The US Internal Revenue Service (IRS) has won the latest microcaptive tax shelter case, involving Sani-Tech West (STW) and its captive, Clear Sky Insurance, created to cover shipping losses.
Despite forming the captive, STW maintained its commercial insurance policies, leading to a substantial overlap in coverage. The IRS argued that the premiums charged by the captive were excessive, as many of the risks were already covered by STW’s existing commercial insurance.
The Tax Court agreed with the IRS, finding that the captive did not meet the necessary requirements for risk distribution because it only covered STW’s risks, rather than spreading risk across a wider pool of insured entities.
Additionally, the captive’s participation with 31 other captive planning associates' clients, known as OMNI, was deemed insufficient to meet the IRS’s standards for legitimate risk-sharing.
The court also found that OMNI’s reinsurance structure, which retained only 12.5 per cent of premiums in trust, suggested that it did not expect claims to exceed that amount, further indicating that the risk distribution was inadequate.
This, coupled with the fact that OMNI employed a one-size-fits-all approach to premium pricing without regard to specific risks, further weakened the legitimacy of the captive.
Furthermore, while an actuarial study was conducted, the court noted that the captive failed to properly underwrite its risks, as the actuary only worked with general industry data and lacked specific details about STW's particular risks.
The court also scrutinised the captive’s US$400,000 loan to Shor, a company owned by STW's owners, finding it an unreasonable financing arrangement that lacked the necessary collateral.
The court concluded that the captive insurance arrangement lacked economic substance and was primarily designed for tax avoidance, rather than serving as a genuine insurance company.
As a result, STW was unable to deduct the premiums paid to the captive as insurance expenses, leading to substantial penalties.
Experts advised that captive owners must ensure that their arrangements comply with IRS regulations on risk distribution and economic substance to avoid costly penalties.
