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November 29, 2022


Captives must follow expected insurance industry practices, part 2

The 10th Circuit in an important opinion has affirmed that microcaptive insurance schemes can be abusive when their purpose is to avoid taxation.

In part 1 of this article, we explained microcaptive insurance arrangements and introduced Reserve Mechanical Corp. v. Commissioner of Internal Revenue (CIR), a May 2022 decision from the U.S. Court of Appeals for the 10th Circuit.

In the Reserve Mechanical case, the appeals court affirmed the U.S. Tax Court and IRS in their finding that microcaptive Reserve Mechanical was operating as a scam to evade taxation. The 10th Circuit opinion contains pages of detailed examples of indicators that Reserve was engaged in an abusive tax-evasion scheme with Peak Mechanical, a related business.

The decision is long and complex, but some of the court’s main reasons for this conclusion include:

  • Unreasonable premiums: Premium amounts must be comparable to those that an unrelated customer would negotiate at arm’s length. The captive must not inflate premiums for correspondingly higher tax deductions out of sync with the level of insured risk.
  • Careless policy drafting: The policies Mechanical issued for Peak contained incorrect information or omitted essential information, appearing to be the result of sloppy drafting. The policies’ language appeared to be from form policies used by other captives and not tailored to Peak’s needs.
  • Questionable premium pricing: The captive failed to conduct adequate risk assessments to set Peak’s premiums accordingly. There was no evidence of solid use of market and comparative data to analyze probability of risk occurrence and the size of such a loss nor was comparable commercial pricing considered.
  • Policies not tailored to Peak’s needs: The policies were form documents received from Capstone, a captive management company the owners consulted and contracted with for management services. The coverage did not conform to protect Peak’s unique needs.
  • Inadequate risk distribution: A qualified insurer would get at least one-third of its insurance business (in this case) from unaffiliated businesses for healthy diversification, which Reserve did not. Pooling arrangements for reinsurance and coinsurance contracts among other insurers and captives managed by Capstone were not “truly arrangements for insurance.”
  • Irregular claims processing: Reserve paid out a large claim to Peak without investigation of the circumstances or supporting materials. A Peak employee signed Reserve’s checks to Peak.

The clear message from the case is that the microcaptive must operate as an insurance company, not just a shell business for tax avoidance. Its actions must have logical substance based on business practices within the insurance industry involving risk assessment, risk distribution, pricing and customer needs.

In this case, the IRS assessed a 30% tax on Reserve’s collected insurance premiums because the tax benefits normally available to true microcaptives were not proper because in many ways Reserve’s business practices were not consistent with the insurance industry.

Avoiding problems with microcaptives

Individuals with less than honest intentions may promote abusive microcaptive insurance arrangements, luring in unsuspecting customers who do not know they may be signing on to illegal, abusive schemes. Anyone considering this kind of arrangement should seek guidance from upstanding legal professionals who understand what the scams look like and how to establish a captive insurance arrangement legally and above board.

The IRS is laser-focused on microcaptive arrangements so anyone who is using or considering one needs to take care to stay within the lines. The financial penalties for captive misuse are very steep, but the agency states it is open to settlement discussions. An experienced tax attorney can facilitate communication with the IRS on behalf of a client facing investigation for allegations of an abusive microcaptive deal.

A lawyer can also assist a taxpayer involved with a microcaptive in reviewing past tax returns to determine whether to file any amended returns, something the IRS recommends.