Decisions offer insight into IRS thinking
Recent tax court rulings offer guidance on the standards for captive insurers
Lorelie Masters, Latosha Ellis, Geoffrey Fehling and Evan Holober of Hunton Andrews Kurth report on what the Keating and Swift judgments mean for captive insurance company owners.
As businesses increasingly look to captive insurance programmes to address unique and emerging risks, the oversight and scrutiny of the administration of captives continues to grow. The US Tax Court recently issued two rulings concerning the proper procedures for organising and administering captive insurance programmes and whether the use of captives constitutes actual “insurance”.
In both cases, Keating v. Commissioner of Internal Revenue, TC Memo. 2024-2, and Swift v. Commissioner of Internal Revenue, TC Memo. 2024-13, the Tax Court agreed with determinations of the Internal Revenue Service (IRS) refusing to acknowledge the tax benefits typically available to entities using a captive insurer and determining that the captives involved did not offer legitimate insurance to the entities that formed them. The rulings highlight both the potential financial advantages and the potential for abuse when using captive insurance. But they also provide useful insight into what factors the IRS considers when evaluating whether an entity is using captive as a legitimate insurer or as a mere vehicle to gain favorable tax treatment.
The Keating Decision
In Keating, the US Tax Court agreed with an IRS determination against favourable tax treatment of premium and dividend payments by a company using a foreign captive. There, Risk Management Strategies (RMS) insured risks through not only a commercial insurance programme but also a captive insurance programme that it had designed, created, and administered in Anguilla, the offshore (non-US) domicile it chose for the captive. The structure of this Anguillan captive varied over time, but RMS used it in two specific ways that drew IRS scrutiny. First, RMS deducted millions of dollars in business expenses that RMS claimed related to the insurance coverage provided by the captive. Second, RMS treated significant distributions from the captive to RMS’s shareholders as qualified dividends subject to preferential tax treatment. Besides benefiting the tax status of RMS’s shareholders, the business expense deduction had a significant impact on RMS’s taxable income.
The IRS challenged RMS’s use of the captive to receive favourable deductions and dividend treatment. The US Tax Court agreed, finding that the payments were not deductible as business expenses because the premiums — which on average were ten times higher than those for average commercial insurance companies — were not reasonable compared to typical industry pricing, were not supported by underwriting, and had not been shown to have paid for actual insurance coverage.
Among the many red flags the tax court noted were that captive issued RMS’s policies erratically, sometimes midway through their policy periods, and backdated policy changes. It often collected lump sum premium payments at the end of the policy term instead of collecting up front, monthly, or quarterly premiums and that the premiums tracked the limits under section 831(b) of the Internal Revenue Code even when coverage varied. The court found that the captive’s insurance policies were not valid and binding and concluded that the shareholders treated the captive “as if it were a tax-free savings account rather than a bona fide insurance company with which they were dealing at arm’s length”.
Because the captive relationship did not withstand IRS scrutiny, the IRS found that RMS was not entitled to deduct the policy premiums, and RMS’s shareholders therefore owed taxes and accuracy-related penalties.
The Swift Decision
Less than one month later, in Swift, the US Tax Court flagged similar issues with a captive insurer established by Swift and related entities, the owners of several urgent care and rehabilitation centers in Texas. Swift formed three captive insurers, one in the British Virgin Islands in 2004 and two in St. Kitts in 2010. The first captive reported annual premiums just under the limit established under section 831(b) of the Internal Revenue Code in each year from 2004 to 2009. After Swift formed two new captives in 2010, Swift’s counsel advised that, based on caselaw and IRS actions, 30% of the captive’s premiums needed to come from unrelated businesses to legitimise the arrangement. Later, in 2012-2015, the captives participated in two reinsurance pools, with reinsurance premiums totaling just over 30% of the total premiums charged by the captive insurers. During the 2012-2015 time period, the captives collected over $5.9 million in insurance premiums, while paying out less than $340,000 total for three claims over the same time period.
The court found that the insureds had not demonstrated that the captives faced independent risks, a crucial criterion in determining whether an arrangement actually qualifies as “insurance.” The reinsurance policies did not constitute bona fide insurance arrangements, the court reasoned, because they failed to meet standards for risk distribution and several policies insured overlapping risks. The court further concluded that the captive arrangement did not constitute insurance in the commonly accepted sense and noted that the captives “made investment choices only an unthinking insurance company would make.”
Because of these issues, the IRS determined that the insureds’ prior tax payments were deficient and imposed accuracy-related penalties on the insureds. The court sustained the IRS’s determination that the insureds were not entitled to deduct the insurance premiums paid to the captives.
