With several references to Avrahami, taxpayer loses in Reserve Mechanical Corp. micro-captive case
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With several references to Avrahami, taxpayer loses in Reserve Mechanical Corp. micro-captive case

In the latest micro-captive case to make it to trial, the U.S. Tax Court backed the Internal Revenue Service (IRS) by holding that a micro-captive was not an insurance company as defined by section 816(a),1 did not qualify for tax-exempt treatment of income under section 501(c)(15), and had an invalid election under section 953(d) to be taxed as a domestic corporation. The court also ruled that revenues received by the captive insurance company qualified as “fixed or determinable annual or periodical” income (FDAP income) and were subject to a 30 percent withholding tax under section 881(a)(1).

The court held that the micro-captive and risk-pooling arrangement did not constitute bona fide insurance and thereby could not be respected as such.

Background

The petitioner in Reserve Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86, (Reserve), is a captive insurance company formed in 2008 to insure certain risks of three business ventures owned by Reserve’s ultimate individual owners, Norman L. Zumbaum and Cory Weikel. The most significant of these ventures was Peak Mechanical & Components, Inc. (Peak), which focused on distributing, servicing, repairing and manufacturing equipment used for underground mining and construction. In forming and operating Reserve, Zumbaum and Weikel engaged Capstone Associated Services, Ltd. (Capstone) to perform a captive feasibility study and other services relating to forming and operating a captive insurance company. Despite the formation of the captive insurance company, the entities owned by Zumbaum and Weikel maintained their insurance from third-party commercial carriers.

Reserve issued direct written insurance policies with Peak and the two other businesses as the named insureds on each policy. All of the policies showed one premium price and did not specify amounts to be paid by each of the insureds. Additionally, each policy listed PoolRe Insurance Corp. (PoolRe) as the stop loss insurer. Capstone administered PoolRe’s operations and maintained its books and records. PoolRe entered into stop loss endorsements similar to those of Reserve for insurance policies that other Capstone entities issued.

In addition to the direct coverages provided by Reserve, for the tax years in issue, Reserve started participating in a quota share reinsurance policy with PoolRe where Reserve, as well as the other Capstone entities, agreed to assume coverage for a specified portion (quota share) of the risks that PoolRe had assumed. This policy was structured such that the quota share that Reserve assumed entitled Reserve to receive payments from PoolRe equal to the premiums that PoolRe was to receive from Peak.

Prior to the formation of Reserve, Peak spent approximately $39,000 and $96,000 insuring its business through third-party commercial insurers during 2006 and 2007, respectively. In 2008, 2009 and 2010, insurance premiums paid to Peak beyond the third-party coverage Reserve continued to maintain were approximately $412,000, $448,000 and $445,000, respectively. Peak made only one claim under its direct written policy with Reserve during 2009 totaling approximately $165,000 related to the loss of a major customer. After the tax years in issue, an addendum to the claim was made for an additional $175,000.

The Court’s holdings

Similar to Avrahami v. Commissioner, 149 T.C. No. 7 (Aug. 21, 2017), the IRS took the position that Reserve’s insurance and reinsurance transactions lacked economic substance and therefore Reserve was not deemed to be an insurance company within the meaning of subchapter L of the Code. Additionally, because Reserve’s predominant activity was not insurance, it could neither make the 953(d) election to be taxed as a domestic corporation nor be considered a tax-exempt insurance company within the meaning of section 501(c)(15). The Commissioner argued that Reserve’s arrangements with Peak and the other insureds was not insurance. The Commissioner also determined that the quota share arrangement provided the appearance of risk distribution without actually distributing any risk, as PoolRe was not a bona fide insurance company.

Judge Kathleen M. Kerrigan confirmed that Reserve’s election under section 953(d) was invalid for the tax years in issue. Because of this, Reserve should be treated as a foreign corporation, and thus would be subject to the 30 percent withholding tax on its FDAP income under section 881.

The court held that there was no true risk distribution, as the number of insureds and independent risk exposures was insufficient to distribute risk. The court further held that Reserve’s quota share policies with PoolRe were not bona fide insurance agreements as the arrangements involved a circular flow of funds and premiums were not determined at arm’s length. Further, the court held that there is no evidence to indicate that the premiums were actuarially determined and PoolRe’s activities were not those of a bona fide insurance company.

Increased scrutiny on micro-captive arrangements

While the negative facts highlighted by the court are specific to this case, it serves as an important reminder for taxpayers to revisit the structures of their micro-captives. The concern is that micro-captives are formed to create a deduction for the related-party owner for the insurance premiums paid, while the micro-captive either is exempt from tax if qualifying as a tax-exempt insurance organization under section 501(c)(15) or pays tax only on its investment income under section 831(b). The micro-captive then builds up a surplus from the annual premium income while paying few, if any, claims.

Micro-captives that do not have similar facts to Reserve Mechanical or Avrahami, and which act as a bona fide insurance company, are paying claims, have actuarially determined premiums and are financially capable of meeting its obligations, should continue to withstand IRS scrutiny.

What constitutes insurance?

The U.S. Tax Court ultimately ruled that the Reserve’s micro-captive arrangement, as well as PoolRe’s risk-pooling arrangement, did not constitute bona fide insurance. While there is no true definition of insurance in either the Internal Revenue Code or the U.S. Treasury regulations, taxpayers are guided by case law in determining whether insurance exists for federal income tax purposes. To be considered insurance, an arrangement must:

  • Involve risk-shifting
  • Involve risk-distribution
  • Involve insurance risk
  • Meet commonly accepted notions of insurance

Other factors that are also considered include:

  • Is the company organized, operated, and regulated as an insurance company?
  • Is the insurer adequately capitalized?
  • Are policies valid and binding?
  • Are premiums reasonable and the result of an arm’s length transaction?
  • Is comparable coverage more expensive or even available?
  • Are claims paid?

Generally, the micro-captive should operate as a separate risk-bearing enterprise and function no differently than a third-party insurer.

Impact of this ruling on micro-captives

There can be significant tax consequences for micro-captives that fall under a fact pattern similar to that presented in Reserve Mechanical or Avrahami. The tax benefit of qualifying as a tax-exempt insurance organization under section 501(c)(15) or a small insurance company under section 831(b) is that the captive is either exempt from tax or is taxed on investment income only (therefore not on underwriting, or premium, income). An insurance company is generally considered a tax-exempt insurance organization when gross receipts are less than $600,000 or a small insurance company when premiums are less than $2.2 million and $2.3 million for 2017 and 2018, respectively. If the captive does not fall under either limitation, underwriting income becomes taxable. However, even more importantly, the company must first be an insurance company. In Reserve Mechanical and Avrahami, it was determined that the arrangements did not constitute insurance.

In addition to ensuring that micro-captive arrangements meet the definition of insurance as discussed above, taxpayers should re-evaluate premium pricing to ensure the use of actuarial assumptions that represent the current market, and reconsider the validity of the assumptions used as compared to those used by other actuaries.

Lastly, taxpayers involved in a risk-pooling arrangement should ensure the fronting company has a valid business purpose, operates as an insurance company and is not formed merely as a mechanism to meet risk-distribution requirements. A circular flow of funds similar to the arrangement under PoolRe may be a cause for concern as to whether or not there is true risk shifting and risk distribution.

We recommend organizations contact their tax and captive advisors to review their specific situation for potential recommendations.

This article originally appeared in the Society of Financial Examiners' (SOFE) The Examiner.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

1 All section references are to the Internal Revenue Code of 1986, as amended.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.