In a recent Tax Court Memorandum opinion, the Tax Court (the “Court”) held that a microcaptive insurance arrangement did not meet the requirements to be classified as insurance for federal income tax purposes, and thus upheld the Internal Revenue Service’s (the “IRS”) Notice of Deficiency (the “Notice”) against the company and its related taxpayers who were parties to the transactions through several S corporations and grantor trusts.1 The company, Syzygy Insurance Company, Inc. (“Syzygy”), was required to include insurance premiums in its income and the individuals were denied the related deduction for the premiums paid.
The parties to the case are members of the Jacob and VanLenten families as well as related companies owned by, and trusts set up by, the families. The primary individuals are John W. Jacob (“Jacob”) and Michael VanLenten (“VanLenten”). VanLenten is married to Elizabeth Jacob VanLenten, thus the connection to the Jacob family.
The primary business is Highland Tank & Manufacturing Co. (“Highland Tank”), a steel tank manufacturer located in Pennsylvania that has been owned by the Jacob family since 1953. Several other businesses involved in the case were formed under the Highland Tank umbrella and are referred to as the “Affiliates” in this article. Highland Tank and the Affiliates (collectively, “HTA”) were all taxed as S corporations during the periods at issue, 2009 through 2011.
There are four trusts relevant to the case. The first trust, the John W. Jacob 2002 Irrevocable Trust (the “2002 Jacob Trust”), was set up by and a grantor trust to Robert Jacob. The second trust, the Michael and Elizabeth VanLenten 2002 Irrevocable Trust (the “2002 VanLenten Trust”), was set up by and a grantor trust to Vincent Jacob. The third trust, the 2008 John W. Jacob, Sr. Separate Trust (the “2008 Jacob Trust”), was set up by and a grantor trust to Jacob. The fourth trust, the 2008 Michael and Elizabeth J. VanLenten Separate Trust (the “2008 VanLenten Trust”), was set up by and a grantor trust to VanLenten. During the periods at issue, all of the Affiliates were owned in various percentages by the four trusts.
Throughout 2008, Jacob was exploring the idea of a captive insurance company. Through an insurance broker, he was connected with Alta Holdings, LLC (“Alta”), a California company that ran a captive insurance program and provided management services for captive insurance companies. In October of 2008, Alta informed Jacob that it determined Jacob would need at least $600,000 of annual premiums paid in to make a captive insurance program feasible. In November of 2008, Alta’s chief underwriter, Greg Taylor (“Taylor”), sent an email to another Alta employee stating that as a “will ass guess” (presumably wild but misspelled), he had identified between $500,000 and $800,000 of premiums for Highland Tank and the Affiliates.
In addition to discussing the captive insurance plan with Alta, Jacob had numerous discussions about the plan with Emanuel DiNatale, CPA (“DiNitale”), who advised Highland Tank on tax and business matters. He had attended some of the meetings with Alta. DiNatale’s testimony indicated that he has spent some time familiarizing himself with captive insurance law during this process, and felt the arrangement complied with the law and was appropriate from a business perspective.
In early December of 2008, Jacob decided to proceed with the plan. Syzygy was established in Delaware on December 15, 2008 and was granted its certificate of authority from the Delaware Department of Insurance (the “DDI”) on December 31, 2008. Syzygy was capitalized with a $250,000 irrevocable line of credit naming DDI as the beneficiary. Syzygy was set up by Jacob and VanLenten and was owned equally by two LLCs, one that was wholly owned by the 2008 Jacob Trust and the other that was wholly owned by the 2008 VanLenten Trust. Jacob and VanLenten served as the managers of the respective LLCs and also were the only officers of Syzygy.
Syzygy and HTA all participated in Alta’s captive insurance program which consisted of not only the captive insurance company, but also the companies purchasing the captive insurance. Under Alta’s program, the policies were typically purchased from fronting carriers rather than from the captive insurance company itself. The fronting carrier’s policies were written on behalf of their segregated portfolios and typically had a maximum aggregate benefit of $1 Million. Syzygy did sell one policy directly to HTA in 2011 that also had maximum aggregate benefit of $1 Million, but the rest were done through the fronting carrier.