Factors To Consider Following Swift and Keating
Properly organised and administered captive insurers can offer benefits to their owners that would not be available if the companies sought insurance protection through the traditional insurance market.
For example, captives can allow companies to take advantage of favourable financial treatment, as they can pay dividends to owners, and premium payments may be deducted as business expenses. The use of captives also allows insureds to reduce operating costs, invest premiums to fund losses, and provide access to reinsurance markets that would not otherwise be available to insureds.
Captives also can offer broader or more tailored coverage than that available in the traditional insurance markets because the captive is controlled by the insured, which can tailor the insurance to its specific needs. Captive insurance may also be an attractive option for companies that operate in an industry where insurance premiums are unreasonably priced in the commercial marketplace or where insurance is unavailable or does not offer sufficient total limits, either because most insurance companies refuse to offer high coverage limits for a particular risk or refuse to insure the risks altogether because the potential losses or claims cannot be calculated so a premium cannot be established. This is often true for industries that have higher exposure to specific risks or unique liabilities, such as higher education, healthcare, construction, manufacturing, cannabis, and cryptocurrency, among others.
Reaping all of those benefits is not without risk, as the Swift and Keating rulings highlight. In both cases, the IRS scrutinised captive premiums that were set exactly at the maximum contribution limits under section 831(b) of the Internal Revenue Code, rather than any underwriting or actuarial assessment of the risks insured. The captives used premiums to purchase illiquid investments, such as securities or real estate ownership investments, leaving little cash available to pay claims.
In Keating, the court identified factors that the IRS evaluates when determining whether a captive arrangement qualifies as actual “insurance,” including whether:
The arrangement involves an insurance risk;
The arrangement shifts the risk of loss to the insurer;
The insurer distributes its risk among its policyholders; and
The arrangement can be considered insurance in the commonly accepted sense.
Additionally, the IRS scrutinises premiums that it does not believe to be reasonable, particularly where the premiums for a given policy exceeded the limits for that policy or were significantly higher than comparable insurance available in the market. For example, in Swift, the insured purchased General Cost of Defense policies that charged premiums that exceeded the aggregate coverage limits under the same insurance policies, and terrorism coverage with premiums totaling $1.5 million over four years (even though comparable coverage could be purchased for less than $6,000 over the same time period).
Other pitfalls relate to the captive’s conduct in implementing the insurance programme as well as the captive’s relationship with affiliated entities, including when:
The captives and entities funding the captives’ failure to maintain an arm’s-length relationship was unlike a traditional insurer-insured relationship;
The entities funding the captive insurers were in charge of managing their own claims and paid their own claims even where they were not reported in a timely manner pursuant to the applicable policy;
The creation of a captive causes the funding entity to pay significantly more in premiums without a meaningful increase in coverage or claims; and
Payment of premium funds to the captive are almost entirely returned to funding entities.
Conclusion
These recent decisions highlight risks to evaluate in avoiding similar IRS scrutiny. While amounts paid for insurance are typically deductible as ordinary and necessary expenses paid or incurred in connection with a trade or business, the deductibility of those insurance premiums depends on whether they were truly payments for insurance. Entities seeking to benefit from captive insurance options should retain professionals to help navigate any insurance, regulatory, or tax considerations to maximise the potential benefits of a captive program while avoiding associated risks.
Lorelie S. Masters is a partner in the firm’s Insurance Coverage group in the firm’s Washington D.C. office. A nationally recognized insurance coverage litigator, Lorie handles all aspects of complex, commercial litigation and arbitration for policyholders. She can be reached at +1 (202) 955-1851 or lmasters@HuntonAK.com.
Latosha M. Ellis is counsel in the firm’s Insurance Coverage group in the firm’s Washington D.C. office. She advises clients on all of their insurance coverage needs from policy procurement and analysis to claims resolution and payment to, if necessary, alternative dispute resolution or litigation. She can be reached at +1 (202) 955-1978 or lellis@HuntonAK.com.
Geoffrey B. Fehling is a Boston-based partner in the firm’s Insurance Coverage group. Geoff dedicates his practice to helping companies and their directors and officers maximize insurance recoveries, especially in the area of directors and officers (D&O), professional liability, and management liability insurance. He can be reached at +1 (617) 648-2806 or gfehling@HuntonAK.com.
Evan Holober is an associate in the firm’s Insurance Coverage group in the firm’s Washington D.C. office. He focuses his practice on first- and third-party insurance coverage and coverage investigations. He can be reached at +1 (202) 419-2042 or eholober@HuntonAK.com.
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