KucherAV /
17 September 2018Accounting & tax analysis

Judgment time for small captives goes on

As the dust settles on the second significant Internal Revenue Service (IRS) victory against small captive insurance companies, the industry is starting to speculate on the next few cases that are pending. There are concerns over how they may pan out, what guidance they offer, and what wider impact their outcomes could have on the industry.

Just as Reserve Mechanical and Avrahami were likely selected because the IRS viewed them as poor or deficient examples of the captive insurance model, the IRS may have similarly chosen three ongoing cases—Caylor Land & Development v Commissioner, Wilson et al v Commissioner and Syzygy Insurance v Commissioner—for the same reason.

Caylor features a brother-sister arrangement: where a third corporation or individual owns two or more corporations, with no risk pool. Wilson uses the same pool as Avrahami but has different experts and witnesses involved. Judge Mark Holmes—the judge in the Avrahami case—will be the judge in both Caylor and Wilson.

In the case of Syzygy, the IRS will be targeting a domestic captive, and seeks to tax both the insured and the captive.

David Kirkup, CFO and COO at Captive Alternatives, suggests the cases were “cherry-picked” as being favourable to the IRS. He also believes there is likely to be a continued focus on the risk distribution model—as long as the IRS views this as a successful strategy.

“We think some of these new cases may have firmer foundations on risk distribution and pricing and will have the benefit of the court rulings on Avrahami in their defence submission, so it will be interesting to see the court’s opinion and whether they believe that any captive insurance models can have substance,” says Kirkup.

“In particular, Caylor bases its risk distribution on having multiple sibling entities, so is likely to be of peripheral interest to mainstream small captives, but will probably also address reasonableness of pricing and coverage.”

Brandon Keim, tax law specialist and partner at Frazer Ryan Goldberg & Arnold, predicts unfavourable outcomes for Caylor, Wilson and Syzygy, suggesting they spell “doom and gloom” for the taxpayers.

“If the Tax 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),” says Keim.

He continues: “The taxpayer in Wilson is likely to suffer the same fate as in Avrahami. 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.”

Avrahami and Reserve Mechanical

There is consensus within the industry that Avrahami is an almost textbook example of an illegitimate captive insurance model. The court found premiums to be grossly excessive—rising from $150,000 to $1.1 million to $1.3 million, and found the actuary’s explanations of them incomprehensible and unpersuasive.

There were also a number of red flags in the case, such as no claims filed until after the beginning of the IRS audit, and that 65 percent of the assets were illiquid, particularly unsecured loans, meaning they could not have been used to pay claims.

Kirkup describes Avrahami as being almost a “caricature of a legitimate captive insurance model”, but he notes that Capstone Associated Services—the manager of Reserve Mechanical’s risk pool entity, Pool Re Insurance—has issued a number of rebuttals of the facts already, adding new layers of nuance.

“There are a number of contentious—and possibly appealable issues—in the Reserve Mechanical case that would need to be considered in future cases,” he says.

“Capstone has pointed out multiple inconsistencies with the facts of the case, has complained that its expert witnesses were largely ignored, and shed new light on its view of the actual insurance model.

“Noteworthy is the apparent conclusion by Judge Kerrigan that businesses should have prior loss histories before being eligible to purchase deductible business insurance. This is clearly news to the risk management industry. After all, insurance logic 101 tells us to insure against the fortuitous risk of future losses, not the fear of a recurrence.”

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

Keim adds that when looking at Avrahami and Reserve Mechanical, 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 (FDAP) income under section 881 of the Code. In Avrahami, however, the parties stipulated that the premiums were not FDAP income. The Tax Court ruled in favor of the government in Reserve Mechanical, finding that the disallowed premiums were FDAP income,” he says.

“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.”

Wider impact

If the IRS continues to gain victories against small captives in the US Tax Court, it may embolden the tax body to target larger captives, suggests Charles ‘Chaz’ Lavelle, partner at Bingham Greenebaum Doll.

Lavelle was tax counsel for two taxpayer victories in captive insurance tax cases in the US court of Appeals: Humana v Commissioner, which ruled on the ‘brother-sister’ issue, and Ocean Drilling & Exploration Company v US, which decided the outside business issue.

“The IRS has always been very sceptical about all captives,” says Lavelle. “The prior litigation was against the larger captives, and the more recent litigation was against smaller ones—I don’t think it implies that the IRS has agreed that anything the larger captives do is okay.”

If the courts develop new ideas around structures used by small captives they deem to be unsuitable, Lavelle anticipates the IRS may use the same logic against large captives—if the same facts are present in a case. He adds that a lot of captives have been docketed by the IRS; none of them is set for trial at the moment, but a couple could be.

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

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

“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.”

Kirkup remains optimistic for the future of properly designed captive insurance programmes that address risk shifting and distribution, can demonstrate arm’s-length pricing and management, and have documented histories of claims reserving and loss payments.

One of the positive sides he sees is that the IRS—in defining a ‘bad’ captive—is being forced to provide more guidelines as to what constitutes a ‘good’ captive, and that the outcomes of these cases should not hurt growth in the legitimate captive insurance market.

“It is also worth pointing out that regardless of the outcome for the IRS in these cases, the 2015 Protecting Americans from Tax Hikes (PATH) Act confirms that Congress fully supports the 831(b) captive option.

“At some point the fundamental IRS dichotomy on captives of ‘yes you can, but no you can’t’ needs to be addressed—with a comprehensive guide to doing things the right way. We are actively involved with the Self-Insured Institute of America (SIIA) who will help lead the way in demonstrating the legitimacy of captives and self-insurance,” Kirkup concludes.