AndreyPopov /
7 June 2019Accounting & tax analysis

Pilot v Commissioner: key questions raised and left unanswered


Jim Cameron, the sole shareholder of Cameron Glass, discussed the possibility of forming a captive insurance company with his CPA and with his commercial insurance broker in 2011. His insurance broker introduced him to Artex Risk Solutions. At the end of 2011, Pilot Series of Fortress Insurance was formed, with ownership divided between Cameron (1 percent) and a trust for his heirs (99 percent).

Pilot made an election under IRC §831(b) to be taxed as an insurance company. From 2011 to 2013, Cameron Glass paid approximately $417,000 annually to an Artex entity, PRS Insurance, which deducted a 2.5 percent fee and forwarded the remaining premium to Provincial Insurance, an insurance company domiciled and licensed in Anguilla. Each year, Provincial paid premiums to Pilot for the risks Pilot reinsured. Pilot received from Provincial an amount equalling approximately the premiums paid by Cameron Glass minus the 2.5 percent fee. Pilot then paid dividends to Cameron and the trust.

The IRS began an examination of Pilot’s 2011 return in July 2014, then opened additional examinations of Pilot for 2012 and 2013, Cameron and his wife for 2011, 2012 and 2013, and Cameron Glass for 2012 and 2013. The examiner determined that Cameron Glass’s deductions for captive insurance should be disallowed, that Pilot was not an insurance company for federal tax purposes, that Pilot should have reported its premium receipts as taxable income, and that penalties applied to both the Camerons and Pilot. The IRS eventually issued notices of deficiency as follows:



Deficiency in tax

IRC §6662 penalties





















The taxpayers petitioned the Tax Court, originally disputing all of the alleged liabilities. On February 28, 2019, the taxpayers conceded that the expenses claimed by Cameron Glass were not deductible and that Pilot was not an insurance company for federal income tax purposes. That left in dispute the penalties asserted against the Camerons, whether Pilot had taxable income in the amount of the premiums received, and whether Pilot was liable for penalties.

In particular, the Commissioner asserted penalties against the Camerons pursuant to IRC §6662(i), the 40 percent penalty for engaging in a transaction lacking economic substance that was not adequately disclosed; §6662(b)(6), the 20 percent penalty for engaging in a transaction lacking economic substance even if it was disclosed; §6662(c), the 20 percent penalty for negligence; or §6662(d), the 20 percent penalty for substantial understatement. The Commissioner conceded that Pilot was not liable for §6662(i) penalties, moving forward only on the §6662(c) and §6662(d) penalties.

“The Commissioner’s effort to introduce audiotapes from a criminal investigation into a civil trial highlights the complexity that arises when criminal and civil actions overlap.”

The Camerons could have defended against the §6662(c) and §6662(d) penalties based on reasonable cause, but the §6662(b)(6) penalty, increased to 40 percent by §6662(i), is a strict liability penalty linked to the codified economic substance doctrine in §7701(o). Pilot Series was set to be the first litigated case involving the strict liability penalty.

In an effort to bolster the argument that the captive insurance transaction lacked economic substance, the Commissioner filed a motion seeking to admit into evidence at trial audio recordings of conversations that took place in 2006 through 2008 between an undercover agent for the Criminal Investigation Division of the IRS and three former employees of Tribeca Strategic Advisors. The Commissioner had previously used excerpts of those same recordings for impeachment purposes in the May 2016 trial in Caylor Land & Development et al v Commissioner. Affirmative use of audiotaped conversations with individuals who would not otherwise be witnesses, obtained in a criminal investigation that took place years before the transactions at issue, was a rather novel and aggressive move by the Commissioner.

On May 24, 2019, the taxpayers objected to the Commissioner’s attempt to introduce the audiotapes, but also filed a notice of concession of all remaining issues, rendering moot the motion regarding the audiotapes. The taxpayers conceded that the Camerons were liable for the 40 percent penalty under §6662(i) for the 2011 and 2012 tax years, that Pilot Series received taxable income in the amounts alleged by the IRS for the 2011, 2012 and 2013 tax years, and that Pilot Series was liable for the 20 percent accuracy-related penalty for the 2011, 2012 and 2013 tax years.

