Tenth Circuit on Captive Micro Insurance coverage Firm and Tax Exemptions

On Could 13, 2022, at Reserve Mechanical Corporation v. Commissioner,[1] the US Court docket of Appeals for the Tenth Circuit upheld a Tax Court docket ruling {that a} micro-captive insurance coverage firm was not eligible for the revenue tax exemption in as a small insurance coverage firm below IRC § 501(c)(15). Due to this fact, the alleged bonus funds the corporate acquired constituted mounted, determinable, annual, or periodic (FDAP) revenue taxable at a charge of 30% below IRC § 881(a). The IRS opinions micro-captive transactions due to their potential for tax evasion. For functions of disclosure necessities, the IRS has recognized sure micro-captive transactions as “listed transactions” in Discover 2016-66. A courtroom not too long ago invalidated opinion 2016-66 for non-compliance with the legislation on administrative process;[2] nevertheless, Reserve Mechanical reveals that micro-captive trades stay weak on the underside.


In Reserve Mechanical, two shareholders owned and operated a mining firm, Peak Mechanical Corp. (Peak). Previous to the years in problem, Peak had industrial insurance coverage and paid annual premiums of $100,000. In 2008, the 2 shareholders consulted Capstone Related Companies, Ltd. (Capstone) on making a micro-captive insurance coverage firm. Capstone promised to supply shareholders with a feasibility research; nevertheless, shareholders proceeded to kind Reserve Mechanical Corp. (Reserve) within the British West Indies earlier than reviewing this info. The reserve had no staff. Capstone offered administration companies to Reserve, together with coverage preparation and premium willpower. One of many shareholders testified that he was sad together with his industrial insurance coverage insurance policies, however Peak continued to take care of industrial protection after Reserve was established.

From 2008 to 2010, Reserve issued 13 direct insurance policies to Peak and two associates in alternate for annual premiums of $400,000. There have been a number of points with direct insurance policies, together with a number of insurance policies itemizing the unsuitable insured and different insurance policies overlapping Peak’s current industrial protection. Capstone suggested Reserve that it will must obtain at the very least 30% of its premiums from firms not affiliated with it to qualify as an insurance coverage firm. To this finish, Reserve participated in a quota-share reinsurance coverage with PoolRe, a threat pool involving 50 captive insurance coverage firms managed by Capstone. Below this settlement, Reserve and different Capstone entities have agreed to imagine a few of the dangers assumed by PoolRe. The coverage has been structured in order that the commissions Reserve receives from PoolRe are equal to the commissions PoolRe receives from Peak. Moreover, Reserve has entered right into a credit score co-insurance settlement with PoolRe involving CreditRe. There isn’t any proof that Reserve acquired any premiums below the credit score co-insurance settlement.

Peak claimed the insurance coverage premiums it paid to Reserve as a enterprise expense on its federal tax returns. As a result of Reserve acquired premiums of lower than $600,000 every year, it concluded that it was a tax-exempt insurance coverage firm below IRC § 501(c)(15) and solely paid no tax on premium funds she acquired from Peak. The IRS decided that Reserve had no proper to exclude bonuses from taxation and proposed assessments for every year.

Authorized evaluation

IRC § 501(c)(15)(A)(i) supplies that insurance coverage firms are exempt from tax the place: (i) gross receipts for the yr don’t exceed $600,000; and (ii) greater than 50% of gross receipts include bonuses. The central problem in Reserve Mechanical was whether or not Reserve was an insurance coverage firm such that it may gain advantage from the tax exemption offered by part 501(c)(15).[3] Insurance coverage shouldn’t be outlined by the Inside Income Code. Courts have adopted a four-part framework for evaluating insurance coverage contracts: (i) the contract should contain insurable dangers; (ii) the association should switch the danger of loss to the insurer; (iii) the insurer should unfold the danger of loss amongst its policyholders; and (iv) the association should represent insurance coverage within the generally understood sense.[4]

Making use of this framework, the Tax Court docket discovered that the reserve association was poor for 2 causes: (i) it did not unfold threat as a result of direct insurance policies concerned too few policyholders and PoolRe didn’t was not a bona fide insurance coverage firm; and (ii) it was not insurance coverage within the generally accepted sense as a result of Reserve was not operated as an insurance coverage firm and the premiums have been unreasonable and never actuarially decided. The Tenth Circuit upheld the Tax Court docket’s resolution on each grounds. Every sample is mentioned under.

