Wednesday, March 30, 2022
In Part One earlier this week, I introduced the concept of a captive insurance company. Part One can be found here: https://lawprofessors.typepad.com/agriculturallaw/2022/03/captive-insurance-part-one.html In Part One, I looked at the income tax, estate and gift tax implications of captive companies and how they might be used as part of an overall income tax planning, estate planning and succession planning vehicle to minimize unique risks of the business.
In Part Two today, I look at the IRS audit issues associated with captive insurance companies and how the courts have addressed the issues.
Captive insurance companies, IRS audit issues and litigation. It’s the topic of today’s post.
IRS Scrutiny, Litigation and Other Developments
The IRS focus. Abusive micro-captive corporations have been a concern to the IRS for several years. The basic issue is where the line is between deductible captive insurance and non-deductible self-insurance.
Note: The IRS focus centers on the fact that with an I.R.C. §831(b) election premiums can be deducted at ordinary income rates and can then be distributed to owners at capital gain rates. To the extent claims are not paid, the premiums can be distributed from the captive in a manner that escapes transfer taxes. Both of these issues, in turn, are centered on whether the captive company is insuring legitimate business risks and that “insurance” is actually involved.
IRS audits. IRS initiated forensic audits of large captive insurance providers at least a decade ago, and the IRS activity resulted in certain transactions making the “Dirty Dozen” tax scam list starting in 2014. In 2015, the IRS put out a news release that notified taxpayers that it would be taking action against micro-captive insurance arrangement that it believes are being used to evade taxes. IR 2015-16 (Feb. 3, 2015). In 2016, the IRS issued a Notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion. Notice 2016-66, 2016-47 IRB 745. Since that time, the IRS has been litigating the micro-captive insurance issue aggressively.
Court cases. Taxpayers have won court cases involving IRS challenges to the tax treatment of and deductions associated with captive insurance companies. The wins involved large captive insurance companies. For instance, in Rent-A-Center v. Comr., 142 T.C. 1 (2014), the Tax Court determined that payments that a subsidiary corporation made to a captive insurance company were insurance expenses deductible under I.R.C. §162. Likewise, in Securitas Holdings, Inc. v. Comr., T.C. Memo. 2014-225, the Tax Court determined that premiums paid to a brother-sister captive insurance company were deductible. Also, in R.V.I. Guaranty Co. Ltd. and Subs v. Comr., 145 T.C. 209 (2015), the Tax Court held that insuring against losses in the residual value of an asset leased to third parties was insurance for federal income tax purposes.
Note: Importantly, in each of the cases involving taxpayer wins, the Tax Court determined that actual “insurance” was involved.
But the IRS has won several prominent cases since ramping up its scrutiny. In Avrahami v. Comr., 149 T.C. 144 (2017), the petitioners (a married couple) owned three shopping centers and several jewelry stores in Arizona. Via these businesses, they deducted about $150,000 in insurance expenses in 2006. The petitioners then formed a captive insurance company under the law of the Federation of Saint Kitts and Nevis (the birthplace of Alexander Hamilton). After the captive insurance company was formed their deductible insurance expenses for the companies increased to over $1.1 million annually, and included coverage for terrorism risks and tax liabilities from an IRS audit.
The Tax Court upheld the IRS determination that the expenses were non-deductible and that the elections the micro-captive company had made under I.R.C. §953(d) and 831(b) were invalid because the micro-captive company did not qualify as a legitimate insurance business. The Tax Court noted that proper policy language, actuarial standards, and payment and processing of claims are required to operate as an insurance company. These features were lacking. In addition, the Tax Court determined that there was inadequate risk distribution, and the actuary did not have any coherent explanation of how he priced the insurance policies. Also, there had been no claims filed until two months after the IRS initiated an audit. In addition, a majority of the investments of the micro-captive were in long-term illiquid and partially unsecured loans to related parties – the petitioners’ other entities. This left little liquid fund from which to pay claims. All of these facts indicated to the Tax Court that the captive was not a legitimate insurance company.
Note: It is important to establish that the captive insurance company was established to reduce or insure against risks, and not just to achieve tax benefits. In additions, policies must be appropriately priced relative to commercial insurance. The payment of excess premiums annually for a number of years while few or no claims are made inures against a finding of a legitimate business purpose for creating the captive.
The next year, the Tax Court in Reserve Mechanical Corp. v. Comr., T.C. Memo. 2018-86, disallowed deductions for insurance premiums based largely on the same reasoning utilized in Avrahami. The case involved an Idaho company engaged in manufacturing and distributing heavy machinery used for underground mining. Its business activities were heavily regulated and subject to potential liability risk under various state and federal environmental laws. To minimize the risk from its business operations in a more cost-effective manner, the owner(s) formed a captive insurance company under the laws of Anguilla, British West Indies to provide itself with an excess pollution policy. The captive company also provided other policies covering business cyber risk.
