In a recent news release (IR-2021-82), the Internal Revenue Service is again reminding participants in abusive micro-captive insurance arrangements to end their participation in these transactions. The IRS stated that the agency “has stepped up examinations of these arrangements” in the past few years, and that combatting abusive microcaptive arrangements has become a major focus for the IRS. The IRS advises taxpayers to seek independent review of micro-captive arrangements prior to filing 2020 returns, so that the participants can determine whether they can validly take deductions from these arrangements.
In 2016, the IRS issued Notice 2016-66, in which the IRS advised that micro-captive insurance transactions have the potential for tax avoidance or evasion. In 2020, the IRS deployed 12 newly formed micro-captive examination teams to substantially increase the examinations of ongoing abusive micro-captive insurance transactions. These examination teams issued letters to taxpayers who participated in microcaptive insurance transactions to allow taxpayers “the opportunity to tell the IRS if they've discontinued their participation in this transaction before the IRS initiates examinations.” (Refer to prior alert.)
The news release additionally notes that the U.S. Tax Court has consistently sided with the IRS in cases involving micro-captive insurance arrangements, and cites to the Service’s most recent win in Caylor Land & Dev. v. Commissioner. In Caylor, the Tax Court found “that a microcaptive didn't actually provide insurance because it failed to distribute risk and didn't act as an insurer commonly would.” The judge authoring the opinion noted that this determination is the same as three other Tax Court cases regarding microcaptive insurance companies- Avrahami v. Commissioner, 149 T.C. 144 (2017), Reserve Mech. Corp. v. Commissioner, T.C. Memo. 2018-86, 115 T.C.M. (CCH) 1475 (2018) and Syzygy Ins. Co. v. Commissioner, T.C. Memo. 2019-34, 117 T.C.M. (CCH) 1165 (2019).
In Caylor, a father and son named Bob and Rob Caylor, respectively, each owned and operated Robert Caylor Construction Company (Caylor Construction). Bob formed Caylor Construction in 1961 and then sold the business to his son Rob in the 1990s. Rob had separately formed Caylor Land & Development Company (Caylor Land). Over the years, several subsidiary and affiliate entities were formed, and after purchasing Caylor Construction, Rob managed all the entities through Caylor Construction.
The Caylors learned about microcaptive insurance companies when the two attended a 2007 presentation from an insurance-management company named Tribeca. In the same year, Rob Caylor decided to establish a captive insurance company with Tribeca as its third-party manager. The captive insurance company, Consolidated, Inc., was incorporated under the laws of Anguilla and licensed as an Anguilla insurance company. However, it was also owned by Rob. On December 21, Consolidated elected under section 953(d) to be treated as a domestic U.S. corporation for tax purposes, as well as an election under section 831(b)(2)(A)(ii) to be taxed to be taxed as a small insurance company - which meant that it would be taxed solely on investment income so long as its annual premiums did not exceed $1.2 million (the limit at the time).
From 2007-2010, Consolidated operated as a captive insurance company, and wrote policies for Caylor Construction and various other Caylor entities. However, the policies were almost never written or issued until after the policy years had closed. Therefore, the Caylor entities frequently paid premiums without knowing what policies they were paying for or the total premium amounts. For at least 2009 and 2010, Consolidated reported itself as a microcaptive and did not include the $1.2 million in premiums as taxable income for either year.
The Tax Court utilized a four-prong test established from case law to determine the validity of the microcaptive arrangement between the Caylor entities and Consolidated. The four criteria utilized by the court for establishing non-deductible self-insurance from deductible insurance are: risk shifting, risk-distribution, insurance risk and whether an arrangement looks like commonly accepted notions of insurance. In this case, as in the other three recent microcaptive Tax Court case, the Tax Court focused on the factors of risk distribution and ‘commonly accepted notions of insurance.’
First, the court determined that there was no risk distribution because Consolidated had not participated in an ‘insurance pool,’ despite the fact that Tribeca had advised its clients “they had to participate in such a pool to have adequate risk distribution.” Alternatively, the court also found that Consolidated could not show that there was “a large enough pool of unrelated risk from the policies issued to the related entities,” because almost all of the risk was concentrated with Caylor Construction. The Court emphasized that the question was not solely the number of ensured parties, but also the number of independent risk exposures. In addition, because all of the entities in the Caylor group relied on the main entity, Caylor Construction, for consulting revenue and related projects, the insured risk exposure was related primarily to the main entity, reducing the number of risk exposures. Additionally, the court found “there was no geographic diversity or industry diversity in the entities that Consolidated insured” because almost all of the entities were in some way in the real-estate industry and all the entities were located in Tucson, Arizona.
Second, the court analyzed the “commonly accepted notion” criteria, although noting that the “absence of risk distribution is enough” to find the arrangement invalid. The court considered several factors, including whether the company was organized, operated and regulated as an insurance company; was adequately capitalized; issued policies that were valid and binding; established reasonable premiums as a result of an arm’s-length transaction; and paid claims. The Caylors argued that Consolidated qualified as an insurance company because it was properly regulated, had adequate capitalization, paid its claims when they were filed, had premiums that were actuarially determined by a third-party captive-management company and that those premiums were paid by the Caylor entities. The court rejected these arguments and found that the pricing of policies and handling of claims was “abnormal,” primarily because Consolidated generally did not provide policies for the Caylor entities until after he claims periods ended. Additionally, the court believed that the premiums had been priced and inflated by Tribeca to fit within the total premium amount, the $1.2 million limit, which the entities wished to pay rather than the pricing being based on the “entities’ historical losses.”
One unique decision in Caylor compared to the other microcaptive Tax Court decisions is that the court has imposed accuracy-related penalties under Code section 6662(a) against the Caylors. This is the first time the court has imposed accuracy related penalties. The court concluded that a section 6662(a) penalty was justified because the Caylor entities understated tax liability and were negligent in maintaining books and records. The court also rejected the Caylors’ reasonable cause argument that they relied on professional advice. Although the Caylors had tax advisors, the tax advisors did not provide the Caylors any specific advice regarding the operation and organization of Consolidated. Those advisors had actually informed the Caylors that they did not have expertise in the captive insurance area, and could not advise on the arrangement.
Based on this news release and the recent Tax Court rulings, Taxpayers who participate in a micro-captive insurance arrangement should consult with their tax advisors to make sure they are not engaging in abusive transactions. Further, taxpayers need to be sure they are filing the appropriate disclosure forms for any micro-captive insurance arrangements they are engaging in. Taxpayers should be aware of the IRS’s heightened scrutiny and ensure they have the proper documentation in place to withstand an investigation into their micro-captive insurance arrangements.