Tenth Circuit on Micro Captive Insurance Company And Tax Exemptions

May 13, 2022, Reserve Mechanical Corporation vs. Commissioner,^[1] The 10th Circuit Court of Appeals upheld the Tax Court’s ruling that microcaptive insurers are not eligible for income tax exemptions as small insurers under IRC §501 (c) (15). Therefore, premium payments allegedly received by the company constitute fixed, decidable, annual or recurring (FDAP) income taxed at a rate of 30% under IRC §881 (a). I did. The IRS will scrutinize microcaptive transactions due to potential tax evasion. For disclosure requirements, the IRS has identified certain microcaptive transactions as “listed transactions” in Notice 2016-66. The court recently revoked Notice 2016-66 for failing to comply with the Administrative Procedure Act.^[2] However, Reserve Mechanical shows that microcaptive transactions remain vulnerable to benefits.

fact

At Reserve Mechanical, two shareholders owned and operated the mining company Peak Mechanical Corp. (Peak). Prior to the year in question, Peak had commercial insurance with an annual premium of $ 100,000. In 2008, the two shareholders consulted with Capstone Associated Services, Ltd. (Capstone) about the establishment of a microcaptive insurance company. Capstone has promised to provide shareholders with a feasibility study. However, shareholders established Reserve Mechanical Corporation (Reserve) in the British West Indies before confirming the information. There were no employees in the reserve. Capstone provided Reserve with management services such as policy preparation and premium determination. One of the shareholders testified that he was dissatisfied with the commercial insurance policy, but Peak continued to maintain commercial insurance even after the reserve was established.

Between 2008 and 2010, Reserve issued 13 direct insurance policies to Peak and two affiliates in exchange for an annual premium of $ 400,000. There were multiple issues with direct insurance. For example, some insurances listed the wrong insured, and others overlapped with peak existing commercial insurance. Capstone advised that in order to qualify as an insurance company, you must receive at least 30% of the premium from a company that is not affiliated with the reserve. To this end, Reserve has participated in a quota share reinsurance policy with PoolRe, a risk pool involving 50 capstone insurers managed by Capstone. Under this agreement, Reserve and other Capstone entities have agreed to assume some of the risks that PoolRe has assumed. The policy was configured so that the Reserve fee received from PoolRe would be equal to the PoolRe fee received from Peak. In addition, Reserve has entered into a joint credit insurance policy with PoolRe, including CreditRe. There was no evidence that the reserve received premiums in connection with the credit joint insurance policy.

Peak deducted the premium paid to the reserve for the cost of the federal income tax return. Since Reserve received less than $ 600,000 annually, it concluded that it was a tax-exempt insurance company under IRC §501 (c) (15) and did not pay taxes on premium payments received from Peak. The IRS has determined that the Reserve does not have the right to exempt premiums from taxation and has proposed an annual assessment.

Legal analysis

IRC §501 (c) (15) (A) (i) provides that insurance companies are exempt from tax if: (I) Total income for the year does not exceed $ 600,000. (Ii) More than 50% of total income is composed of insurance premiums. The central issue with reserve mechanical was whether the reserve was an insurance company that could benefit from the tax exemption of §501 (c) (15).^[3] Insurance is not defined by the Internal Revenue Code. The court has adopted a four-part framework for assessing insurance policies. (Ii) The arrangement must transfer the risk of loss to the insurance company. (Iii) The insurance company must distribute the risk of loss to policyholders. (Iv) The arrangement must constitute insurance in the generally accepted sense.^[4]

Applying this framework, the Tax Court concluded that the reserve arrangement was inadequate for two reasons. (Ii) The reserve was not operated as an insurance company, the premiums were unreasonable and not actually determined, so it was not an insurance in the generally accepted sense. The 10th Circuit upheld the Tax Court’s ruling for both reasons. The rationale for each is explained below.

(I) Reserve arrangements did not provide risk allocation

In the appeal, Reserve did not disagree with the Tax Court’s conclusion that the direct policy issued at Peak did not provide risk sharing. Rather, he argued that the reinsurance and joint insurance arrangements with PoolRe provided sufficient risk allocation for the reserve to be a valid insurer. Reserve alleged that the tax court misapplied the risk allocation test by focusing on whether PoolRe was a well-meaning insurance company. Circuit 10 acknowledged that, in theory, arrangements that provide risk sharing could be insured even in the absence of an insurance company. However, PoolRe’s products were not insured. According to the court, the reinsurance arrangement was nothing more than a cyclical flow of funds with no meaningful distribution of risk. In addition, there was no evidence that a joint insurance policy with PoolRe existed. This is because PoolRe did not receive or claim premiums between 2008 and 2010. However, even with the existence of joint insurance, the reserve did not take any meaningful risk. According to the 10th Circuit, the Tax Court underestimated the evidence that PoolRe was fake. The 10th Circuit noted that the Tax Court’s ruling did not reach a conclusion on the legitimacy of general risk pooling. However, it was clear that PoolRe’s risk pool did not provide risk diversification.

(Ii) The reserve arrangement was not insurance in the generally accepted sense.

In the appeal, Reserve alleged that the tax court made the following mistakes: (Ii) Conclude that the premium was unreasonable and was not negotiated at arm length. (Iii) He claims that the reserve was not operated as an insurance company because it was controlled by Capstone. I didn’t agree with the 10th circuit. First, the Tax Court concluded that it did not misunderstand the direct policy issued by Reserve at its peak. It was clear that direct insurance would only apply after all other insurance had been exhausted. Second, the tax court said premiums were unreasonable and were not negotiated at arm length, as premiums were four times the peak trade policy and reserves did not explain how to calculate risk. I have properly concluded. Finally, the tax court justified by concluding that the reserve does not have employees and therefore does not operate as an insurance company. I have never done business in Anguilla. The president knew nothing about its operation. And he couldn’t investigate the only claim he received before paying about $ 340,000. Therefore, it was clear that reserve policy was not insurance in the generally accepted sense.

Conclusion

The Reserve Direct Policy and PoolRe’s risk pool contained a number of flaws specific to this case. However, Reserve Mechanical could strengthen the IRS’s determination to shut down rogue microcaptive transactions. The court said there was disagreement over the legitimacy of risk pooling in general, but the proceedings set high standards for microcaptive insurers to establish risk allocation. Taxpayers participating in microcaptive transactions are advised to consult with a tax accountant to understand how reserve mechanicals affect them.

ENDNOTES

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

[2]CIC Services, LLC v. IRS, Case Number 3: 17-cv-110 (ED Tenn, March 21, 2022). SeeGT Alert, Court has disabled Notification 2016-66 on Microcaptive Transactions, and IRS Notifications have been disabled for the second time this month.

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

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