Tax Court again denies microcaptive insurance arrangement

The Tax Court determined that transactions entered into by a captive insurer were not insurance under federal tax law, and thus the captive was not an insurance company exempt from taxation under Sec. 501(c)(15). The decision follows the court’s recent decision in Avrahami, 149 T.C. No. 7 (2017), in which it also found that a captive arrangement did not constitute insurance (see “Tax Matters: Microcaptive Premium Deductions Disallowed,” JofA, Nov. 2017.

Facts: In 2008, Norman Zumbaum and Cory Weikel co-owned Peak Mechanical & Components, an S corporation engaged in mining support services, and two other domestic companies, RocQuest LLC and ZW Enterprises LLC. Zumbaum and Weikel engaged Capstone Associated Services Ltd., a captive insurance planning and management company, to form Reserve Mechanical Corp., a foreign captive insurance company that they owned through a holding company.

From 2008 through 2010, Peak maintained primary insurance coverage with third-party insurers. After Reserve Mechanical was formed in 2008, it issued direct-written, excess liability insurance policies naming Peak, RocQuest, and ZW Enterprises as the insureds on each policy. The annual policy limits were $8 million to $13 million.

Reserve also participated in a risk pool administered by Capstone. Each of the Reserve policies included a stop-loss endorsement naming PoolRe Insurance Corp., another foreign company whose operations Capstone administered, as the stop-loss insurer, and 18.5% to 19.9% of the premium for each Reserve policy was paid to PoolRe. PoolRe was also the stop-loss insurer on approximately 400 other policies issued by other captive insurers that worked with Capstone.

Reserve then entered into an associated quota share arrangement with PoolRe, whereby Reserve agreed to reinsure a blended portion of PoolRe’s stop-loss risk pool. PoolRe paid Reserve reinsurance premiums in an amount equal to the premiums paid to PoolRe as the stop-loss insurer on the Reserve policies. PoolRe had similar arrangements with the other captives that participated in the risk pool.

For 2008 through 2010, Reserve elected to be taxed as a domestic corporation under Sec. 953(d).

Issue: The primary issue was whether Reserve qualified as an insurance company under federal tax law.

Under Secs. 501(a) and (c)(15), an insurance company is exempt from federal taxation if its annual gross receipts do not exceed $600,000 and more than 50% of its receipts consist of premiums. For an insurer to qualify as an insurance company for purposes of Sec. 501(c)(15), more than half of the company’s business must be the issuance of insurance or reinsurance of risks underwritten by insurance companies. While neither the Code nor regulations define “insurance,” case law holds that to constitute insurance, an arrangement must involve insurable risk, the risk of loss must be shifted to the insurer, the insurer must distribute the risk, and the arrangement must constitute insurance in the commonly accepted sense.

Holding: The Tax Court held that Reserve’s transactions were not insurance or reinsurance for federal tax purposes.

The court first found that the Reserve policies did not distribute risk, which typically requires insurers to pool a sufficiently large number of unrelated risks such that a single claim would be unlikely to exceed the amount taken in as premiums and set aside for payment of such a claim. While there were three named insureds, RocQuest and ZW had insignificant, if any, operations, and the risk of loss was primarily associated with Peak’s operations. The Reserve policies covered between $8 million and $13 million in potential losses stemming from one insured, the employment of a maximum of 17 employees, and operation of only two facilities. The number of insureds and independent exposures was too small to distribute the risk under the policies.

The Tax Court then looked at the PoolRe risk pool and the quota share arrangements and found that these reinsurance agreements failed to distribute risk because PoolRe itself was not a bona fide insurance company. The agreements were not arm’s-length contracts, and the premiums were not actuarily determined. Instead, the agreements were a circular flow of funds that shifted premiums from the named insureds to their tax-exempt affiliated captive insurer. Each year, Reserve received reinsurance premiums from PoolRe in an amount equal to the stop-loss premiums Peak paid to PoolRe. The agreements also did not cover actual and insurable risk because the Reserve policies were excess-liability policies, Peak had extensive primary coverage and minimal loss history, and the stop-loss endorsement was unlikely to be triggered, due to a high claim threshold.

While the absence of risk distribution was sufficient to determine that Reserve’s transactions were not insurance, the Tax Court went on to find that the transactions also did not constitute insurance in the commonly accepted sense. Reserve was not operated as a bona fide insurance company, as it had no employees, and its president and CEO, Zumbaum, knew little about its operations, which were managed entirely by Capstone at Capstone’s direction. Reserve conducted minimal, if any, due diligence prior to issuing policies or entering into reinsurance agreements. The one claim filed under the Reserve policies was paid without substantiation of loss or amount, and the first payment was made before a settlement and release was signed. In addition, the premiums charged by Reserve were not reasonable, as Peak had no genuine business need for additional insurance on top of its primary coverage.

Because Reserve’s transactions were not insurance or reinsurance, Reserve was not an insurance company and, therefore, was not eligible for tax-exempt status as a small insurance company under Sec. 501(c)(15). In addition, the Tax Court held that because Reserve was not an insurance company, it was not a foreign insurance company eligible to make a Sec. 953(d) election to be taxed as a domestic corporation. Instead, as a foreign corporation, Reserve was subject to the 30% withholding tax imposed on foreign corporations that receive U.S.-source fixed or determinable annual or periodical income under Sec. 881(a).

• Reserve Mechanical Corp., T.C. Memo. 2018-86

— By Elizabeth Lyon, J.D., LL.M., assistant professor of accountancy, California State University, Sacramento.