The taxpayers’ concession left unanswered important questions regarding taxation of non-deductible premium payments, application of the codified economic substance doctrine, adequate disclosure, and admissibility of audiotaped conversations between an undercover criminal agent and individuals unrelated to the taxpayer.


When the parties agree that premiums were not deductible by the insured, can IRS still tax them as income to the captive?

The Commissioner originally disallowed the deductions for premiums paid by Cameron Glass and, apparently as an alternative position, determined that the amounts received by Pilot were taxable income. The taxpayers argued that the positions are legally inconsistent alternatives that cannot occur simultaneously because disallowing the deduction while also including those amounts in income would result in the same income being taxed twice and violate the tax benefit rule.

If the captive insurance transaction lacked economic substance, the result should be that the disallowed insurance premiums were a deemed distribution from Cameron Glass to Jim Cameron and a deemed contribution (not taxable income) to Pilot.

The Commissioner, however, vigorously pursued both the disallowance of the deduction and the income inclusion, citing as controlling precedent Syzygy Insurance et al v Commissioner and Reserve Mechanical v Commissioner. Somewhat ironically, the Commissioner argued that the taxpayers could not “have it both ways” because “they cannot argue on the one hand that the transaction does not lack economic substance but then on the other hand argue that the Court should reform the transaction.”

From the Commissioner’s point of view, “a conclusion that the amounts paid were really capital contributions could only be reached if the entire form of the transaction and each individual step is disregarded and unwound. Should the Court only unwind some parts of the transaction and not unwind the payments from Provincial to Pilot, then those payments are still an accession to wealth for Pilot.”

The economic substance doctrine

This issue highlights an important facet of the economic substance doctrine. The doctrine favours only the IRS. Taxpayers are stuck with the transactional form they choose, and the Tax Court frequently allows the Commissioner to recast only the parts of the transaction that increase the tax liability.

Logical consistency is not required. Taxpayers contemplating transactions that may fail the economic substance test need to be aware that the end result may be that their tax liability is doubled rather than eliminated.

Is there a relationship between the definition of insurance for federal tax purposes and the test for lack of economic substance that triggers the strict-liability penalty?

The taxpayers argued that “an insurance transaction can have economic substance even if a deduction is disallowed” because economic substance is a separate inquiry from the “rigorous judicially-created definition of insurance for federal income tax purposes.”

Technically, of course, they are two different tests. Section 7701(o) creates a two-part, conjunctive test for economic substance: (1) a meaningful change in the taxpayer’s economic position; and (2) a substantial purpose (apart from Federal income tax effects) for entering into the transaction. To decide whether an arrangement constitutes insurance, courts look to whether (1) an insurable risk has (2) been shifted to another party, (3) the insurer adequately distributes that risk, and (4) the arrangement in the whole is insurance as commonly accepted.

The open question is whether it is possible for a captive insurance arrangement to fail to meet the definition of insurance yet pass both the objective and subjective prongs of the economic substance test.

The Commissioner took the position that failing the four-part test that governs whether an arrangement constitutes insurance is sufficient but not necessary to trigger the strict-liability penalty. From the Commissioner’s point of view, a finding that the transaction is a sham is adequate to sustain the strict-liability penalty and courts may determine that a captive insurance arrangement is a sham without ever reaching the four-part definition of insurance.

As argued by the Commissioner, “Pilot and Provincial’s business operations departed so significantly from industry norms that they can be considered a sham” without any further inquiry. If the court does apply the four-part test, failure to meet those prongs demonstrates that “the purported insurance transaction did not change in any meaningful way the economic position” of the taxpayers and “weighs heavily in favour” of finding that the taxpayers no had substantial purpose other than tax benefits.

Although the Pilot Series case no longer presents an opportunity for the Tax Court to clarify how, if at all, these two tests interact, taxpayers should understand that failure to meet the four criteria to qualify as insurance will trigger not only disallowance of the deduction, but also assertion of a strict-liability penalty by the IRS.

Adequate disclosure

What counts as adequate disclosure of a captive insurance transaction?