The Tax Court held that the micro-captive company was not a legitimate insurance company because its transactions were not “insurance transactions.” The Tax Court also determined that the micro-captive didn’t qualify as a domestic corporation. The Tax Court upheld the IRS’ determination that the company was subject to a 30 percent tax under I.R.C. §881(a) on fixed or determinable annual or periodical (FDAP) income the company received from U.S. sources. The Tax Court determined that the income was not effectively connected with the conduct of a U.S. trade or business.
In Syzygy Insurance Co. v. Comr., T.C. Memo. 2019-34, the petitioners had a family business that manufactured steel tanks. Annual revenue averaged about $55 million. The business obtained policies from a captive insurance company, but the arrangement, the Tax Court determined, did not resemble insurance transactions. As it had in the 2018 case, the Tax Court noted that for a company to make a valid I.R.C. §831(b) election, it must transact in insurance. As noted above, if insurance is actually involved, premiums paid are deductible. The Tax Court analyzed the policies and concluded that there was no risk distribution, the arrangement was not “insurance” in the commonly accepted sense of the term. Thus, the premium payments were not deductible. They were neither fees or payments for insurance. The Tax Court also noted that the president of the family business had sent an email stating that one of the reasons for leaving the previous insurance arrangement was the decrease in premiums. Judge Ruwe wrote, “It is fair to assume that a purchaser of insurance would want the most coverage for the lowest premiums… The fact that [the president] sought higher premiums leads us to believe that the contracts were not arm’s-length contracts but were aimed at increasing deductions.”
Note: To reiterate, business deductions must have a business purpose, and not be solely for the purpose of lowering income tax liability.
In early 2021, the Tax Court decided Caylor Land Development v. Comr., T.C. Memo. 2021-30. In Caylor, the petitioner was a construction company. The petitioner’s $60,000 annual insurance cost was deemed to be too high. Beginning in late 2007 the company took out policies from a related micro-captive company formed under the laws of Anguilla. Doing so caused the petitioner’s insurance bill to increase to about $1.2 million. The petitioner paid $1.2 million to the captive insurance company on the day of formation and deducted that amount on its 2007 return. Each year thereafter, the deducted consulting payments (legal, accounting and management fees) were about $1.2 million. The micro-captive company did not include the $1.2 million in income. The Tax Court held that the arrangement did not qualify as insurance for tax purposes because the micro-captive company did not provide insurance (because there was no risk distribution). IN addition, the Tax Court concluded that the arrangement did not resemble any type of commonly accepted notion of insurance. The Tax Court also upheld 20 percent accuracy related penalties for substantial understatement of tax and for negligence.
Taxpayer victory – sort of. In late 2021, the Tax Court entered an order in Puglisi et al. v. Comr, No. 13489 (Nov. 5, 2021). The IRS conceded the case before trial to avoid an adverse ruling on the merits. The petitioners owned an egg farm in Delaware with more than 1.2 million egg-producing hens. The farm owned a liability insurance policy but wasn’t able to buy insurance to insure against the Avian flu.
Note: In early 2022, reports of Avian influenza surfaced in flocks of chickens in Montana, Nebraska, South Dakota, Iowa and elsewhere. The presence of this influenza results in the destruction of the flock at great cost to the owner(s).
As a result, the petitioners formed a captive insurance company to provide that additional coverage. The captive company was a Delaware corporation operaitng as a reinsurance company. The egg farm bought insurance from a fronting company. The fronting company then entered into a reinsurance arrangement with the captive company. Under the reinsurance arrangement the captive insurance company reinsured 20 percent of all approved claims of the egg farm, and 80 percent of all approved claims of unrelated entities that the fronting company insured. The egg farm was organized as an LLC which resulted in deductions flowing through to the petitioners’ personal returns. Before the IRS initiated an audit, the egg farm had submitted a total of five claims to the fronting company.
The IRS audited and issued statutory notices of deficiency (taxes and penalties) exceeding $2.7 million (total) for 2015, 2016 and 2018. Ultimately, the IRS conceded the deductions and sought an order from the Tax Court that the deficiency was a mere $18,587 for 2015. The petitioners objected, wanting the Tax Court to rule on whether the fronting company was an insurance company for income tax purposes because the issue of the deductibility of premiums paid to the fronting company would be an issue that would continue to arise annually. and they wanted the issue resolved. In addition, many other businesses paid insurance premiums to the fronting company that were reinsured, at least in part, by the petitioner’s captive insurance company. The Tax Court refused to rule on the matter and entered a decision in line with the IRS’ concession. Presently, it remains to be seen whether the IRS will challenge the petitioners’ captive insurance company in the future.
Note: It’s important to note that the IRS continued to maintain that the fronting company was not an insurance company for tax purposes, even though it conceded the tax deficiency issue.
Captive insurance certainly has come under IRS scrutiny in recent years. But, if it truly involves insurance and is providing risk-management for unique risks of the business with premiums set at reasonable rates, it is a legitimate concept. The court cases illustrate those points and show the boundaries of what is an appropriate use of a captive insurance company and what is not.
In Part Three, I will turn my attention to IRS administrative attempts to tighten the screws on captive insurance transactions without following procedural law and the courts pushing the IRS back. These developments have filing/disclosure implications for tax practitioners and “material advisors.”