HTA paid premiums directly to the fronting carrier but the fronting carrier ceded 100% of the insurance risk. The fronting carrier charged a fronting fee, 2.5% for one of the carriers involved in this case. The Court describes the responsibility for paying claims as a 2 layer system. The first layer covered losses up to $250,000 and anything between $250,000 and $1 Million was allocated to layer 2. Alta allocated 49% of each premium to layer 1 and 51% to layer 2. For layer 1 claims, Syzygy resinsured the first $250,000 of any HTA claim. Upon receipt of the premiums from HTA, the fronting carrier would cede 49% of the net premiums to Syzygy. For layer 2 claims, Syzygy agreed to reinsure its quota-share percentage of losses, such quota-share being the net premium paid by HTA to the segregated portfolio of the front carrier over the total net premiums paid to the segregated portfolio of the front carrier. Additionally, Syzygy provided layer 2 resinsurance to approximately 857 policies issued to unrelated companies. Three and a half months after the policy ended, the fronting carrier would pay Syzygy 51% of the net premiums less the amount of claims paid on any layer 2 losses.
With regard to its 49%/51% premium allocation between layer 1 and layer 2 claims, Alta sought input from Taylor-Walker & Associates, Inc. (Taylor-Walker), an actuarial consulting firm. Taylor-Walker informed Alta that the average premium allocated to layer 1 in this case would be somewhere between 57% to 78%. In order to support the 49%/51% allocation Alta was using, Taylor-Walker suggested either lowering the layer 1 attachment to something lower than $250,000 or increasing policy limits to something above $1 Million. In a follow up email, Taylor-Walker informed Alta that it estimated that 70% of losses would occur in layer 1 under the current structure. Alta did not change its allocation. Taylor-Walker’s employee testified that he did not know why Alta had chosen its 49%/51% allocation method and never asked. Jacob testified that the 49%/51% allocation was to take advantage of a tax related “safe harbor”.
In addition to advising on the premium allocation, Taylor-Walker was also hired to prepare an actuarial feasibility study for Syzygy’s insurance application. The study did mention premium prices charged but the primary purpose of the study was to determine financial solvency, and the report concluded that Syzygy was “feasible from a financial solvency perspective”. The report did not advise on whether the proposed premiums were appropriate. The report also relied on information provided by Alta, and did not use any independent data. The report was review by the DDI as part of the application process, but DDI testified that it also was unconcerned with premiums being too high, but rather was only interested in the premiums were sufficient for Syzygy to remain solvent.
HTA purchased various policies through Alta’s program during the periods at issue. Each policy did not provide pro-rata refunds for early cancellation, provided that claims could only be made within 7 days after the policy expired, and there was no purchase option to extend the claim reporting period. The premiums for 2009 were set by Taylor who is not an actuary. In addition to the captive policies, HTA had extensive commercial insurance coverage maintaining between 11 and 13 policies with premiums paid between $981,882 and $1,471,042. The average rate-on-line for these policies was 1.14%.
For the policies purchased by HTA, the average rate-on-line ranged from 6.08% to 6.2%. None of the policies were actually timely issued. HTA did not file any claims under the program although it did file multiple claims under commercial insurance policies and incurred deductibles. HTA did not have a claims management process for the captive policies and Jacob testified that no claims were filed because of time management issues which prevented the claims from ever being on his “radar screen”.
Syzygy did pay out $209,106.74 on a layer 2 claim made on an intellectual property policy held by an unrelated company. The testimony indicates that it is unlikely the claim was even covered by the policy. Nevertheless, Syzygy did not investigate the claim and paid out based on a fronting carrier’s settlement.
Syzygy met Delaware’s minimum capitalization requirements for an insurance company at all times during the periods at issue. Nevertheless, the assets held were questionable for an insurance company. In 2010, Syzygy’s listed assets included two life insurance policies. The policies were not directly owned by Syzygy but rather were owned by the 2008 Jacob Trust and the 2008 VanLenten Trust respectively. Syzygy was not a beneficiary of either policy. Syzygy did however pay the premiums of the policy under a split-dollar agreement which provided Syzygy with the right to the greater of premiums it paid or cash surrender value upon the death of an insured, but Syzygy was prohibited from accessing the cash value otherwise.
Syzygy’s Exit from Alta’s Program
In 2011, Syzygy decided to exit Alta’s captive insurance program. Syzygy’s premiums were lowered by more than $200,000 in 2011. Jacob notified Alta of the exit by an email which stated that Syzygy was changing managers because, among other things, he was displeased with the decrease in premiums.
Tax Reporting and the Notice of Deficiency
The premium payments to the front carriers were apportioned among the various entities of HTA and were deducted by those entities, which in turn flowed through to the shareholders. The trusts were grantor trusts so deductions flowing through to the trusts were claimed by the grantors. Syzygy made a Section 831(b) election which allowed it to avoid including the premiums in its income.
