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On Wednesday, March 10, the Tax Court issued its fourth case concerning “Microcaptive” insurance companies. In Caylor Land & Dev. v. Comm’r, the IRS continues its winning streak against captive arrangements. In the words of Judge Holmes, who authored the opinion as well as that of the seminal Avrahami case, “We will break no new ground today.” While the Court follows its previous framework set forth in Avrahami, it does address a few concepts not seen in prior cases.

Notably, this is the first time the Tax Court has addressed a captive arrangement wherein the Taxpayer has attempted to satisfy the “risk distribution” requirement of bona fide insurance, via independent risk exposures and not through use of a risk pool. The theory being that the insured was engaged in so many unique and independent risks that it was able to take advantage of the “law of large numbers” and distribute the risk of loss. Commercial insurers accomplish this by insuring multiple individuals for a multitude of loss events (e.g., automobile insurance, life insurance, and homeowners insurance sold to multiple customers in multiple regions). The Court recognized the 34 risks identified by the Government’s expert as inadequate to establish proper risk distribution. Holmes compares the Rent-A-Center case, which established sufficient risk exposures with 14,000 employees, 7,000 vehicles, and 2,600 stores. However, it’s important to note that Judge Holmes seems to assign each entity as a single exposure unit, rather than looking at the individual risks that make up each exposure.

This case marks the Tax Court’s first imposition of penalties against a taxpayer stemming from his or her participation in a captive program. The IRS has continually chased penalties during exam, ranging from the 20% penalty for negligence or substantial understatement (what was imposed here) to the 40% penalty for lack of economic substance. This could be a product of a the Court noting particular facts. For example,

• The captive set the amount of premiums it wished to pay and worked backwards to select policies that fit the budget.
• The insureds paid premiums to the captive without knowing the total premiums for each and without knowing what those policies would be for that year. Two claims were even paid on policies that had not yet been written.
• Premiums were determined or allocated based on revenue of the entities.
• The captive manager utilized a “captive risk factor” which was explicitly intended to inflate premiums and increase funds in the captive.
• The captive manager recommended that the captive participate in a risk pool in order to distribute risk, and the shareholders declined.

It is important to note that Holmes upheld penalties based on the lack of advice rendered by the taxpayer’s advisors. Without any concrete advice to provide the taxpayer (as the advisors so testified at trial), the taxpayer had no advice to rely upon that it could point to in order to establish reasonable cause.

With this win the IRS is likely to continue its pressure on 831(b) captives. An audit campaign is under way, and two settlement programs have been issued thus far requiring participants to cease participation in captive programs.

If you have questions about the Caylor case, or your captive program, please contact John Dies at 713-350-3529.