Editor: Mark G. Cook, CPA, CGMA
Captive insurance companies have long been used by taxpayers to self-insure in a financially effective manner. Typically, a captive insurance arrangement is created when a taxpayer forms a new entity to function as an insurance company (a captive insurer) for the taxpayer. The captive insurer, in other words, functions as self-insurance for the taxpayer.
Taxpayers can use captive insurance arrangements to generate financial savings. From a cost perspective, the taxpayer can tailor the insurance to its industry or its specific business needs. From a tax perspective, the taxpayer can deduct the insurance premiums it pays the captive insurer. Additionally, if the captive insurer meets certain qualifications in Sec. 831(b), it can exempt the premiums it receives from income tax.
However, the IRS has recently begun analyzing captive insurance companies and, specifically, microcaptive transactions with increased scrutiny. Beginning in 2015, microcaptive transactions have been listed on the IRS’s “Dirty Dozen” list of the worst tax scams for every year, with the exception of 2020. See, generally, Newkirk and Webber, “Microcaptive Insurance Arrangements After CIC Services,” 53 The Tax Adviser 18 (September 2022).
Despite the IRS’s increased scrutiny, captive insurance companies can, if used appropriately, offer valuable tax savings. A number of requirements must be followed to ensure proper compliance; however, this item focuses solely on the requirement that captive insurance companies must sufficiently distribute their risks for an arrangement to be considered insurance for federal income tax purposes. This was an issue of interest in the recent case Reserve Mechanical Corp., a decision originally filed by the Tax Court on June 18, 2018, and affirmed on appeal May 13, 2022 (Reserve Mechanical Corp., T.C. Memo. 2018-86, aff ’d, 34 F.4th 881 (10th Cir. 2022)).
Criteria for determining insurance and factors for defining a bona fide insurance company
As neither the Code nor the regulations define insurance, courts have looked to four nonexclusive criteria for establishing a framework for determining the existence of insurance for federal income tax purposes: (1) the arrangement involves insurable risks; (2) the arrangement shifts the risk of loss to the insurer; (3) the insurer distributes the risk among its policyholders; and (4) the arrangement is insurance in the commonly accepted sense (Reserve, T.C. Memo. 2018-86 at *33, citing Amerco, 96 T.C. 18, 38 (1991)).
As stated above, this discussion focuses solely on the “distribution of risk” criteria. On this point, the courts crafted a list of nine factors to be used to determine if the captive insurer (or its reinsurer, as the case may be) was indeed a bona fide insurance company (id., citing Avrahami, 149 T.C. 144, 185 (2017)). The nine factors are as follows:
Whether the company was created for legitimate nontax reasons;
Whether there was a circular flow of funds;
Whether the entity faced actual and insurable risk;
Whether the policies were arm’slength contracts;
Whether the entity charged actuarially determined premiums;
Whether comparable coverage was more expensive or even available;
Whether the entity was subject to regulatory control and met minimum statutory requirements;
Whether it was adequately capitalized; and
Whether it paid claims from a separately maintained account.
The distribution-of-risk criteria, as well as the nine-factor test, are discussed in greater detail below.
Reserve’s distribution-of-risk argument
Generally, risk distribution occurs when the captive insurer pools together a sufficiently large number of unrelated risks. Prior courts have determined that this criterion was satisfied if the insurer pooled enough risks to take advantage of the “law of large numbers” or if the insured risks were adequately independent of one another to sufficiently distribute the risk (id. at 181).
Taxpayers have attempted to satisfy this criterion in myriad ways. In one case, the court found that a taxpayer sufficiently distributed its risk, even though the risk was distributed primarily among the taxpayer’s commonly owned brother-sister entities, because the risks that the insurance covered constituted “a sufficient number of statistically independent risks” (Rent-A-Center, 142 T.C. 1, 20–21 (2014)). However, in Avrahami, the taxpayer attempted to distribute its risk by issuing policies to its group of three affiliated entities, as well as by insuring several unrelated entities by participating in a risk-distribution program (Avrahami, at 181–82). The court in Avrahami, however, found that insuring only three affiliated entities was not sufficient to distribute its risk, nor was the riskdistribution program a bona fide insurance company per the nine-factor test (id. at 197).
In Reserve, the taxpayer argued that it achieved risk distribution by insuring a sufficient number of unrelated parties (Reserve, at 36–37). Reserve accomplished this by engaging another entity, PoolRe Insurance Corp., as a stop-loss insurer; by doing this, the taxpayer argued, it effectively distributed its risk among the other entities that PoolRe insured (id.). The court, however, rejected the taxpayer’s argument because it found that PoolRe was not a bona fide insurance company (id. at 45–46). In its decision, the court reviewed six of the nine factors it deemed most relevant and found that PoolRe was not a bona fide insurance company (among the factors considered were PoolRe’s failure to obtain an insurance license during relevant periods, the appearance of a circular flow of funds, and the existence of a one-size-fits-all rate for its participants) (id. at 39–46). Due to the court’s finding that PoolRe was not a bona fide insurance company, the court determined that Reserve’s risk had not been distributed among unrelated parties and, therefore, was not sufficiently distributed (id. at 46).
Takeaways from Reserve
The taxpayer in Reserve was unsuccessful in satisfying the distribution-of-risk criteria primarily because its stop-loss insurer, PoolRe, was deemed to not be a bona fide insurance company. In Reserve, the court used the nine factors as a guideline and found that PoolRe failed to operate as a proper insurance company and, thus, was not a bona fide insurance company.
The holding in Reserve illustrates the importance the court has placed on the nine factors in determining whether a reinsurer, when used as a vehicle for distributing risk, is a bona fide insurance company. In light of this, it is recommended that tax professionals’ clients that have captive insurance companies take great care to distribute risk properly. If a taxpayer wishes to distribute risk by insuring other, unrelated parties, the taxpayer should make certain the insurance vehicle used meets most, if not all, the above factors to ensure it is a bona fide insurance company.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or email@example.com. Contributors are members of or associated with SingerLewak LLP.