IRS wins another microcaptive case

A fifth micro-captive legal case in the US has been decided entered in favour of the Internal Revenue Service (IRS), in Keating vs the IRS Commissioner, filed in the US Tax Court.

According to the court docket during the years 2012–14 (years at issue), the petitioners (Terence Keating, Cheryl Doss, and Arthur Candland) were shareholders of Risk Management Strategies (RMS), an S corporation in the business of acting as a sole employer for its clients, which were primarily banks administering special needs trusts. RMS assumed the employer liability resulting from the employment of caregivers who worked for special needs trusts, handled payroll, and generally carried out the responsibilities of being an employer to caregivers and other employees that would have otherwise fallen on its clients.

For each year at issue RMS reported incurring approximately $1.2 million of expenses for purported insurance coverage provided through an arrangement among its affiliated captive insurance company, Risk Retention, and other entities.

According to the docket the following issues were to be decided on: “whether transactions conducted through a purported microcaptive insurance arrangement among RMS, Risk Retention, and other entities during the years at issue constitute insurance for federal income tax purposes; whether expenses RMS incurred during the years at issue (a) through the purported microcaptive insurance arrangement or (b) to Artex Risk Solutions, or PRS Insurance for services rendered in connection with the arrangement constitute ordinary and necessary business expenses deductible under section 162; if not, whether any of those expenses are deductible as losses under section 165; whether dividends paid by Risk Retention to Mr. Keating and Mr. Candland in their 2012 and 2014 taxable years are qualified dividends or ordinary dividends; and whether petitioners are liable for accuracy-related penalties imposed under section 6662(a) for the years at issue.”

David Slenn, partner at legal firm Akerman, said that, the judges found that the premium payments in Keating were not deductible under IRC section 162, nor were they deductible under section 165. Further, since this involved a foreign captive, the court had to decide whether the 953(d) election was valid. Following precedent on this issue, the court held the election was invalid. The distributions from the foreign captive were found to be taxable (not qualified) dividends. The court upheld penalties.

Finally, the court upheld accuracy related penalties of around $434,000 against the owners of the company for substantial understatement/negligence.

The decision is the latest in a number of legal cases in which the IRS has highlighted what it perceives to be deficiencies around microcaptives. In April of 2023 the IRS won a microcaptive case against the Delaware Department of Insurance and there have been calls from the captive insurance industry for more clarity from the IRS about its stance on this topic.

Slenn highlighted a number of findings by the court:

·       “Under the management of Artex, and with some significant input by Mr. Candland, Risk Retention and Provincial operated during the years at issue in a manner in which only unthinking insurance companies would operate. Insurance transactions, including premium pricing, premium payments, and claims approval, were completed after the fact, even though in a typical insurance program they would be completed prospectively.”

·       “Mr. Candland, Mr. Keating, and RMS also treated Risk Retention 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. Risk Retention posted collateral with United States Fire Insurance Co. to fund deductibles under RMS’s commercial workers’ compensation policy without any clear obligation for it to do so, other than its self-imposed one under the deductible agreements. Risk Retention never documented its purported loan to finance Mr. Keating’s and Mr. Candland’s buy-sell life insurance policy premiums on each other, and it is unclear whether these loans were enforceable or secured. Artex also characterized the purported loan repayments from RMS to Risk Retention in excess of principal repayment not solely as interest but also as (1) premiums paid and (2) as “extra” money that is “circled back out pretty quickly” to pay further life insurance premiums.”

·       “We find that the policies were not valid and binding. Our first concern is the delivery of claims-made policies well into the coverage period without binders in place in the interim.”

·       “The amounts of premiums charged were also patently unreasonable. The average rate-on-line for RMS’s captive policies during the years at issue was more than ten times greater than the average rate-on-line for comparable commercial insurance policies, even though there is no credible evidence indicating that RMS had major issues with its existing commercial insurance coverage, or in obtaining the insurance required by its client contracts.”

·       “There is no apparent reason for allocating each captive’s premiums approximately 51% to the pool policies and 49% to the facultative policies other than to come within a perceived IRS safe harbor. In a typical captive arrangement involving quota-share reinsurance, one would expect members to pay individually and actuarially determined premiums based on the expectation of each member’s losses. A one-size-fits-all approach to allocating premiums between layers of reinsurance, like the one used here, suggests that the allocation is inconsistent with an actual actuarial determination.”

·       “Perhaps more concerning, however, is the manner in which Artex and Provincial handled the claims. Artex added or altered policies for its clients retroactively in order to permit them to file claims against the Provincial Pool or to reduce their premiums if they were unable to pay in full. It did not consistently enforce the prior-knowledge limitation when adjusting claims or treat claims as uncovered because no coverage was in effect at the time of the loss, even though it should have. It also approved some claims on the basis of only slight documentation. Furthermore, the contractual linkage of consulting, insurance, and reinsurance agreements had an inappropriate influence on claims management, as did the staffing overlap between Artex’s underwriting and claims functions.”