Lack of Risk Distribution Dooms Microcaptive Insurance Arrangement

(Parker Tax Publishing April 2025)

The Tax Court held that an S corporation's microcaptive insurance arrangement did not constitute insurance for federal income tax purposes because (1) the purported microcaptive insurer did not achieve risk distribution and (2) the arrangement did not resemble insurance in the commonly accepted sense. Therefore, the purported insurer was not entitled to exclude the premium payments from its income under Code Sec. 831(b) and the S corporation could not deduct the premiums as ordinary and necessary business expenses under Code Sec. 162(a). Jones et al. v. Comm'r, T.C. Memo. 2025-25.

Background

Sani-Tech West, Inc. (STW) is an S corporation with a principal place of business in Camarillo, California. Richard Shor founded STW in 1992 and served as its president and chief executive officer until 2020. Sherry Maxson was STW's chief operating officer. Besides Shor and Maxson, no other STW shareholder had an executive role at the company.

During 2015 and 2016 the shareholders of STW participated in a captive insurance program formed by Captive Planning Associates (Planning Associates) and deducted as premiums the payments it made to Clear Sky Insurance Co., Inc. (CSI). CSI was a captive insurer incorporated in Montana and owned by STW's executive officers. In late December of 2015, STW paid CSI $813,256 in premiums. CSI provided STW with two insurance policies: General Liability and Directors and Officers Liability. The General Liability policy included 15 different coverages, and the Directors and Officers policy covered a single type of professional liability exposure (thus a total of 16 different coverages). Each line of coverage was subject to an individual limit, which for all but one of the 16 lines of coverage is was $1 million. The two policies were subject to a shared liability limit of $1.5 million.

Concerned that the IRS would determine that STW's payments to CSI were not payments for insurance because of a lack of risk distribution, CSI sought to achieve risk distribution by participating in a reinsurance pool managed by OMNI Insurance Co. (OMNI), a risk pool owned by Planning Associates. As a participant in the OMNI reinsurance pool, CSI ceded to OMNI a portion of the risk it had assumed from STW and paid OMNI a reinsurance premium of $409,693, an amount equal to 50.38 percent of the total premiums CSI charged STW. Consistent with the overall scheme, CSI then insured a pro-rata share of pooled risk in exchange for a retrocession premium equal to the reinsurance premium it had just paid, less a $52,000 deposit into the OMNI Trust an required fees of $7,875 to OMNI and $7,500 to Planning Associates.

In August of 2016, CSI's board of directors consent to a proposal to lend Shor $400,000 at 1.5 percent interest. The loan was an unsecured personal loan and was to be used to purchase a building to be used as STW's headquarters and warehouse. Shor issued a promissory note to CIS for the $400,000 loan. The note had no payment terms except that the unpaid principal balance plus interest was due on August 15, 2017. Shor paid off the loan in 2020 after he had sold STW. He did not make any payments on the loan before 2020 because "it slipped his mind" and CSI did not demand payment. As president of CSI, Shor was responsible for demanding repayment from himself on CSI's behalf.

In November of 2016, STW terminated the captive insurance arrangement with CSI after only one year of coverage. According to Shor, the decision not to renew the CSI policies was based on a reassessment of STW's liability-related concerns and a determination by Shor and Maxson that some of STW's risks were manageable without a captive reinsurer. In addition, during 2016 Shor and Maxson were entertaining offers from potential buyers seeking to acquire STW. Shor believed that STW was worth more than the offers made because he knew its EBITDA was low partly due to the captive insurance expense. Thus, eliminating the captive insurance expense would increase STW's EBITDA, thereby increasing its sale price.

For 2015, STW claimed $813,256 in deductions for amounts paid to CSI, deducting them under as insurance premiums that were ordinary and necessary business expenses under Code Sec. 162(a). In addition, CSI made small insurance company election under Code Sec. 831(b) and excluded from its income the premiums it received from STW. The IRS disallowed STW's deductions, determining that the payments STW made to CSI were not for insurance and were not ordinary and necessary business expenses. CSI disclosed the captive insurance transaction by filing Form 8886, Reportable Transaction Disclosure Statement. In 2019, the IRS issued notices of deficiency to CSI and the shareholders of STW, and CSI and the shareholders filed petitions with the Tax Court.

A captive insurance company is a corporation whose stock is owned by a small number of shareholders, and which handles all or a part of the insurance needs of its shareholders or their affiliated entities. A microcaptive insurer is a captive insurance company that elects the alternative tax structure provided for under Code Sec. 831(b). To make a valid Code Sec. 831(b) election, Code Sec. 831(b)(2)(A) provides that a captive entity must be an "insurance company." Under Code Sec. 831(c) and Code Sec. 816(a), an entity is an insurance company for this purpose if more than half of its business during the tax year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

The deductibility of insurance premiums under Code Sec. 162(a) depends on whether the payments were truly payments for insurance. Thus, the resolution of the central issues presented in this case - whether CSI could make a Code Sec. 831(b) election to exclude the purported insurance premiums from its income and whether STW was entitled to deduct those payments from its income - hinged on whether the arrangements under consideration constituted insurance for federal income tax purposes.

The term "insurance" is not defined in the Code or regulations. In determining whether an arrangement constitutes insurance for federal income tax purposes, the Tax Court has applied a four-factor test under which an arrangement constitutes insurance only if (1) the arrangement involves an insurable risk of loss; (2) the arrangement shifts the risk of loss from the insured to the insurer; (3) the insurer distributes the risk of loss among its policyholders; and (4) the arrangement is insurance in the commonly accepted sense.

Analysis

The Tax Court held that the CSI Program did not constitute insurance for federal tax purposes because CSI did not distribute the risk of loss among its policy holders, and the CSI Program was not insurance in the commonly accepted sense.

The court rejected CSI's argument that it distributed its risk by participating in the OMNI Reinsurance Pool. In the court's view, the OMNI Insurance Pool did not perform the functions of a bona fide insurance company and therefore, CSI did not - and indeed, could not - insure against sufficiently numerous, diverse, and independent risk exposures through participation in it. Several factors lead the court to conclude that the OMNI Reinsurance Pool did not perform the functions of a bona fide insurance company, including the court's findings that (1) there was a circular flow of funds between the participating captives in the pool, (2) the policies were not arm's length transactions, and (3) OMNI did not charge actuarially determined premiums.

Next, the court found that the CSI Program was not insurance in the commonly accepted sense because CSI was not operated as an insurance company. The court noted that CSI's foray into the insurance business was short lived, lasting only a year. No underwriting analysis was performed when crafting the CSI policies, and STW did not submit an insurance application with CSI. The court also found that CSI had an unusual financing arrangement with Shor: CSI made a $400,000 advance to Shor without requesting a loan application. In the court's view, it was not commercially reasonable for an insurance company to lend a significant sum of money without any evaluation of the borrower's creditworthiness. The court also found that CSI's policies contained references to nonexistent documents, meaning that some of the CSI policies were likely not binding. In addition, the court found that the premiums were neither reasonable nor the result of an arm's length transaction. The court observed that the captive coverage was between 48 and 63 times as expensive as STW's commercial insurance, which the court found especially striking considering that the CSI policies provided "excess" coverage, which should be less expensive than primary coverage.

Having concluded that the amounts STW paid to CSI were not for insurance, the court held that the payments were not ordinary and necessary business expenses paid or incurred in connection with a trade or business, and thus STW was not entitled to deduct the payments under Code Sec. 162(a).

For a discussion of microcaptive insurance arrangements, see Parker Tax ¶92,730.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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