On April 10th, The Tax Court issued its latest opinion involving micro-captives. In mostly finding for the IRS, the Court maintains the analytical framework set forth in its opinions in Avrahami (2017) and Reserve Mechanical (2018). It also provides a window into what happens when the IRS invalidates the 831(b) election.
The Court found that Syzygy, a Delaware captive insurance company, failed to establish that it was an insurance company for tax purposes on the grounds that it failed to properly distribute risk and that the arrangement was not “insurance in the commonly accepted sense.”
In its analysis of Syzygy’s risk distribution, the Court relied on Avrahami and Reserve, focusing on aspects of the risk pool. The insured entities in this case have 400 employees and operate in six different locations. Interestingly, the Court, however, did not analyze whether there were a sufficient number of independent risk exposure units to establish risk distribution outside of the risk pool analysis.
In determining that the arrangement was not insurance in the commonly accepted sense, Judge Ruwe focused on the set-up and operation of the captive, in a manner nearly identical to the Avrahami and Reserve Mechanical. In addition to disallowing deductions for the insured, the Court found that would-be premium payments were in-fact taxable income to Syzygy. The Court made this finding without any explanation of its rationale.
While not otherwise taxpayer friendly, the Court did disagree with the IRS on penalties. As in Avrahami, the Court assessed no penalties for the captive transaction. Much like the Avrahami decision, the CPA’s counsel provided the taxpayer with reasonable reliance, and this was sufficient to negate the 20% penalty. In another major win for the taxpayer, the Court declined the need to assess the economic substance penalty, which would have led to a 40% penalty. These penalty holdings are in line with Avrahami and Reserve. No Court to date has upheld the assessment of a penalty against a taxpayer in a microcaptive case, and despite the Service’s attempts, no Court has supported IRS assertions that these transactions lack economic substance.
It is important that current captives, whether in audit or not, review their substantiation and formalities to ensure the best outcome of any interaction with the IRS. Please contact John Dies or Steven Miller with any questions on this or other matters.