Last August, the US Tax Court issued its decision in Avrahami v. Comm’r of Internal Revenue, No. 17594-13, (T.C. Aug. 21, 2017), the earliest Tax Court opinion involving a micro-captive. A second case has joined its ranks. On June 18, the Tax Court released its ruling in Reserve Mechanical v. Comm’r of Internal Revenue, No. 14545-16, (T.C. June 18, 2018). While it involved a small insurance company and whether it qualified under Internal Revenue Code section 501(c)(15), Reserve Mechanical provides additional information about the Tax Court’s views on captives and what the court considers insurance in this context.

Captive insurance owners and managers should note that even though the taxpayer’s facts in Reserve were different than those facts presented in Avrahami, the Court’s underlying analysis of the issues remained similar between the two cases. For example, both the Avrahami and Reserve decisions focused primarily on two of the four criteria required for a company to qualify as insurance for federal income tax purposes: the existence of sufficient risk distribution and whether the arrangement constituted insurance in the commonly accepted sense. We will get to risk distribution but much like in the Avrahami decision, the Court leaned heavily on the taxpayer’s specific facts in coming to its determination that the captive transaction was not insurance in the commonly accepted sense in Reserve.

In reviewing risk distribution, the Court in Avrahami determined that the captive failed to cover a sufficient number of independent risk exposures through direct policies with its brother sister entities. Next, the Avrahami decision looked to the taxpayer’s risk distribution pool, determining that for various reasons the pool was not a bona fide insurance company. The Reserve discussion of risk distribution followed a similar path. Ultimately, the Court determined both that the captive’s direct policies did not adequately distribute risk on their own and that the taxpayer could not rely on the risk distribution pool because it was found not to be a bona fide insurance company.

However, Reserve also provided guidance on some items not addressed in Avrahami. One item that captive owners and managers should note is the Court’s determination that premium payments were “fixed or determinable annual or periodical” (FDAP) payments. As such they were income to the captive and the payments subject to certain taxes.  In Reserve, the captive was a foreign corporation that made an election to be taxed as a domestic corporation under IRC § 953(d). However, to make this election the captive must be an insurance company and meet the requirements of IRC §§ 816(a) and 501(c)(15), including the requirement that 50 percent of the taxpayer’s gross receipts must be made up of insurance premiums. The Court determined that because the taxpayer didn’t issue insurance or reinsurance contracts, it didn’t receive more than 50 percent of its gross receipts from insurance premiums. Therefore, the Court held that the taxpayer’s section 953(d) election was invalid, and that a 30 percent withholding tax should have been imposed under IRC § 881 on premium payments made to the captive by the insured.  The Avrahami opinion did not speak to this issue.

The Tax Court’s position on captives continues to take shape.  There remain many cases in the examination stream, in IRS Appeals and pending before the Tax Court.  I continue to believe that the IRS must issue guidance in this area as to what it finds offensive and what the law allows. Going forward, captive owners and managers alike need this information.  Meanwhile, they should review their operations under the lens of both Reserve and Avrahami. Should you have any questions regarding captive insurance arrangements, Reserve Mechanical v. Comm’r of Internal Revenue, or any other complex tax issue please contact me at