(i) The reserve mechanism didn’t present for threat spreading

On enchantment, Reserve didn’t problem the Tax Court docket’s discovering that the direct insurance policies issued to Peak didn’t lead to an allocation of threat. As an alternative, he argued that the reinsurance and co-insurance agreements with PoolRe resulted in ample threat spreading for Reserve to be a sound insurance coverage firm. Reserve claimed the Tax Court docket misapplied the danger allocation check by specializing in whether or not PoolRe was a bona fide insurance coverage firm. The Tenth Circuit acknowledged that, in idea, an association that offered for the allocation of threat may represent insurance coverage even within the absence of an insurance coverage firm. Nevertheless, PoolRe’s product was not insurance coverage. In keeping with the courtroom, the reinsurance settlement was nothing greater than a round move of funds with out a important distribution of threat. Furthermore, there was no proof that the co-insurance settlement with PoolRe even existed as a result of it acquired no premiums or paid any claims through the 2008-2010 interval. However, even when the co-insurance existed, Reserve didn’t assume any important threat. In keeping with the Tenth Circuit, the Tax Court docket downplayed proof that PoolRe was a sham. The Tenth Circuit famous that the Tax Court docket’s resolution didn’t come to a conclusion on the legitimacy of threat pooling usually. Nevertheless it was clear that PoolRe’s threat pooling didn’t result in threat spreading.

(ii) The reserve association was not insurance coverage within the generally accepted sense

On enchantment, Reserve argued that the Tax Court docket erred: (i) in incorrectly characterizing the insurance policies as extra protection insurance policies; (ii) concluding that the bonuses have been unreasonable and never negotiated at arm’s size; and (iii) contemplating that Reserve was not working as an insurance coverage firm as a result of it was managed by Capstone. The Tenth Circuit disagreed. First, she discovered that the Tax Court docket didn’t misread the direct insurance policies Reserve issued to Peak. It was clear that direct insurance policies utilized solely in any case different insurance coverage protection had been exhausted. Second, the Tax Court docket accurately concluded that the premiums for the insurance policies have been unreasonable and never arm’s size negotiated as a result of the premiums have been 4 occasions larger than the industrial insurance policies of Peak and Reserve offered no rationalization of how she calculated the dangers. Lastly, the Tax Court docket was justified find that Reserve was not working as an insurance coverage firm as a result of it had no staff; by no means did enterprise in Anguilla; its president knew nothing of its operations; and he failed to research the one declare he acquired earlier than paying round $340,000. Due to this fact, it was clear that the Reserve insurance policies weren’t insurance coverage within the generally accepted sense.


Reserve’s direct insurance policies and PoolRe’s threat pool concerned many defects particular to this case. However Reserve Mechanical may bolster the IRS’ resolve to finish abusive micro-captive buying and selling. Though the courtroom stated it was not ruling on the legitimacy of threat pooling typically, the case units a really excessive bar for micro insurance coverage captives to ascertain threat pooling. Taxpayers who take part in micro-captive transactions might want to seek the advice of their tax advisor to grasp how Reserve Mechanical impacts them.


[1] 129 AFTR 2nd 2022-1804 (tenth Cir. 2022).

[2]CIC Companies, LLC c. IRS Case No. 3:17-cv-110 (ED Tenn. Mar. 21, 2022). SeeGT alert, court strikes down micro-captive trading notice 2016-66, second time an IRS notice has been struck down this month.

[3] TC Memorandum 2018-86 (2018).

[4]Harper Group. v. Comm’r, 96 TC 45 (1991), case 979 F.2nd 1341 (ninth Cir. 1992).

©2022 Greenberg Traurig, LLP. All rights reserved. Nationwide Regulation Evaluation, Quantity XII, Quantity 172

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