Caylor, Wilson and Syzygy cases spell doom and gloom, says tax specialist

Following the outcomes of Avrahami and more recently Reserve Mechanical, upcoming US Tax Court cases - Caylor v Commissioner, Wilson v Commissioner and Syzygy Insurance v Commissioner - are likely to suffer similar fates, spelling further IRS victories.

This is according to Brandon Keim, tax law specialist and partner at Frazer Ryan Goldberg & Arnold, speaking to Captive International ahead of the VCIA annual conference in Burlington, Vermont.

“The immediate future—Caylor, Wilson, Syzygy—is doom and gloom,” said Keim. “If the Court accepts the government’s argument that consulting payments in Caylor lack substance and were merely designed to create the appearance of 12 distinct entities for purposes of satisfying Revenue Ruling 2002-90, the Court is likely to find the absence of risk distribution (assuming it even finds that all of the other requisites of that revenue ruling are met).”

He continued: “The taxpayer in Wilson is likely to suffer the same fate as in Avrahami. And if the Court agrees with the government’s contention that Syzygy’s layered pooling arrangement lacks actuarial support, it too is likely to fall the same way as Reserve Mechanical’s layered pooling arrangement.”

In the Reserve Mechanical case, Keim says that Judge Kerrigan’s opinion on the case highlights the need for sound actuarial determinations in certain reinsurance transactions.

“The opinion recognises that the risks in the particular pool structure were different than the risks retained by the captive, and the Tax Court was bothered that there was ‘no evidence’ to support the calculation of the reinsurance premiums. The taxpayer’s failure to support its reinsurance premiums in a layered pool arrangement reminds me of an important truism in litigation: the devil is in the details,” he said.

“I fear that readers will fail to appreciate that the reinsurance agreements at issue in Reserve Mechanical involved an attachment point and a ceiling that caused different risk profiles for the insurance company that issued the policy and the pool that reinsured it, whereas first-dollar quota share arrangements provide for the same risk to be shared by both the insurance company that issues the policy, and the pool that reinsures it.”

Keim noted that the Tax Court had rejected the notion that the premiums - if disallowed - should be treated as capital contributions or nontaxable deposits.

“Taxpayers have relied on IRS Revenue Ruling 2005-40, which provides that arrangements that lack the requisite risk distribution “may instead be characterised as a deposit arrangement, a loan, a contribution to capital . . ., an indemnity arrangement that is not an insurance contract, or otherwise’, ” he said.

Keim added that the Court’s rejection of this concept could make it more difficult for taxpayers to settle cases with the IRS by classifying premiums as capital contributions to the captive.

When looking at both Avrahami and Reserve Mechanical, Keim suggested the government had taken an inconsistent position in the two cases.

“The IRS argued in Reserve Mechanical that the premium payments should be disallowed, and that they are US source fixed or determinable, annual or periodical income (FDAP income) under section 881 of the Code. In Avrahami, however, the parties stipulated that the premiums were not FDAP income,” he explained. “The Tax Court ruled in favor of the government in Reserve Mechanical, finding that the disallowed premiums were FDAP income.”

He continued: “A review of the taxpayer’s briefs in Reserve Mechanical indicates that the taxpayer never challenged the government’s argument that the disallowed premiums should be classified as FDAP income under section 881, but instead argued that the income was effectively connected with a US trade or business and that it was entitled to expenses under section 882. That is a rather bizarre move for the taxpayer, and one that seems to have been costly.

“The government will have to proceed with caution if it chooses to argue that premiums should be FDAP income but also lack economic substance, as those arguments are at odds with each other, and may prove fatal for the government where the government asserts a 40 percent penalty under the codified economic substance doctrine.”

Following Avrahami and Reserve Mechanical, Keim doesn’t expect any increased IRS attention as he already feels the sector is in the “danger zone.”

“If the IRS feels emboldened and refuses to allow disallowed premiums to be classified as capital contributions, and asserts that disallowed premiums were subject to withhold as FDAP income, there are likely to be even less settlements than there already are, and more cases piling up in Tax Court,” he said.

However, Keim believes that the situation in the small captives sector will eventually calm down, as he harkens back to when the IRS had gone after Fortune 500 companies and their captive structures.

“Eventually the doom and gloom will end with taxpayers proving that section 831(b) was not merely passed by Congress to add more pages to the 74,608 page long tax code, but that there are businesses legitimately concerned about risk and seeking solutions to manage that risk,” he said.

“The IRS’s arguments, especially as they relate to risk pools, will become more difficult to make as the risk pools in the industry begin to look more like the traditional insurance market.”