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The IRS on Wednesday won its fourth consecutive case against 831(b) captive owners when the U.S. Tax Court ruled that a construction business’ captive did not qualify as insurance for tax purposes.
The long-awaited ruling in Caylor Land & Development Inc. v. Commissioner of Internal Revenue is another loss for the once-booming microcaptive sector, which has been under fire from tax authorities for nearly 10 years.
The case revolved around a captive established by a Tucson, Arizona-based family-owned construction business. The business was founded in 1958 and grew and thrived so that by the 1990s the business had sprouted many subsidiaries and affiliates, court papers say. Much of the revenue of many of the subsidiaries, however, was derived from “consulting fees” from Caylor Construction, the principal business entity of the group.
Caylor bought extensive insurance coverage, at an average cost of $60,000 a year, but the owners were irritated that they still incurred average uninsured losses of about $50,000 a year, the ruling states.
After attending a captive presentation in 2007 by Tribeca Strategic Advisors LLC, which was bought by a unit of Arthur J. Gallagher & Co. in 2010, the family formed an Anguilla-domiciled captive, Consolidated Inc., that was taxed under section 831(b) of the U.S. tax code. So-called 831(b) captives are only taxed on investment income – not underwriting income – provided their annual premiums don’t exceed the cap, which was then $1.2 million a year.
Caylor Construction immediately paid $1.2 million into the captive for claims-made coverage for 2007 even though there were only 10 days left in the year. The company continued to pay $1.2 million in premium for the next three years and had few claims paid by the captive.
While unlike in earlier microcaptive cases the Caylor captive did not enter a risk-pooling agreement, the court found that there was insufficient risk transfer to constitute insurance.
“In the 10 years leading up to Consolidated’s formation, the Caylor entities had incurred only $500,000 in what the Caylors called uncovered claims — roughly $50,000 per year. While we don't think that any premium over $50,000 per year would be per se unreasonable, a premium that is so much higher —$1,150,000 higher to be specific — looks unreasonable and thus likely to be for something other than ‘insurance’ as that term is commonly understood,” the ruling stated.
In addition, the risk sharing between the various related Caylor entities did not shift sufficient risk and the premiums paid to the captive and deducted by the Caylor entities are not insurance for federal tax purposes, the ruling stated.