In June, the US Tax Court’s ruling in the Reserve Mechanical case signified another win for the IRS in its campaign against micro captives. Find out how the industry reacted
The Internal Revenue Service (IRS) claimed another scalp in its campaign against micro captives in June with the US Tax Court opinion in the Reserve Mechanical v Commissioner of Internal Revenue case.
The court held that PoolRe, the risk pool used by Reserve and operated by Capstone Associated Services, was not a “bona fide insurance company” as it did not effectively provide risk distribution.
This absence of risk distribution meant that the transactions of Reserve Mechanical, for whom PoolRe was acting as a stop-loss insurer, in the tax years in issue (2008, 2009 and 2010) were not insurance transactions and, therefore, Reserve’s deductions for premiums paid to the captive were denied. The court ruling was met with some surprise from the captive industry, with a number of factors drawing concern, including amongst others the stance on risk distribution pools, the criticism of ‘cookie cutter policies’, and the court’s apparent view that if a business hadn’t experienced actual losses in an area of coverage then no non-tax reason exists for acquiring insurance.
Capstone disputed the court’s opinion, calling it “a disservice to the captive insurance industry and bona fide companies like Reserve” and asking if captive insurance still exists after the verdict.
Reliance on Avrahami
One of Capstone’s criticisms of the court decision was its use of the verdict from the Avrahami case, in which the court ruled in favour of the IRS, who argued that Benyamin and Orna Avrahami’s captive insurance company was organised to provide tax deductions under Section 831(b) of the Internal Revenue Code and lacked insurance risk or risk distribution. While there were some similarities between the cases—and it is understandable for the court to rely on a recent case between the IRS and captive insurance which concerned the issue of risk distribution—the two cases also differed greatly. The court’s heavy reliance on Avrahami in its verdict drew some criticism from the industry.
Anne Marie Towle, captive practice manager at JLT Insurance Management, released a statement following the verdict in which she disagreed with the court’s use of the Avrahami opinion.
She commented: “It would seem that this tax court case bears no resemblance to the Avrahami case, as Reserve Mechanical cites numerous reasons and transactions showing how its business was insurance-related.”
“If the court gave no weight to more than three dozen previous rulings in favour of captives and similar arrangements, as it seems to have happened, I expect this will not be the last we hear of this case.”
Ryan Work, vice president of government relations at the Self-Insurance Institute of America (SIIA), said he was also concerned about the use of the Avrahami verdict.
He explained: “Simply, looking at Reserve and Avrahami, they’re very different captives in different areas of the country, looking at different risks.”
“You can’t compare terrorism cover in the greater Phoenix area to a captive covering various mining risks in Nevada.”
“I was surprised that there were so many references to Avrahami, it is fresh in the court’s mind, and I understand that, but there is also a number of case law and precedent before that, which was wholly set aside.”
Alan Fine, partner in charge of insurance advisory services at Brown Smith Wallace, said that he had no issue in the court using the framework of previous cases to determine what is a ‘bona fide’ insurance arrangement but that the two cases in question were very different.
He said: “I hate to pile on Avrahami but it read like a list of what not to do when it comes to an insurance company, and I don’t even come close to the same feeling here, I think there are one or two things that should’ve been done better.”
Fallout
Moving forward, it appears that the IRS will continue to lean on previous victories for future cases, and Work suggested that the captive industry could use the Reserve case as a learning opportunity.
He said: “The IRS is going to learn more and more on cases like Reserve and Avrahami, and I think in the future as people tighten up their captives they need to ensure that they’re following the highest standards they can.”
“Every setback is also an opportunity, and I think, and there is no doubt that in different court cases, whether the industry wins or loses, people are dissecting them and figuring out what the IRS is looking at and what they can do better as a captive owner or manager.”
“At the same time we all, including the IRS and the courts, have to realise that each captive is different and we can’t treat a future captive case like it’s the same structure as Avrahami or Reserve.”
In its original response to the decision, Capstone stated it was “evaluating the full range of additional relief available to rectify the court’s opinion”. Fine suggested that the future impact of the case may depend on whether the case is successfully appealed.
He said: “I have thought about it long and hard, and I think it could go one of two ways. If the case is appealed then I think the impact, at least in the next year or so will probably be mitigated.”
“I think if the taxpayer decides not to appeal it will potentially have a chilling effect on new captive formations. I think it will also cause risk sharing facilities and their managers to take a step back and reevaluate their programme in light of this case.”
Fine agreed with Work that the case could act as a learning experience for the industry, particularly influencing feasibility studies.
He said: “I think you’ll see feasibilities studies looking a bit better. In this new world, I recommend to clients to make painstakingly sure that the risks and the need for this insurance is documented in the feasibility study.”
“That is the biggest takeaway, whether the case is appealed or not, that as an industry we should all be looking to make sure the need for insurance is clear–because that is going to be questioned.”
New IRS commissioner
According to Work, the Reserve case represents one step on a longer path toward a point where the IRS, the industry and the court all share an understanding about the captive market.
He commented: “My hope is eventually we are going to get to an endgame where the IRS and the court better understand the captive market and, in turn, the market matures in the way it needs to.”
One of the things that may influence when this point is reached is the stance of the next IRS commissioner on the Service’s campaign against captives.
Charles Rettig has been nominated as the next IRS commissioner.Rettig has more than 35 years of experience as a tax attorney, much of it spent fighting the IRS, and as a strong supporter of the integrity of the US tax system has been appointed to numerous advisory boards for state and federal taxing authorities.
Work explained that Rettig had made some interesting comments in his confirmation hearing before the US Senate on 28 June.
Work said: “I can’t say one way or another specific to captives, but in Charles Rettig’s confirmation process in the Senate a couple of weeks ago he said that he would review whether the IRS’s campaigns are appropriately designating limited IRS resources and whether they’re focusing on things that, at the end of the day, aren’t priorities for them.”