With respect to the individuals, the Notice concluded that the arrangement lacked economic substance, the premiums were not paid for insurance, and the amounts were not ordinary and necessary business expenses,. Thus, all deductions related to premium payments were denied.
With respect to Syzygy, the Notice concluded that Syzygy was not an insurance company and the transactions were not insurance transactions. Accordingly, the Section 831(b) election was invalid and the premiums received were taxable income.
The Notice also alleged that each party to the case was liable for the accuracy related penalty under Section 6662(a).
The two matters for the Court to decide were (1) whether the amounts received by Syzygy as premiums were excluded from gross income; and (2) whether the individual petitioners were entitled to the benefit of deductions taken by their S corporations for insurance under Section 162.
With regard to Syzygy, Section 831(b) provides an alternative taxing structure for certain small insurance companies, typically referred to as microcaptives. If the company meets the requirements and makes the Section 831(b) election, the company is only taxed on its investment income and premiums received are not taxable income. An inherent requirement for Section 831(b) to apply is that the company transact in insurance.2
With regard to the individual petitioners, insurance payments are deductible as ordinary and necessary business expenses under Section 162, and there is not prohibition on payments made to a microcaptive.
Thus, in order to render a decision on both matters, the Court first had to determine whether the arrangement was an insurance arrangement.
Whether the Arrangement Was Insurance
Neither the Internal Revenue Code nor the related Treasury Regulations define insurance for federal income tax purposes, and thus the Court had to look to case law. The following four criteria have been used by courts to determine whether an arrangement constitutes insurance:
- Whether the arrangement involves insurable risk;
- Whether the arrangement shifts the risk of loss to the insurer;
- Whether the insurer distributes the risk among its policyholders; and
- Whether the arrangement is insurance in the commonly accepted sense.3
The four nonexclusive factors form a framework for determining the existence of insurance4 and all of the facts and circumstances are considered in light of such framework.5
The Court first looked at risk distribution. Syzygy argued that it distributed risk by participating in the fronting carrier’s captive insurance pools and reinsuring unrelated risks. Thus, the Court first had to determine whether the fronting carriers were bona fide insurance companies. 6 The Court considered nine factors in determining whether a fronting carrier was a bona fide insurance company:
- Whether the company was created for legitimate non-tax reasons;
- Whether there was a circular flow of funds;
- Whether the entity faced actual and insurable risk;
- Whether the policies were arm’s-length contracts;
- Whether the entity charged actuarially determined premiums;
- Whether comparable coverage was more expensive or even available;
- Whether it was subject to regulatory control and met minimum statutory requirements;
- Whether it was adequately capitalized; and
- Whether it paid claims from a separately maintained account.7
The Court noted that many of these factors are interrelated and chose to address the most relevant.
Circular Flow of Funds
First, the Court addressed the circular flow of funds. Under the arrangement, HTA paid the premiums to the fronting carriers who then resinsured all of the risk, making sure Syzygy received reinsurance premiums equal to the net premiums less Syzygy’s liability for any layer 2 claims. For the years at issue, this resulted in HTA paying premiums of $1,373,500 and Syzygy receiving $1,319,055.76. While not a complete loop, the court has noted this looks like a circular flow of funds under similar circumstance.8
Arm’s Length Contract
Next, the Court looked at whether the contracts were arm’s length. For HTA’s captive policies, the average rate-on-line was between 6.08% and 6.2% compared to an average of 1.14% for HTA’s commercial policies. This resulted in HTA paying almost five times more for the captive policies. A higher rate-on-line means a higher cost per dollar of coverage which results leads to higher deductions for those paying premiums. Since the captive policies were typically for excess coverage, there typically would be a lower rate-on-line rather than a higher one when comparted to the commercial policies.9 The Court went on to point out various other factors which tended to show the contracts were not arm’s length. The policies were non-refundable which is not unheard of but is not the norm in the industry. The policies provided that claims must be made within 7 days of the policy ending. Typically, policies, including HTA’s commercial policies provided anywhere from 30-60 days for such claims. Further, Jacob stated in his email that one of the reason for leaving Alta was due to the decrease in premiums. Based on all the facts, the Court concluded the contracts were not arm’s length.
Actuarialy Determined Premiums
The last of the nine factors considered was whether there were actuarially determined premiums. While there is not definition for “actuarially determined”, the Court has held that premiums were actuarially determined when the company relied on an outside consultant’s “reliable and professionally produced and competent actuarial studies” to set premiums and the Court has looked favorably on outside actuary’s determining of premiums.10 On the flip side, the Court has held that premiums were not actuarily determined when there has been no evidence to support the calculation of premiums and when the purpose of premium pricing has been to fit squarely within the limits of Section 831(b).11 The Court noted two issues with the captive policy premiums: (1) the reasonableness of the premiums; and (2) the 49%/51% allocation between layer 1 and layer 2.
