The Internal Revenue Services (IRS) can use a deficiency case to challenge the legality of micro captive arrangements, the US Tax Court has ruled.
The Tax Court ruled on 11 February that the nature of Phoenix Capital Management’s relationship with its captive, SMS Insurance Company, was relevant to its dispute with the IRS over insurance expenses.
Phoenix formed SMS in 2009 to provide coverage for a drug store company bought in 2001.
In 2009 and 2010, Phoenix paid premiums to SMS for the coverage of risk. In 2009, the captive owner filed $1.2 million premium paid as insurance expenses and another $1.13 million in 2010.
After an audit, the IRS disallowed the deductions and issued a notice of deficiency (NOD) on in September 2014. The NOD said that the deductions had been disallowed because the amount of premiums shown were not insurances expense and had not paid.
Phoenix challenged the NOD in the Tax Court, but disputed the IRS’s motions to raise new matter not mentioned in the NOD, including whether any risk shifting existed between the captive owner and SMS.
“We are not at all persuaded that the NOD is as simple as Phoenix asserts,” the Tax Court ruled.
“The quintessence of insurance is the shifting of risk and where an alleged insurance premium is paid to a ‘captive’ entity owned by the very person who wants the coverage and makes the payment, the question naturally arises whether risk has actually been shifted, a question not really answered just by showing an insurance policy.”
“Since a payment to one’s own entity can sometimes be the mere moving of money from one pocket to another, the question whether a premium has really been ‘paid’ to a captive insurer is not really answered just by showing a canceled check.”
“Thus, if an NOD denies a deduction for premiums paid to a captive insurer because (the IRS says) ‘you did not establish that the amount shown was (a) insurance expense, and (b) paid’, then that notice has raised much more than ‘a straightforward expense substantiation dispute’.”
