Recently, in Caylor Land & Dev. v. Comm., the Tax Court once again held that a micro-captive insurance arrangement failed to qualify as an insurance company for federal income tax purposes. As a result, the taxpayers were unable to deduct the insurance premiums that they paid to the captive and were subject to accuracy-related penalties on the taxes owed.

What is a Micro-Captive?

A captive insurance company is formed as a subsidiary to a private parent company. The subsidiary acts as an insurer to its parent company, and the parent company pays insurance premiums to the captive. Often, a captive is formed to supplement a commercial insurance policy that the parent company has already purchased.

A micro-captive insurance company is a captive that qualifies under I.R.C. Sec. 831(b). To qualify, the captive must meet certain diversification requirements and it may not receive more than $2.2 million in annual premiums. Once qualified, the micro-captive enjoys a variety of tax benefits. For example, it does not have to pay income tax on the premiums, only on investment income. Moreover, the parent company can deduct insurance premiums paid to the captive and any dividends are preferential qualified dividends.

Increased IRS Scrutiny

Beginning in 2014, the IRS began listing micro-captive transactions as potentially abusive tax schemes in its annual list of tax scams. In Notice 2016-66, the IRS asserted its position that micro-captive transactions have the potential for tax avoidance or evasion. In the summer of 2020, the IRS formed 12 new examination teams to drill down on audits of micro-captives. Following the Tax Court’s decision in Caylor, the IRS issued a press release urging taxpayers to consider exiting micro-captive transactions and not to deduct the insurance premiums.

In recent case law, the Tax Court has used the following four criteria to determine whether a premium payment constitutes a payment for insurance:

  1. The premium payment covers insurable risks;
  2. The premium payment shifts the risk of loss to the insurer;
  3. The insurer can distribute the risk assumed among its policyholders; and
  4. The insurance transactions meet commonly accepted notions of insurance.

In short, a micro-captive must operate in a manner consistent with that of a commercial insurance carrier.

Implications of the Caylor Holding

The Caylor case provides clarification on the fourth criteria listed above. Specifically, the Tax Court lays out some additional factors to be used in determining whether an insurance arrangement constitutes insurance in the “commonly accepted” sense:

  1. Was the captive properly formed and operated as an insurance company?
  2. Was the captive adequately capitalized?
  3. Were the policies valid and binding?
  4. Were the premiums reasonable and the result of arm’s-length transactions?
  5. Were claims paid?

In applying the above criteria to the facts in Caylor, the Tax Court determined that the micro-captive did not qualify as insurance; thus, the insurance premiums were not deductible. Moreover, unlike in previous cases, the Tax Court found that the accuracy-related penalties assessed by the IRS on the taxpayer were proper.

The holding in Caylor provides a clearer list of criteria for micro-captive insurance companies and their insureds to consider in determining whether they qualify as a “legitimate” insurance company under Sec. 831(b). However, given heightened scrutiny by the IRS, it is important to consult a tax advisor if you are considering a captive or already have one.

For questions on this article, please contact Meghan Andersson at [email protected]