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November 29, 2022


US appeals court affirms abusive microcaptive insurance arrangement, part 1

The IRS publicized the holding of this closely watched appeal.

In a highly anticipated May 2022 decision, the U.S. Court of Appeals for the 10th Circuit held that microcaptive insurance transactions can be abusive shams to avoid taxation, agreeing with the federal government’s long-held position. Today we consider the lessons of Reserve Mechanical Corp. v. Commissioner of Internal Revenue (CIR) and its guidance for those who seek to legitimately self-insure their businesses using captives.

What is a microcaptive insurance company?

On a basic level, a microcaptive is a legal entity set up to self-insure a related business with the same or overlap in ownership or control, usually a parent-subsidiary relationship. Entities setting up captive insurers range from large corporations to small nonprofits.

A microcaptive with less than a preset annual collective premium amount qualifies for special tax treatment. It is exempt from income tax on premiums collected and only incurs tax liability on investment income. To qualify, it must operate as a genuine insurer engaged in legitimate commercial activity.

Normally, a business may deduct insurance premiums as legitimate business expenses. Those premiums would also normally be taxable income to the insurer receiving them. The potential for tax evasion exists with a microcaptive arrangement because of financial incentive to inflate premiums for higher deductions. The microcaptive is exempt from income tax on the premiums so since ownership overlaps, there is no motivation to negotiate them down.

Captive insurers have been around for more than a century, reports the National Association of Insurance Commissioners (NAIC), and may be either domestic or foreign. NAIC states that captives worldwide have grown seven-fold since 1980. Businesses may choose offshore domiciles for their captive entities because of lighter regulatory oversight.

In 2022 as in years past, the IRS has named abusive captive insurance arrangements as one of the annual “dirty dozen” tax scams on which it focuses significant enforcement resources.

Court said the obvious intention was to avoid taxation

Cory Weikel and Norman Zumbaum owned Peak Mechanical, a mining equipment company operating in Idaho and Nevada. They set up Reserve Mechanical in the British West Indies to function as a microcaptive insurer for Peak. The two companies had a common parent company. Reserve issued multiple business policies to Peak.

The U.S. Court of Appeals for the 10th Circuit agreed with the U.S. Tax Court and the IRS that the arrangement was abusive because Reserve did not operate like a legitimate insurer “in the commonly accepted sense” and was not actually engaged in the business of insurance. Because of this, it did not qualify for the small insurance company exemption from income tax, so it owed back taxes at a 30% rate on the premiums Peak had paid to Reserve.

In part 2 of this article, we will explain why the 10th Circuit affirmed the Tax Court’s finding that Reserve Mechanical was not operating as a bona fide insurance company and look at lessons from this case.

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