How Dealings between Related Parties Doomed a Captive Insurer
March 16, 2021
Insurance: What is it? How does it work?
Assume that Acme Co[i] is paying premiums for commercial insurance[ii] coverage to protect itself from economic losses that may arise out of various events. These premiums are deductible in determining Acme’s taxable income; they represent an ordinary and necessary expense of conducting Acme’s business.[iii] As in the case of most insurance, the premiums are “lost” as the policy period expires – they are not recovered notwithstanding that the insured has not suffered a loss.
Businesses will sometimes “self-insure” with respect to a particular loss[iv] by setting aside funds to cover their exposure to such loss. Thus, Acme may decide to establish a segregated account to which it will periodically make cash contributions – basically, a reserve – and from which it may withdraw funds to cover the loss, as needed. The amount set aside as part of a self-insurance program, however, is not deductible for purposes of determining the taxable income of the business;[v] what’s more, these funds remain subject to the claims of Acme’s creditors.
The Code, on the other hand, affords businesses the opportunity to establish their own insurance company. Indeed, it encourages businesses to do so by providing certain incentives; specifically, in the case of an electing[vi] “small captive,” (i) the insured business is permitted to deduct the premiums paid to its captive insurance company, provided the premiums are reasonable for the coverage being purchased, and (ii) the captive may receive up to $2.2 million[vii] of annual premium payments free of income tax, provided the premium is reasonable for the loss being insured by the captive. In order to qualify for these benefits, however, the captive has to satisfy certain requirements.[viii]
One common business purpose for which an electing captive may be organized is to provide coverage for a particular risk exposure for which conventional commercial coverage is either not available or very expensive; another is to cover a gap in coverage in an existing conventional policy (for example, an exclusion from such a policy); there are others.
A business which identifies a bona fide, insurable risk, may incorporate a captive under the laws of a jurisdiction[ix] that has captive insurance laws; the captive will be regulated by, and will have to report to, the insurance authorities of such jurisdiction.[x] This corporation would be treated as a C corporation for tax purposes. Like other insurance companies, it will underwrite policies, set aside appropriate reserves to cover claims made against those policies, and invest the balance of the premiums received. As an electing small captive, it will be taxable only on the net investment income and gains it recognizes, provided its premium income does not exceed the above-described premium cap.
Captive as True Insurance Company
The foregoing is all well and good, but in order to enjoy these tax benefits, it is imperative that the captive actually operate as a bona fide insurance company. It must insure a bona fide risk, not one that is certain of occurring; in other words, there must be an element of “fortuity,” as the courts say, in order for the risk to be insurable.
In addition, in order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk being insured from the business to the captive insurer. Risk distribution is the exposure of the captive to third-party risk, and vice versa, as in the case of conventional insurance; in the case of the latter, generally speaking, the actuarially determined premiums collected from many insureds provide the pool of liquidity from which the loss suffered by one insured may be covered. The IRS has issued several rulings over the years that explore these concepts in the case of a captive insurance company.
In most cases, however, it will be difficult for a captive founded by a single business to satisfy the “risk-shifting” and, especially, “risk distribution” requirements. To achieve the status of real insurance, therefore, the captive will often pool its premiums with other captives (not necessarily from the same type of business).[xi] These pools are managed by an experienced (and hopefully reputable) management company for a fee. The management company will conduct annual actuarial reviews to set the premiums, manage any claims, take care of regulatory compliance, pay on claims from the pool as they arise, etc.
Proceed With Caution – or Not
However, it seems that taxpayers are often enticed by sponsors of the above-described pools into forming captives other than solely for genuine business reasons. Indeed, many promoters tout the captive arrangement as a vehicle for retirement, compensation or estate planning device. That’s why the IRS has included captives on its list of “dirty dozen” tax scams. Among the abusive tax structures highlighted by the IRS is a variation on the so-called small captive insurance company discussed herein. The IRS has characterized the scam version as an arrangement with “poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums.’ ”[xii]
A recent decision[xiii] by the U.S. Tax Court considered whether the large premiums paid by Taxpayer to their captive constituted actual premiums, and whether the transaction in which the two engaged was actually insurance. Spoiler alert: it didn’t go well for Taxpayer.
Taxpayer was a commercial construction company with expertise as a general building contractor. As its business grew, Taxpayer and its shareholders established many subsidiaries and affiliates (the “Entities”), which the Court observed what “not at all unusual for an industry where leveraged financing is common and every project carries some risk.”
Notwithstanding the presence of many separate business entities, it was clear, according to the Court, that most of their collective business was run through Taxpayer, and the “fortunes of all these . . . entities were closely tied to the fortune of” Taxpayer.[xiv] In one year, for example, one Entity had $1.4 million in gross receipts, of which $1.2 million was “consulting fees” received from Taxpayer. This Entity then turned around and paid “consulting fees” to several of the other Entities, which “fees” turned out to be a significant part of the Entities’ revenues.
