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IRS wins another microcaptive insurance case

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Tax Hot Topics newsletterThe IRS prevailed in a third case against a putative captive insurance company electing “microcaptive” status under Section 831(b).

Microcaptive insurance companies are those that write no more than $2.2 million in aggregate net written premiums for a tax year. They enjoy a permanent benefit in that earned premiums are not income to the captive (only investment income). Microcaptives have become a popular method for promoters to advise companies to set up captive insurance companies, often not following all the proper procedures for setting up a valid insurance company, with dubious insurance coverage or otherwise questionable business practices. Thus, the IRS has an active campaign to scrutinize such structures and has a number of active cases making their way through the legal process.

Syzygy, Inc. v. Commissioner (T.C. Memo 2019-34) marks the third such case brought by the IRS, after successive victories in Avrahami v. Commissioner (149 T.C. No. 7) and Reserve Mechanical Corp. v. Commissioner (T.C. Memo 2018-86). All three involve putative microcaptive companies using risk-pooling.

Syzygy likewise involved many questionable or outright “bad” facts. The insured, Highland Tank & Manufacturing Co. (and its affiliates), were Subchapter S corporations all controlled by two related families through both direct ownership as well as various trusts over the tax years in question. While the process initially started on the right path by engaging third party providers to assess the viability of a captive company and insurable risks to consider, when Syzygy was formed and capitalized, the process quickly went askew.

It appears most of the recommended practices were not followed. Premiums did not appear set to actuarial computations but were more capricious. Few to no claims were actually paid out during the years in question. A fronting-arrangement was used to ostensibly employ risk-pooling to achieve risk distribution but with no claims being paid out. The way in which the reinsurance premiums were computed and paid, resulted in an almost circular cash flow where, the premiums from Highland Tank and affiliated ended up at Syzygy, which was also controlled by the two families. Perhaps most damning was the dismissal of the first captive manager for apparently suggesting that the premiums were too high and should be lowered to cover the same putative risk of loss.  

There are four requirements to have a valid insurance arrangement. There must be an insurable risk, risk shifting, risk distribution, and the arrangement must be insurance in the commonly accepted sense.  The tax court held that the latter two requirements were not met.

Contact:

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

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