The big problem in the Syzygy’s v Commissioner of Internal Revenue case was when the premiums decreased, the taxpayer switched captive managers, which according to Chaz Lavelle, partner, Bingham Greenebaum, “is what the court was concerned about”.
When discussing the section 831(b) court case decision during this year’s tax update at the Vermont Captive Insurance Association Conference, Lavelle explained the court was also concerned about “the precise determination of the premiums, they also said the captive manager did not testify on exactly why the pooling entity would have been a good entity for federal tax purposes”.
Lavelle explained that “you can’t use the risks that were assumed from the pooling entity in returning your risk distribution”.
He continued to ask the audience if they think the pooling entity has to be an insurance company for tax purposes, in order for the captive to count risks assumed from it for risk distribution purposes.
Although the majority of the audience answered yes, Lavelle said it is “irrelevant” whether or not the pooling entity is a valid insurance company.
Lavelle explained that “risk distribution is determined by whether it is assuming the risks of unrelated people and it seems to be irrelevant whether or not those risks come directly from the insured or from an entity that is an insurance company that does qualify as an insurance company for tax purposes or an entity that doesn’t qualify as it has an obligation to pay a third party when a contingency occurs, that to me is an unrelated business”.
In the tax court decision, Judge Ruwe found that the arrangement between captive insurer Syzygy, its parent company High Tank and Manufacturing, and its fronting carriers, were not insurance transactions, meaning the Syzygy’s section 831(b) election is invalid and it must recognise the premiums it received as income.
Judge Ruwe, therefore, ruled that the captive’s fronting carriers were not bona fide insurance companies and therefore Syzygy did not distribute risk and did not accomplish sufficient risk distribution for federal income tax purposes through the fronting carriers.
He found that the arrangement between Syzygy and its fronting carriers “looks suspiciously like a circular flow of funds” and that the fact that the captive owner sought higher premiums led the court to believe “that the contracts were not arm’s-length contracts but were aimed at increasing deductions”.
Lavelle said captives should go the “extra mile” and that “it’s not hard to follow the tasks the courts provided”.
He added: “In today’s world, captives are in a hard market with the Internal Revenue Service and courts.”