For many years, Taxpayer purchased conventional third-party commercial property, casualty, and liability insurance through its longtime insurance broker. These policies were the broadest policies available in the commercial-insurance marketplace for the risks covered.[xv] In addition, they not only insured Taxpayer, but also other the other related entities, as well as the family of the principal shareholder (“Shareholder”).
However, this traditional insurance did not cover every loss that Taxpayer and its related entities faced over the years. In fact, there was a gap in coverage such that Taxpayer incurred losses of approximately $50,000 per year.
At some point, Shareholder was introduced to the concept of captive insurance. He concluded that captive insurance, “if done correctly, had potential.” Without much in the way of due diligence, Shareholder incorporated a foreign captive insurance company (“Captive”) in December of Year One, acquired all of its stock, and contracted with a company (“Manager”) to manage the captive. To ensure adequate risk distribution (see above), Manager “required” the captives it managed to participate in a risk pool. Captive never participated in this pool.
On the day after its incorporation, Captive elected[xvi] to be taxed solely on its investment income – as a small insurance company – so long as its annual premiums did not exceed the annual premium cap[xvii] set under the Code.
That same day, Taxpayer paid Captive a “premium” in the amount of $1.2 million, which it deducted as an insurance expense on its tax return for Year One.
The Court observed that this premium payment “was at least a bit odd,” because Taxpayer had not yet completed any underwriting questionnaires, and “perhaps even odder” because Captive had not yet underwritten or issued any policies to any of the Entities.[xviii]
“But what really made this first year remarkable,” the Court explained, was that the Year One policies that Captive finally got around to issuing in Year Two were “claims-made” policies, “which means that any claim had to be reported during the applicable policy period.” In other words, when Taxpayer paid the $1.2 million “premium” to Captive at the end of Year One – the same amount it would be paying annually during each of the subsequent years at issue in exchange for a full year’s worth of coverage – in reality Taxpayer was receiving at most 10 days of coverage (i.e., for the rest of December) and possibly none at all.
As in the case of Year One, the underwriting process for Year Two did not begin until after the Year Two coverage period had already closed.
During the years at issue, Taxpayer and the Entities also carried traditional commercial insurance. They supplemented this coverage with their insurance through Captive, for which they paid $1.2 million per year. As in the earlier years described above, Captive delivered these claims-made policies well after the policy periods. Thus, the Entities paid these premiums without knowing what policies they were paying for.
Fees to Premiums to Policies
The Court described the means by which money found its way from Taxpayer to Captive as “noteworthy.” The payment of Captive’s premiums during the earlier years began when Taxpayer paid just over $1.2 million to an Entity for “consulting” services. The payee Entity’s only workers at the time were two minor children related to Shareholder. The consulting payments were made without any contract between the two corporations, and indeed without any records that described when the consultation took place, what advice was received, or even what subjects were discussed.
The above payee Entity then paid another $1.1 million for “professional-consulting fees” to still other Entities that were covered under Captive’s insurance program. As these entities received this “consulting” revenue, they applied it toward the payment of premiums for on insurance from Captive.
“It is not by chance,” the Court stated, “that the consulting payments match the premiums so closely.”[xix] This pattern was repeated every year.
All these premiums, for all these years, from all of the related entities began piling up. During the periods being reviewed, Captive collected $4.8 million. During all that time, however, Captive paid only four claims aggregating only $43,000.
“And, inasmuch as these claims were made on claims-made policies that [Captive] didn’t issue until after the policy years had closed,” the Court continued, “one might expect there to be something odd about them. One would be right.” For example, as to two of the claims, the Manager requested additional support for the claims, but none was ever submitted. Instead, Shareholder (as Captive’s owner) overruled the Manager and ordered that the claims be paid. And both these claims were filed before Captive issued the policies under which they were made; indeed, before the policies were even underwritten.
In calculating its taxable income, Taxpayer deducted the payments that it made to the Entity as consulting expenses. All the other Entities reported their payments to Captive as a combination of deductible insurance and other, related expenses – Captive reported these as premiums.
Captive reported itself as a small insurance company and, therefore, did not include the $1.2 million in premiums as taxable income on its tax returns.
For the years at issue, CPA prepared the tax returns for Taxpayer and almost all of the Entities. The Entities provided CPA with anything that was requested, and CPA simply reported the information that was given to him.[xx] He was unaware that many of the Entities were paying nearly 100% of their gross receipts from consulting on insurance premiums to Captive.
This activity “set off some alarms,” as the Court put it, and the IRS investigated; eventually, notices of deficiency were issued to Shareholder, Taxpayer, and many of the Entities, which then petitioned the Tax Court.
