United States: U.S. Tax Court Finds Captive Insurer Is Not An "Insurance Company" Under The Internal Revenue Code

Last Updated: July 31 2018
Article by Jeanne Kohler

In this case, Reserve Mechanical Corp. ("Reserve"), a captive insurer incorporated under the laws of Anguilla, sued the Commissioner of Internal Revenue in the U.S. Tax Court regarding the Commissioner's findings of $477,261 in deficiencies in Reserve's federal income tax for the tax years 2008 through 2010. During those years, 100% of Reserve's stock was owned by Peak Casualty Holdings LLC ("Peak"), a Nevada limited liability company.

The U.S. Tax Court held that Reserve failed to qualify as an insurance company for federal income tax purposes under the Internal Revenue Code section 501 (a), (c)(15), which provides for the tax-exempt treatment of income received by insurance companies that meet certain criteria. Because Reserve did not qualify as an insurer, the Court also determined that Reserve is not eligible to make an election under section 953 to be subject to U.S. federal income tax as a U.S. company.

In determining whether Reserve could be considered an "insurance company," the U.S. Tax Court looked at risk distribution, focusing on the number of insureds and the number of risk exposures to determine whether Reserve distributed risks. For 2008, Reserve issued 13 direct written insurance policies with Peak and two other named insureds. For 2009, Reserve issued 11 policies and, for 2010, Reserve issued 11 policies involving the same parties. The policies covered between $8 and $13 million in potential losses. Each policy listed PoolRe Insurance Corp. as the stop loss insurer. For each of the years at issue, Reserve and PoolRe executed a joint underwriting stop loss endorsement, which by its terms applied to all of the policies Reserve issued. PoolRe executed reinsurance agreements designed to redistribute them to entities of Capstone Partners, a Texas limited partnership. For each of the tax years, the Court noted that Reserve and the Capstone entities each executed a quota share reinsurance policy with PoolRe, and Reserve also executed a credit insurance coinsurance contract with PoolRe, under which Reserve agreed to assume a small portion of risk that PoolRe had agreed to assume from an unrelated company, CreditRe Reassurance Corp. Ltd.

As for the direct policies, the Court found that ''the number of insureds and the total number of independent exposures were too few to distribute the risk that Reserve assumed.'' The Court held that it was not a bona fide insurance company and that there was no legitimate business purpose for the policies that Reserve issued for the insureds, noting: ''[t]he direct written policies increased Peak's insurance coverage and expenses for the tax years in issue, when it also continued to hold policies with third-party insurers. In the light of all the facts and circumstances the premiums charged for the policies were unreasonable.'' Therefore, the Court ruled that Reserve's transactions were not insurance transactions. The Court also found that Reserve's quota share policies with PoolRe were not bona fide insurance agreements because the quota share arrangement involved ''a circular flow of funds'' and that the ''premiums were not negotiated at arm's length.'' The Court noted that it found no evidence that the premiums the insureds paid PoolRe and the premiums that PoolRe paid Reserve ''were actuarially determined.'' Thus, the Court held that PoolRe's activities as they relate to the policies were not those of a bona fide insurance company.

Therefore, as a result of its finding that Reserve did not qualify as an "insurance company", the Court held that for the tax years at issue, Reserve is not eligible to make an election under section 953(d). Thus, the Court concluded that Reserve was subject to the 30 percent withholding tax on the premium it had received under section 881 (a) of the Internal Revenue Code and that Reserve did not provide proof to the court that these amounts should not be considered fixed, determinable, annual, periodical income. The Court rejected Reserve's contention that the amounts it received during the tax years were capital contributions or nontaxable deposits. It also found that Reserve is not entitled to deductions, explaining that Reserve failed to establish that ''it was engaged in or received income treated as income effectively connected with a trade or business within the United States.''

Reserve Mechanical Corp. v. Commissioner of Internal Revenue, No. 14545-16 (U.S. Tax Ct. June 18, 2018).

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