It’s Not All About 2017

A casual review of the recent tax literature may leave a “lay person” with the impression that, prior to the passage of the 2017 tax legislation, tax advisers had nothing else to write about.[i] Opportunity zones, GILTI, qualified business income, etc. – the spawn of 2017 dominates the tax hit parade.[ii]

That being said, the bread and butter issues of the tax professional have not changed: the adviser continues to plan for the recognition of income and deductions, gains and losses, with the ultimate goal being to reduce (or at least defer) their clients’ tax liabilities, to preserve their assets, and to thereby afford these clients the opportunity to channel their economic resources into more productive endeavors.

One example of such an issue, which was itself the subject of fairly recent legislation, and one form of which has been on the IRS’s own version of the hit parade,[iii] is captive insurance. Before getting into the details of a recent decision of the Tax Court – which illustrates what a taxpayer should not do – a brief description of captive insurance may be in order.


Assume that Acme Co.[iv] pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining Acme’s taxable income. As in the case of most insurance, the premiums are “lost” every year as the coverage expires.[v]

In order to reduce the cost of insurance, a business will sometimes “self-insure” by setting aside funds to cover its exposure to a particular loss. Self-insurance, however, is not deductible.

The Code, on the other hand, affords businesses the opportunity to establish their own “small captive” insurance company.[vi] Indeed, the Code encourages them to do so by allowing the captive to receive up to $2.2 million of annual premium payments from the insured business free of income tax. What’s more, the insured business is allowed to deduct the premiums paid to the captive, provided they are “reasonable” for the risk of loss being insured. The insured business cannot simply choose to pay, and claim a deduction for, the $2.2 million maximum amount of premium that may be excluded from the captive’s income.

From a tax perspective, the key is that the captive actually operate as an insurance company. It must insure bona fide business risks. An insured risk must not be one that is certain of occurring; there must be an element of “fortuity” in order for it to be insurable.

In order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the insured business to the captive insurer. Risk distribution is the exposure of the captive insurer to third-party risk (as in the case of traditional insurance).[vii]

To achieve the status of real insurance (from a tax perspective), the captive pools its premiums with other captives (not necessarily from the same type of business).[viii] These pools are managed by a captive management company for a fee. The management company will conduct annual actuarial reviews to set the premium, manage claims, take care of regulatory compliance, etc. This pool will pay on claims as they arise.

In theory, the captive arrangement should lead to a reduction of the commercial premiums being paid by the business.[ix] Unfortunately for one taxpayer, they did not get the proverbial memo that explained the foregoing.

The Captive

Corp was a family business owned by Shareholders.[x] It had a number of subsidiaries, and maintained a dozen or so policies for which it paid substantial premiums.

Shareholders explored forming a captive insurance company. They met with Manager, a company that ran a captive insurance program and provided management services for captive insurance companies. At one point, Manager informed Shareholders that a captive would not be feasible unless Corp were paying at least $600,000 of premiums annually. After Manager’s chief underwriter indicated that it had “identified” up to $800,000 of premiums, Shareholders decided to form a captive.

Captive was incorporated in Delaware, and received a certificate of authority from the Department of Insurance. Captive was initially capitalized with a $250,000 irrevocable letter of credit naming the Department as the beneficiary. Captive was owned by two LLCs, each of which was wholly-owned by a different trust; the LLCs were managed by Shareholders, who were also Captive’s only officers; thus, Captive was basically a sister company as to Corp.

Captive and Corp participated in Manager’s captive insurance program. Participants in the program consisted of companies (like Corp) that purchased captive insurance and their related captive insurance companies. In general, participants did not purchase policies directly from their captive insurance companies but from “fronting carriers” related to Manager.[xi] The policies issued by the fronting carriers, which included “deductible reimbursement” policies,[xii] had a maximum benefit of $1 million.

Premiums and Coverage

Corp paid premiums directly to the fronting carriers, but the fronting carriers ceded 100-percent of the insurance risk. The responsibility for paying a covered claim under a policy was described as a two-layered arrangement: the first $250,000 of a single loss was allocated to “Layer 1,” and any loss between $250,000 and $1 million was allocated to “Layer 2.” Manager uniformly allocated 49-percent of each captive participant’s premiums to Layer 1 and 51-percent to Layer 2, notwithstanding that an actuarial consulting firm had reported that 70-percent of the loss experience would occur in Layer 1, given the proposed limits, and 30-percent in Layer 2.[xiii]

Captive reinsured[xiv] the first $250,000 of any Corp claim.[xv] Thus, shortly after the fronting carriers received Corp’s premiums, they ceded 49-percent of the net premiums to Captive.

