United States Tax Court Hands IRS Another Win Against Risk-Pooled Small Captives

On June 18, 2018, the United States Tax Court issued an opinion upholding the IRS’ notice of deficiency against Reserve Mechanical Corp., f.k.a. Reserve Casualty Corp. (Reserve), a captive insurer. The opinion repeatedly references the Court’s previous ruling in Avrahami v. Commissioner, and affirms that Avrahami is the rule of law in Tax Court, even though Reserve’s facts were different from the facts presented in Avrahami.

Norman Zumbaum and Cory Weikel were 50% owners of Peak Mechanical & Components (Peak), headquartered in Osburn, Idaho. Peak’s business was servicing and manufacturing equipment used in underground mining and construction. Part of Peak’s business was cleaning equipment used in mines polluted with heavy metals such as zinc and lead, as a result of historic mining practices. One of those mines was an EPA “Superfund Site” known as Bunker Hill in Idaho. Peak’s employees had potential exposure to hazardous materials and Peak maintained a variety of commercial insurance policies including general liability, worker’s compensation, and commercial property, with total premiums less than $100,000. However, Peak had a long history of making few, if any, claims against its insurance policies.

Zumbaum and Weikel also co-owed two other companies, RocQuest LLC and ZW Enterprises, LLC. RocQuest owned real estate in Idaho and Nevada, while ZW owned a 10% interest in an Osburn, Idaho bar.

Zumbaum and Weikel were introduced to Capstone Associated Services, Ltd. (Capstone) through a mutual friend. Capstone was the captive insurance manager for an arrangement in which Reserve, incorporated in Anguilla as a Class B insurer, issued direct written insurance policies to Peak, RocQuest, and ZW. Peak, RocQuest, and ZW all kept their existing third-party commercial insurance policies in place. Reserve also participated in a risk pool administered by PoolRe Insurance Corp., in addition to a second reinsurance program involving vehicle service contracts. Capstone managed PoolRe’s operations and kept its books. Reserve also entered into a quota share reinsurance arrangement where it and other captive insurers assumed a blended risk in exchange for reinsurance premiums.

The issues presented in the Tax Court case were two fold: (1) did the transactions qualify as insurance for federal income tax purposes?; and (2) was the captive eligible to make a 953(d) election?

The Court’s opinion focused primarily on two of the four criteria required for a company to qualify as insurance for federal income tax purposes. As stated in Avrahami, those four requirements are: (1) the arrangement involves insurable risks; (2) the arrangement shifts the risk of loss to the insurer; (2) the insurer distributes the risk among its policy holders; and (4) the arrangement is insurance in the commonly accepted sense.

In Reserve’s case, Judge Kerrigan decided that it failed to achieve risk distribution: “the number of insureds and the total number of independent exposures were too few to distribute the risk that Reserve assumed under the direct written policies.” Though Reserve insured Peak, RocQuest, and ZW, the operations of RocQuest and ZW were “insignificant,” and therefore most of the risk was associated with the business operations of Peak. While Reserve argued that it achieved risk distribution through the use of PoolRe and its risk distribution pool, and a quota share arrangement, Judge Kerrigan found that PoolRe was not a bona fide insurance company. Citing to Avrahami again, Judge Kerrigan found a circular flow of funds between Reserve and PoolRe, no arm’s length negotiations on the premiums paid, and a “one-size-fits-all” rate for the participants in the quota share arrangement.

Judge Kerrigan also found that Reserve did not provide insurance in the commonly accepted sense. At trial, Zumbaum, Reserve’s 50% owner, president, and CEO, knew virtually nothing about its operations: he had little knowledge of the insurance policies issued by Reserve; he did not know how claims were made or handled; and he did not know where or how Reserve’s records were kept. In addition, Judge Kerrigan found no evidence that any due diligence was performed for the insurance policies that Reserve issued and no evidence that Reserve performed due diligence with respect to the reinsurance agreements with PoolRe. Further, for the one claim filed under Reserve’s insurance policies, no supporting documentation accompanied the claim notice, and Reserve did not require any substantiating documents regarding the occurrence or the amount of the claimed loss. In addition, Judge Kerrigan agreed with the IRS that Reserve’s direct written policies were “cookie cutter” in form and indicated “on their face” that they were the copyrighted material of Capstone, the captive insurance manager.

Finally, Judge Kerrigan noted that Reserve failed to explain why Peak maintained its full set of third-party commercial insurance coverage, even after it paid 400% more for additional coverage from Reserve: “The facts do not reflect that Peak had a genuine need for acquiring additional insurance during the tax years at issue. There was no significant history of losses that would justify such a drastic increase, and Zumbaum’s testimony that he was concerned about increased risk beginning in 2008 did not support a significant increase in insurance coverage. . . . Peak had never come close to exhausting the policy limits of its third-party commercial insurance coverage.”

While much of the insurance legal analysis in the Reserve opinion is an Avrahami repeat, the second issue in the case – the section 953(d) election – was not taken up by Avrahami. Reserve had made an election to be taxed as a domestic corporation under IRC section 953(d). To make this election, a captive must be an insurance company and meet the requirements of IRC sections 816(a) and 501(c)(15), including the requirement that 50% of gross receipts be made up of insurance premiums. Because the Court determined that Reserve didn’t issue insurance or reinsurance contracts, it didn’t receive more than 50 percent of its gross receipts from insurance premiums. As such, the Court held that Reserve was not eligible to make an election under section 953(d) and that a 30 percent withholding tax should have been imposed under IRC section 881 on premium payments made to the captive by the insured.

Avrahami and Reserve are now the two captive insurance Tax Court opinions providing guidance to captive owners and managers. The attorneys at Silver Law have extensive experience in captive insurance related audits, litigation, and case resolution. If you have a captive insurance company or an insured that is under audit by the IRS, it is vital that you obtain experienced NV legal representation in order to obtain successful resolution of your case. The attorneys at Silver Law are all former trial attorneys for the IRS, and can provide you with the experience you need to successfully handle captive insurance audits by the IRS.

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