The Tax Court dealt a swift but sturdy blow to the world of captive insurance companies this week.  In the opinion, the Tax Court held that the payments made by married taxpayers’ companies to a captive insurance company did not qualify as insurance premiums under Code Sec. 162.  The facts of the case are long and intricate and the holding, authorized by Judge Holmes, includes a detailed analysis and guidebook on the history of the tax legislation of captive insurance companies. Truth be told the decision has within it some valuable lessons, mainly the wrong way and the right way to create, maintain and use a captive insurance company, including details on how not to value the premiums.  All those in the captive insurance world or thinking about getting their feet wet, might want to give it read here.

The basic facts of the case are as follows:

The taxpayers, through their S-corporation, owned three successful jewelry stores. In addition, they owned several real-estate companies. In order to protect their assets, the taxpayers established a foreign captive insurance company as an estate planning device. The wife was the sole shareholder. The captive insurance company elected under Code Sec. 953(d) to be treated as a domestic corporation for federal income tax purposes. It also elected to be taxed as a small insurance company under Code Sec. 831(b).

Arrangement Did Not Provide Insurance

Despite the formation of the captive insurance company, the taxpayers’ companies continued to buy insurance from third-party commercial carriers and made no change to its coverage under those policies after contracting with the captive insurance company. The taxpayers companies deducted over $1 million on their tax returns for insurance costs. Three fourths of that amount were payments made to the captive insurance company. In addition, for two years the taxpayer’s S-corporation paid a foreign reinsurance company $360,000 for terrorism insurance and, in both years, the reinsurance company paid the captive insurance company $360,000 in reinsurance premiums.

Accumulated Surplus Loans

Because no claims were filed, the captive insurance company accumulated a surplus, which it transferred to the wife and an LLC that was owned by the taxpayers’ three children. The LLC’s primary asset was 27 acres of land in Arizona. The insurance company transferred money to the LLC as “mortgage and real estate loans.” The LLC then issued a promissory note payable to the insurance company for the same amount.

No Risk Shifting

In order to be considered insurance the arrangement must involve: (1) risk-shifting; (2) risk-distribution; (3) insurance risk; and (4) commonly accepted notions of insurance. Because the captive insurance company only insured three or four related affiliates, it failed to adequately distribute the risk. More importantly, it failed to cover a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities. The taxpayers’ claim that the captive insurance company distributed risk by utilizing a foreign reinsurance company was rejected. The agreement between the captive insurance company and the foreign reinsurance company did not accomplish sufficient risk distribution for its arrangements to be considered “insurance” for federal income tax purposes. The (1) circular flow of funds between the captive insurance company and the reinsurance company; (2) unreasonably high premiums; and (3) fact that it was unlikely that a reasonable, profit-seeking business would enter into a contract under the terms specified by the reinsurance company absent certain beneficial tax considerations; led to a determination that the reinsurance company was not a bona fide insurance company.

Premiums Unreasonable

In addition, the captive insurance company failed to meet the commonly accepted notions of insurance. It dealt with claims “on an ad hoc basis.” It invested only in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them. Further, the taxpayers’ companies made no claims against the captive insurance company until two months after the IRS sent the taxpayers an audit notice suggesting that the captive insurance company was a sham. Also, the claims that the insurance company did receive were handled in questionable ways. Finally, the insurance premiums were “utterly unreasonable.” Accordingly, the payments were not for insurance, were not an ordinary and necessary business expenses and were not deductible under Code Sec. 162(a).

Small Insurance Company and Domestic Corp Elections

In order to elect to be taxed as a small insurance company under  Code Sec. 831(b), a company must be an “insurance company” as defined by Code Sec. 816(a). Because the captive insurance company did not meet this definition, its election was invalid. Moreover, since the foreign captive insurance company was not an “insurance company” its Code Sec. 953(d) election to be treated as a domestic corporation was also not valid.

Bona Fide Loans

Further, the transactions between the captive insurance company and the LLC were bona fide loans. The LLC had adequate assets to satisfy the loans, plus interest, and the loans were properly papered. Although the IRS argued that the court should apply the substance-over form and step-transaction doctrines to construe the transfer as a constructive dividend to the wife, the court found that the economic reality of the transaction was a bona fide loan between the parties.

Finally, the taxpayers acted reasonably and in good faith when relying on their tax professional’s advice. Thus, they were not subject to Code Sec. 6662(a) penalties to the extent the underpayments are attributable to the nondeductibility of the premiums paid to the captive insurance company

Wilson Tax Law Group, APLC, a delightful and tactful tax law firm in Orange County, comprised of former IRS attorneys.

 

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