. v. Comm’r, 96 TC 45 (1991), case 979 F.2d 1341 (9th Cir. 1992).