The Court’s Analysis
A taxpayer is allowed to claim a deduction for all ordinary and necessary business expenses. However, where the expenses are incurred between related parties, both the IRS and the Courts are more skeptical of their legitimacy. The reason is that “expenses” paid by one related party to another often represent disguised distributions of profits, which are not deductible. In order to allay any concerns over the true nature of the payments, the IRS and the Courts will look for corroborating evidence related to the expenses claimed.
Both consulting fees and insurance premiums are deductible by a taxpayer as ordinary and necessary expenses if paid or incurred in connection with a trade or business.[xxi] In turn, the consulting fees and premiums are included in the income of the consultant or insurance company, as the case may be.[xxii] Insurance companies are generally taxed on their income in the same manner as other corporations. According to the Court, “that’s what made the $1.2 million in consulting deductions and premiums so likely to raise the IRS’s bureaucratic eyebrows – that’s the limit on premiums that an insurer can receive without owing tax.[xxiii]
A “small insurance company,” the Court stated, with premiums that do not exceed $1.2 million for the year, can elect under the Code to be taxed only on its investment income. These rules are more complicated, the Court explained, when the insurer and the insureds are related to one another because while insurance is deductible, amounts set aside in a loss reserve, as a form of self-insurance, are not. Unfortunately, neither the Code nor the regulations actually define what is meant by “insurance.”
According to the Court, the line between nondeductible self-insurance and deductible insurance can be blurry. In order to distinguish one from the other, the Courts look to four nonexclusive criteria: “risk-shifting; risk-distribution; insurance risk; and whether an arrangement looks like commonly accepted notions of insurance.”
To determine whether Captive’s policies were insurance, the Court applied the four-part test described above.
Risk distribution is one of the common characteristics of insurance, and courts will find it when an insurer pools a large enough collection of unrelated, independent risks that occur randomly over time. “By doing so, the insurer smooths out losses to match more closely its receipt of premiums.”
In previous small captive insurance cases considered by the Court, the captive tried to show risk distribution by investing in an “insurance pool” – a way to reinsure a large number of diverse third parties. In the present case, Captive chose not to participate in such a pool.
The Court then noted that another way that small captive insurers have tried to show that they met the risk-distribution requirement was by issuing policies to their own brother and sister entities. In those cases, the Court asked: “[W]as there a large enough pool of unrelated risk?” “The question is not solely about the number of brother-sister entities insured,” the Court explained, “but the number of independent risk exposures.” In other words, was there a large enough pool of unrelated risk from the policies issued to the related entities?
In Taxpayer’s case, the IRS argued that Captive did not have enough independent risks. The risks it faced made for much too small a risk pool. Moreover, all of the risks were heavily tied to one entity – Taxpayer. The strong correlation of risk between the smaller Entities and Taxpayer prevented Captive from having adequate risk distribution.[xxiv]
In response, Taxpayer argued that Captive adequately distributed risk, relying upon the “law of large numbers”: that Captive insured a sufficient number of unrelated risks to allow the law of large numbers to predict losses. The Court rejected this argument, relying upon caselaw which, according to the Court, demonstrated that the number of independent risks that had to exist in order for risk to be sufficiently distributed to meet this element was “orders of magnitude” greater than the risks covered by Captive. What’s more, the majority of the risks Captive faced were not independent risks. The Entities were all very dependent on Taxpayer.[xxv]
Looks Like Insurance?
Finally, Captive was not operated as an insurance company. For one thing, its process of pricing policies was “very different” in that it backed into the premium amount. In addition, it didn’t issue policies until after the claims period being insured had ended.[xxvi] Its handling of claims was also abnormal; two claims were even paid on policies that had not yet been written. Finally, the Court pointed to the payment made by Taxpayer to Captive for only 10 days of coverage, which was nearly the same as later paid for a full year’s worth of coverage. “This particular fact,” the Court stated, “shows how much more likely it is that [Captive] is self-insurance, if not just a tax-avoidance scheme.”
Next, the Court found that Captive’s premiums were neither reasonable nor the result of an arm’s-length transaction. The historical loss experience of the Entities did not justify the amount paid to Captive as premiums. An unreasonably large premium, the Court noted, is likely to be for something other than “insurance” as that term is commonly understood. Finally, the Court found that the premiums weren’t actuarially determined, and their parameters and assumptions were not properly documented.
Thus, the Court concluded that the premiums paid to Captive and deducted by Taxpayer and the Entities were not paid for “insurance” for federal tax purposes.[xxvii]
A Silver Lining
The Court’s holding on the above facts was a foregone conclusion. Taxpayer had no chance of sustaining its claim that Captive was an insurance company.
That being said, the Court’s opinion highlighted the importance of treating at arm’s length with related parties, including in the context of transactions that intend to be insurance.