Pilot filed Form 1120-PC, US Property and Casualty Insurance Company Income Tax Return, for each of the tax years at issue. The Forms 1120-PC disclosed the existence of an insurance company, the amount of the premiums collected by Pilot, Pilot’s election to be treated as a captive insurance company organised under IRC §831(b), and the identity of Pilot’s shareholders, including Jim Cameron.

Cameron Glass identified as insurance expenses the amounts deducted in its return, and the fact that Jim Cameron was its sole shareholder. As such, the taxpayers argued that they provided all facts necessary to enable the IRS to identify the potential controversy, meeting the test for adequate disclosure.

The Commissioner disagreed, alleging that disclosure was inadequate because the Camerons’ returns did not reveal “(1) the fact that the purported insurance premiums were not insurance premiums for tax purposes; (2) the circular nature of the flow of funds from Jim Cameron to himself and his own family via intermediary entities; or (3) the identities of, and relationships between, all the entities involved in the circular flow of funds.” The Commissioner further criticised the Camerons for failing to file Form 8275 with their return and failing to notify the Office of Tax Shelter Analysis of their transactions within 90 days after microcaptive insurance arrangements became transactions of interest in Notice 20166-66.

The IRS is setting the bar for adequate disclosure so unrealistically high for microcaptive insurance arrangements that it seems likely that IRS will seek to increase every 20 percent strict-liability penalty under §6662(b)(6) to a 40 percent strict-liability penalty under §6662(i).


May the IRS introduce audiotapes from previous criminal investigations to prove a lack of economic substance in a captive insurance transaction?

The Commissioner’s motion to introduce into evidence audiotaped conversations between an undercover criminal investigator and individuals who had no relationship whatsoever with the Camerons or Pilot was shocking in its audacity. The taxpayers were not participants in the recorded conversations and there was no evidence that the taxpayers ever had any contact with any of the individuals who were recorded.

There was no link between those recorded conversations about a hypothetical captive insurance arrangement with employees of Tribeca in 2006 to 2008 and the actual transactions involving the Camerons in 2011 to 2013. Glossing over the distinction between Tribeca and Artex and the years that elapsed between those conversations and the Camerons’ transaction, the Commissioner claimed that the recordings were relevant to whether the Camerons’ captive insurance transaction lacked economic substance because “the fact that Artex engaged in practices like those reflected in the recording on one occasion reasonably leads to the inference that they engaged in similar practices on other occasions, such as when discussing captive insurance with the Camerons or their advisors.”

The taxpayers correctly argued that the audiotapes were inadmissible under the Federal Rules of Evidence because they were irrelevant, unfairly prejudicial and confusing, not properly authenticated, and inadmissible hearsay. While difficult to imagine any proper purpose for which the Commissioner could introduce those audiotapes in a case where the recorded individuals are not witnesses, the team trying the Pilot Series case apparently could not resist the temptation to tarnish all captive insurance arrangements with the most salacious evidence they could dig out of a closed criminal investigation.

Because the court in Pilot Series had no opportunity to rein in the Commissioner’s misguided effort to taint all captive insurance arrangements with statements made by three individuals over 10 years ago, taxpayers should expect to see this move again and be ready to counter it.


What are the other potential implications of parallel criminal and civil proceedings involving captive insurance?

Although there is no indication that the Pilot Series case involved parallel proceedings, the Commissioner’s effort to introduce audiotapes from a criminal investigation into a civil trial highlights the complexity that arises when criminal and civil actions overlap. A criminal investigation may exist for years before a targeted taxpayer becomes aware of it, and the existence of a civil action in no way preempts or precludes a criminal prosecution.

The IRS and Department of Justice Tax Division each make judgement calls about whether to pursue alleged misconduct criminally or civilly, and those judgement calls may differ based on all sorts of factors that are not necessarily well-defined or apparent.

The Court of Appeals for the 11th Circuit in US v Donaldson in March 2019 upheld the felony convictions of two individuals who promoted an insurance arrangement that failed to meet the economic substance test. The government’s allegations regarding the sham nature of the insurance transactions are not that different from the allegations made in many of the pending civil captive insurance cases.

When faced with signs of a potentially overlapping criminal investigation, taxpayers should be on high alert and proceed cautiously with advice from attorneys who specialise in defending criminal tax investigations.