The only evidence on the record about how the captive policy premiums were set related to Taylor doing so using a “quantitative risk analysis.” The Court noted that Taylor is not an actuary and produced no calculations showing how he arrived at the premiums. He even stated in his November 2008 email that through a “wil[d] ass guess” he had identified range of premiums that could be supported by Syzygy and HTA. Petitioners alleged that in addition to Taylor, both Taylor-Walker and DDI had reviewed the premiums from an actuarial point of view and approved them. However, as the Court noted, both Taylor-Walker and DDI stated that they only performed an actuarial review of the premiums for solvency purposes, not to determine whether the premiums were appropriate under the circumstances. Accordingly, the Court concluded the captive policies did not have actuarily determined premiums. The Court also noted its issue with the premium allocation. Even though Taylor-Walker advised that the 49%/51% allocation between layer 1 and layer 2 was not supported by the studies, and that layer 1 would likely be responsible for 70% of claims paid, the allocation was not changed. Accordingly, the Court concluded that the allocation as not actuarily determined either.Based on its analysis of the three factors discussed above, the Court concluded that the fronting carriers were not insurance companies for federal income tax purposes, and thus they did not issue insurance policies.12 As such, Syzygy’s resinsurance of those policies did not distribute risk. As a result, Syzygy did not accomplish sufficient risk distribution for federal income tax purposes through the fronting carriers.
Insurance in the Common Sense
Having concluded that there was not adequate risk distribution in the arrangement, the Court next looked to whether the arrangement was insurance in the commonly accepted sense, although the Court noted that the lack of risk distribution by itself was enough to conclude the arrangement was not insurance. In determining whether an arrangement is insurance in the common sense, the Court looked at numerous factors including:
- Whether the company was organized;
- Whether the company was adequately capitalized;
- Whether the policies were valid and binding;
- Whether the premiums were reasonable and the result of arm’s length transactions; and
- Whether claims were paid.13
First, Syzygy was organized as an insurance company and regulated as such in Delaware. Nevertheless, the Court must look beyond the formalities and consider the realities of the purported insurance transactions.14 The Court pointed out numerous issues with how Syzygy operated in this respect. First, HTA did not submit a single claim on the captive policies during the years at issue despite submitting claims on commercial policies and having incurred deductibles that were “too numerous to list”. Jacob maintained that he was to busy to submit the claims, but the Court was not persuaded. Next, on the one claim Syzygy did pay to an unrelated company, Syzygy did not even investigate the claim. The Court was also troubled by the investment choices of Syzygy, particularly with respect to the split-dollar agreement and the life insurance policies which could not be converted to cash should Syzygy need to access the asset to pay out claims.
Second, the Court noted that Syzygy did meet the minimum capitalization requirements under Delaware law, and meeting the minimum requirements has been held to be enough to be adequately capitalized.15
Next, the Court looked at where the policies issued were valid and binding. The main issues disputed in the present case where whether the policies were timely issued, identified the insured, and specified what was covered by the policies. Given all of the issues with the timeliness of the policies as well as the ambiguities and conflicting terms contained therein, the Court concluded that, in the context of a related party transaction, the valid and binding policies factor weighed against the Petitioners.
For the fourth factor, the Court referenced its prior analysis in concluding that the arm’s length factor weighed against Petitioners.
For the fifth factor, the Court did note that the one claim that was submitted was paid, although there were issues with how and why it was paid. Nevertheless, the Court concluded this factor weighed slightly in favor of Petitioners.
All things considered, the Court concluded that Syzygy was not operated like an insurance company, thus the arrangement was not insurance in the common sense.
Court Conclusion – The Arrangement Did Not Constitute Insurance
Having determined that the arrangement did not have adequate risk distribution and was not insurance in the commonly accepted sense, the Court concluded the arrangement was not insurance for federal income tax purposes. The Court did not analyze the other factors nor did the Court address the economic substance argument raised by the IRS.
Tax Effect of the Court’s Conclusion on Petitioners
Having determined that there was no insurance, the Court quickly concluded that Section 831(b) was not applicable to Syzygy and thus the premiums paid to Syzygy were taxable income. But whether the individuals were entitled to the deduction for such premiums under Section 162 was not quite as clear cut.