The Court also called attention to many practices that should be avoided by anyone who is planning to organize a small captive if they hope to attain the desired tax treatment. As that great American philosopher, Groucho Marx, once said, “Learn from the mistakes of others. You can never live long enough to make them all yourself.”
[i] Yep, I’m channeling Wiley Coyote.
[ii] Generally speaking, commercial insurance covers general liability (to cover claims against the business), workers’ compensation (to cover employees’ work-related injuries), and property insurance (to cover damage to business property).
[iii] IRC Sec. 162.
[iv] Say, for example, anything involving the Road Runner.
[v] After all, the business taxpayer that self-insures is simply moving money from their left pocket to their right pocket – or is it from right to left?
[vi] The election is irrevocable.
[vii] Adjusted for inflation. See the Protecting Americans from Tax Hikes (PATH) Act of 2015, which was enacted in 2015, as part of the Consolidated Appropriations Act (P.L. 114-113). The premium cap was set at $1.2 million for taxable years beginning before January 1, 2017.
[viii] Among other things, these include a “diversification” requirement which was added to IRC Sec. 831(b) as part of the PATH Act in an effort to prevent the use of captives for other than insurance planning purposes; specifically, for estate planning (as evidenced by the alternative test described below).
In order to satisfy the diversification test, no more than 20 percent of the written premiums of the captive company for the taxable year may be attributable to any one policyholder (a risk diversification test); “related” policyholders are treated as one policyholder for this purpose.
In the event that the foregoing test is not satisfied – a likely outcome considering we are taking about a captive insurance company, which was probably organized by a single business – the Code provides an alternative test which may be satisfied if no person who holds (directly or indirectly) an interest in such captive insurance company is a “specified holder” who holds (directly or indirectly) aggregate interests in such company which constitute a percentage of the entire interests in such insurance company which is more than a de minimis percentage higher than the percentage of interests in the relevant “specified assets” with respect to such insurance company held (directly or indirectly) by such specified holder. https://www.law.cornell.edu/uscode/text/26/831 .
[ix] Vermont or Delaware seem to be popular choices.
[x] Among other things, these State insurance regulators seek to ensure that a captive formed in their jurisdiction maintains adequate liquid reserves. They also regulate investments by a captive in order to reduce the risk of investment loss that may impair the captive’s ability to satisfy its obligations.
[xi] Much the same way that many insureds pay premiums to a single insurance company.
[xii] According to the IRS, promoters in such scams received large fees for managing the captive insurance company while assisting unsophisticated taxpayers “to continue the charade.”
[xiii] Caylor Land & Development, Inc. v. Comm’r, T.C. Memo. 2021-30.
[xiv] The Court described the relationship among these entities as follows: “[Taxpayer] was the driver of the success or failure of all the other . . . entities – in a room full of mice, it was the 800-pound gorilla.”
[xv] Commercial property, general liability, umbrella/excess liability, electronic data processing, contractors equipment, installation floater, commercial auto, and terrorism.
[xvi] Under IRC Sec. 831(b).
[xvii] $1.2 million for the taxable years at issue.
[xviii] Taxpayer eventually filled out an underwriting questionnaire for the year at issue and it did eventually acquire policies that covered itself and several other related entities.
[xix] In fact, Shareholder testified that when he began making these payments in 2008, he made sure the consulting payments were slightly more than the premium payments so, as he put it in an email, “the pay-ins do not match the payouts exactly.”
[xx] The Court found that CPA was unable to advise the entities about whether Consolidated was properly operated as an insurance company. He never provided a tax opinion or memorandum regarding the requirements for a small captive insurance company under the Code.
[xxi] IRC Sec. 162; Reg. Sec. 1.162-1.
[xxii] IRC Sec. 61.
[xxiii] IRC Sec. 831(b).
[xxiv] The Court rejected Taxpayer’s arguments to the contrary: insuring a number of unrelated risks sufficient to allow the law of large numbers to predict expected losses; having risks of at least 12 affiliated companies, none of which has liability coverage of less than 5% nor more than 15% of the total risk insured by the insurance; or arranging for at least 30% of the risks assumed by the insurance company to be those of unrelated parties.
[xxv] Many of the Entities received all or most of their revenue from Taxpayer. Many had no clients other than Taxpayer. If something were to happen to Taxpayer, it would have a severe effect on all of the other Entities.
Taxpayer, in turn, was concentrated in the real estate market of a single geographic region. This lack of diversity supported the Court’s finding that the risks insured by Captive were not sufficiently distributed; absent sufficient risk distribution, what Captive provided was not insurance.
[xxvi] A policy written after the claims period is being written after there is no longer a risk of loss, which defeats the whole purpose of insurance.
[xxvii] Because Captive failed to distribute risk and was not selling insurance in the commonly accepted sense, the Court did not decide whether Captive’s transactions involved insurance risk or risk shifting.