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The Internal Revenue Service has won another victory in its crackdown on microcaptives as a U.S. Tax Court has ruled that the Section 831(b) election by Syzygy Insurance Co. is invalid and that the insurer must recognize the premiums it received as income.
Captives electing to be taxed under Section 831(b) of the Internal Revenue Code are taxed only on their investment, not their underwriting income, effectively lowering their tax liabilities compared with other captives and commercial insurers. The 831(b) captives are often used by small and midsize firms that are too small to establish conventional captives, but many observers say they have also been used by wealthy individuals, their family members and others to create the appearance of insurance coverage while being used to avoid tax.
Syzygy Insurance Co. was a microcaptive insurance company established by the family that owned Stoystown, Pennsylvania-based Highland Tank & Manufacturing Co., which manufactures above-ground and below-ground steel tanks, according to the decision in Syzygy Insurance Co. v. Commissioner of Internal Revenue released on Wednesday. It was incorporated in Delaware in December 2008.
Syzygy and Highland Tank participated in a program by Irvine, California-based Alta Holdings LLC, according to the decision. Typically, participants did not directly purchase policies from their captive insurers, but from fronting insurers related to Alta. From 2008 until December 31, 2010, the fronting insurer was U.S. Risk Associates Insurance Co. (SPC) Ltd. From the end of 2010 until the end of 2011, Newport Re Inc. acted as the fronting insurer.
The tax court considered four key issues: whether payments through a microcaptive insurance arrangement from Highland Tank and its affiliates to Syzygy and its fronting insurers were deductible as insurance premiums; whether Syzygy’s section 831(b) election was invalid for the years at issue; whether the purported premium payments were otherwise included in Syzygy’s income if the court found the arrangement was not insurance; and whether petitioners were liable for accuracy related penalties for the years in issue.
“We have concerns with Syzygy’s operation,” the tax court stated in its decision. “The first problem is claims.”
During the years at issue, Highland Tank did not submit a claim to a fronting insurer or Syzygy, according to the court’s decision. Highland Tank Board Chairman John W. Jacob testified that there were claims eligible for coverage under the deductible reimbursement policy that were not submitted, and the petitioners did not dispute that about $100,000 worth of claims were covered.
“The deductible reimbursement policy was one of HT&A’s most expensive insurance policies, and HT&A’s failure to submit claims after paying deductibles is indicative of the arrangement’s not constituting insurance in the commonly accepted sense,” the tax court ruled.
“Petitioners’ contention that John W. Jacob was too busy to submit claims does not lead us to believe the arrangement was insurance in the commonly accepted sense because HT&A had claims processes for commercial policies that they did not implement for the captive program policies,” the tax court continued.
The tax court also took issue with the captive’s investment choices, according to the ruling. At the end of 2011, the life insurance policies insuring Mr. Jacob and another family member totaled more than 50% of Syzygy’s assets and were its largest investments, but Syzygy could not access the cash value of the policies or borrow against them and could not surrender or cancel them or unilaterally terminate the agreements.
“Syzygy’s investment choices are also troubling,” the tax court stated. “We do not think that an insurance company in the commonly accepted sense would invest more than 50% of its assets in an investment that it could not access to pay claims.”
In determining whether an entity is a bona fide insurance company, the tax court considered factors such as whether the policies were arm’s-length contracts. In 2011, Syzygy decided to exit Alta’s captive insurance program after its premiums dropped by more than $200,000 that year, with Mr. Jacob writing an email to Alta stating that one of the reasons Highland Tank was leaving the Alta program was the decrease in premiums, which the court said deepened its view that the policies were not arm’s-length contracts.
“It is fair to assume that a purchaser of insurance would want the most coverage for the lowest premiums,” the tax court ruled. “In an arm’s-length negotiation, an insurance purchaser would want to negotiate lower premiums instead of higher premiums. Seemingly, the main advantage of paying higher premiums is to increase deductions. Therefore, the fact that John W. Jacob sought higher premiums leads us to believe that the contracts were not arm’s-length contracts but were aimed at increasing deductions.”
The tax court also rejected the petitioner’s argument that the premiums were actuarially determined because the person who set the premiums was not an actuary and his underwriting report had no calculations showing how he arrived at the premium prices. The premiums were reviewed in the context of the captive’s solvency, not in relation to whether the premiums were reasonable, meaning the policies issued by the fronting insurers did not have actuarially determined premiums, according to the tax court’s decision. These factors indicate that U.S. Risk and Newport Re were not bona fide insurance companies, meaning that they did not issue insurance policies and that Syzygy’s reinsurance of those policies did not distribute risk. Therefore, Syzygy did not accomplish sufficient risk distribution for federal income tax purposes through the fronting insurers, according to the ruling.
“Although Syzygy was organized and regulated as an insurance company, met Delaware’s minimum capitalization requirements, and paid a claim, these insurance-like traits do not overcome the arrangement’s other failings,” the tax court stated in ruling against the microcaptive. “Syzygy was not operated like an insurance company. The fronting carriers charged unreasonable premiums and late-issued policies with conflicting and ambiguous terms.”
Attorneys for the family could not be immediately reached for comment.
The Captive Insurance Companies Association has issued guidance on commonly accepted practices for risk pools in response to a controversial tax court decision — a move praised by a captive regulator in a top U.S. domicile.