The Court noted that there was little precedent addressing the deduction of amounts paid for invalid insurance, and neither party cited cases, but they may nevertheless be deductible under Section 162. For an expense to be deductible under Section 162, it must be both ordinary and necessary.16 An expense is necessary if it is appropriate and helpful to the development of the taxpayer’s business.17 In the context of a captive insurance arrangement, the indemnified party must intend to seek indemnification in order for the payments to have a valid purpose. In the present case, HTA’s failure to file any claims indicates there was no intent to seek indemnification, and thus no valid purposes, and, as such, he payments were not necessary and not deductible under Section 162.
The Courts did discuss several Revenue Rulings which held that arrangements that purported to be insurance but lacked the requisite risk distribution may be recharacterized in a manner such that the expenses paid are deductible.18 The Revenue Rulings involved circumstances where the IRS determined that the transactions were not insurance but nevertheless were recharacterized in a manner that expenses paid for the arrangement may be deductible. However, as the Court noted, for a taxpayer to rely on a Revenue Ruling as precedent, the facts of the taxpayer’s transaction must be substantially the same as those in the ruling.19 Such was not the case here and the Court found the Petitioners’ argument unpersuasive. The Court thus concluded the payments were not deductible.
While the Court ruled against Petitioners regarding whether the arrangement constituted insurance for federal income tax purposes, the Court did find that Petitioners were not liable for the accuracy related penalties under Section 6662(a). The Court found the Petitioners had reasonable cause and good faith for their position due to their reliance on DiNatale and his professional advice.
After reading the facts included in the opinion, one would not have a hard time guessing what the Court was going to conclude. Here, there are numerous facts that go against the Petitioners, and when viewed as a whole, it is not surprising the Court ruled against Petitioners. There are several points to take away though. First, the insurance laws and tax laws related to insurance companies are complex. The Courts have laid out various factors they will look at when considering these types of arrangements. Taxpayers would do well to review case law and the relevant factors courts consider when structuring their captive companies and transactions such that each factor weighs on their side. The Petitioners in this case clearly failed to do so. Second, as was the case here and as is the case with most if not all microcaptive insurance arrangements, related party transactions will receive specially scrutiny. Taxpayers engaging in any related party transaction should plan accordingly. Next, it always pays to follow the proper formalities related to a business structure, which in this case, would, among other items, include filing claims on policies purchased, but this concept is also applicable in other contexts. For example, setting up an entity for asset protection requires proper formalities to be followed to obtain that benefit of such asset protection, and the failure to follow such formalities may result in the loss of asset protection. Finally, there were several emails that came to light during trial and in which the Court placed significant weight, including Taylor’s “wil[d] ass guess” on premiums and Jacob’s email expressing his displeasure about decreasing premiums. As the saying goes, “Dance like no one is watching, but email like it will be read aloud in a deposition.”
It should be noted that with the release of IRS Notice 2016-66, Section 831(b) microcaptive arrangements such as the Syzygy are now listed “transactions of interest”. Taxpayers and material advisors who participate in a “transaction of interest” are subject to the formal disclosure requirements of Section 6011 (§ 1.6011-4), the material advisor disclosure statement requirements of Section 6111 (§§ 301.6111-1, 301.6111-2, 301.6111-3), and the list maintenance requirements of Section 6112 (§ 301.6112-1). For taxpayers, the disclosure requirements are met through the filing of a Form 8886. For material advisors, the disclosure requirements are met through the filing of a Form 8918.
- Syzygy Ins. Co., Inc. et al, v. Comm’r, TC Memo 2019-34.
- Avrahami v. Comm’r, 149 TC 144 (2017).
- Harper Grp. v. Comm’r, 96 TC 45 (1991), aff’d 979 F.2d 1341 (9th Cir. 1992).
- AMERCO & Subs. v. Comm’r, 96 TC 18 (1991), aff’d 979 F.2d 162 (9th Cir. 1992).
- Rent-A-Center, Inc. v. Comm’r, 142 TC 1 (2014).
- Avrahami at 185.
- Rent-A-Center, Inc. at 10-13.
- Avrahami at 186.
- Id. at 187.
- Rent-A-Center at 27.
- Avrahami at 196.
- Id. at 190.
- Rent-A-Center at 24-25.
- Hosp. Corp. of Am. V. Comm’r, TC Memo 1997-482.
- Avrahami at 194.
- Welch v. Helvering, 290 US 111 (1933).
- Id. at 113.
- See. Rev. Rul. 2005-40, Rev. Rul.2008-8.
- Barnes Grp., Inc. & Subs. v. Comm’r, TC Memo 2013-109.