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Tax Court strikes down putative captive insurance arrangement

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Tax Hot Topics newsletterIn a memorandum decision, the Tax Court ruled in favor of the IRS that a company in the British territory of Anguilla was not an insurance company eligible to elect domestic status (and subsequent section 501(c)(15) tax-exempt status). Instead, the company was a foreign corporation with a federal income tax liability from its Section 881(a) fixed, determinable, annual or periodic (FDAP) income.  

In Reserve Mechanical Corp. v. Commissioner, T.C. Memo 2018-86 (2018), two individuals owned all of a subchapter S corporation that was in the mining business. The same two individuals formed a partnership that held all the interests of an Anguilla corporation that was putatively set up to insure certain risks of the S corporation.

The arrangement was set up with the help of a promoter and had a number of deficiencies: (1) the two individuals performed no due diligence on the policies issued and were otherwise oblivious to the dealings of their captive insurance company (all aspects were managed by an entity associated with the promoter); (2) there was only a single claim made on any of the policies during the periods at issue; and (3) the captive set up an arrangement with a reinsurer related to the promoter that itself did not have adequate reserves, among other things.

A captive insurance arrangement must satisfy four common law factors. First, the risks must be insurance risks; second, there must be risk shifting; third, there must be risk distribution (the so-called law of large numbers); and fourth, the arrangement must be insurance in the commonly accepted sense. The Tax Court held that there was neither insurance in the commonly accepted sense nor was there risk distribution.

Contact Greg Fairbanks
Managing Director,
Washington National Tax Office
T +1 202 521 1503

Joshua Brady
Principal
National Tax Standards Group
T +1 202 521 1563

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