For Corp’s claims between $250,000 and $1 million (Layer 2 claims), Captive agreed to reinsure its “quota-share” percentage of losses.[xvi] Additionally, Captive provided Layer 2 reinsurance for policies issued to unrelated companies in the fronting carriers’ pools. After the policy periods ended, the fronting carriers ceded the remaining 51-percent of net premiums to Captive less the amount of any claims paid for Layer 2 losses.

In other words, during the years in issue, Corp paid gross premiums to the fronting carriers, and the fronting carriers ceded net premiums to Captive.

Corp purchased a number of other policies during the years in issue. For example, it purchased deductible reimbursement policies that had among the highest premiums of any Corp policy. It also purchased various excess-coverage policies, under which the insurer agreed to indemnify against a loss only if it exceeded the amount covered by another policy.

Corp’s premiums were set by a non-actuary whose underwriting report did not detail any rating model, calculations, or any other analysis describing how premiums were determined. The report provided only general information about projected losses, previous claims, and information about Corp’s other insurance. Nothing in the report suggested that comparable premium information was used to price the premiums.[xvii]

Manager’s underwriting report projected that Captive would pay annual Layer 1 claims under certain policies, and projected that Captive would have an overall
“loss and loss adjustment expense” (LLAE) ratio[xviii] of 56-percent overall and 29-percent in Layer 2 for the years in issue. However, Captive’s actual LLAE ratio was only 1.5-percent: 0-percent for Layer 1 and 3-percent for Layer 2.

Corp did not file any claims under the captive program policies during the years in issue, but did file multiple claims under its commercial insurance policies, and it also paid deductibles, though it did not keep specific records of the deductibles.

Shareholders testified that they did not file captive program claims “because of time management issues.” They acknowledged that Corp did not have a claims management system in place for its captive program, though it had “different processes” in place for its commercial policies.

Captive’s Assets

Captive met Delaware’s minimum capitalization requirements during the years in issue. Its assets were listed on financial statements for each year in issue, and consisted of the initial $250,000 letter of credit, varying amounts of cash and cash equivalents, varying amounts of unceded premiums,[xix] and two life insurance policies on the lives of Shareholders.

However, Captive did not own the life insurance policies listed on the financial statements, nor was it a beneficiary of the policies. Rather, they were owned by the trusts (which were also the beneficiaries of the policies) under the terms of split-dollar life insurance agreements that required Captive to pay the premiums for the policies. Captive’s only right under the agreements was to be repaid the greater of the premiums paid or the policy’s cash value.[xx] Captive was prohibited from accessing the cash values of the policies, borrowing against the policies, surrendering or canceling the policies, or taking any other action with the respect to the policies.[xxi]

Returns and Notices of Deficiency

Captive decided to exit Manager’s captive insurance program after Captive’s premiums dropped significantly. Shareholders explained to Manager that Captive was changing managers because, among other things, they were displeased with the decrease in premiums.[xxii]

For the years preceding its exit from the captive program, Captive filed corporate tax returns on which it made a Section 831(b)[xxiii] election, and reported no taxable income.

Corp also filed returns for those years, in which the premium payments to the fronting carriers were apportioned among Corp’s subsidiaries, and deducted accordingly.[xxiv]

The IRS examined these returns and timely issued notices of deficiency. The IRS determined that Captive did not engage in insurance transactions and was not an insurance company. It found that Captive’s Section 831(b) election was invalid, and that the premiums were taxable income to Captive, and not deductible by Corp.

Corp and Captive (the “Taxpayers”) timely filed petitions with the U.S. Tax Court.

Tax Court

The issues before the Court were: (1) whether Captive was an insurance company, (2) whether the amounts received by Captive as premiums were excluded from its gross income under Section 831(b) of the Code, and (3) whether the amounts paid by Corp as premiums for insurance were deductible as business expenses.[xxv]

The Court began its discussion by briefly explaining the taxation and deductibility of micro-captive insurance payments.


The Court explained that insurance companies are generally taxed on their income in the same manner as other corporations, but that Section 831(b) provides an alternative taxing structure for certain “small” insurance companies. During the years in issue, the Court continued, an insurance company with written premiums that did not exceed $1.2 million for the year could elect to be taxed under section 831(b).[xxvi] A qualifying insurance company that made a valid election was taxable only on its investment income – its premiums were not taxable (a “micro-captive” insurance company). [xxvii]

What’s more, the captive rules do not prohibit deductions for the insured business that pays or incurs micro-captive insurance premiums, provided they are ordinary and necessary expenses paid or incurred in connection with a trade or business.[xxviii]

Real Insurance

According to the Court, in order for a company to make a valid Section 831(b) election, “it must transact in insurance.” Likewise, the deductibility of insurance premiums depended on whether they were truly payments for insurance.

The Court noted that, in order to determine whether a transaction constitutes insurance for income tax purposes, it had to consider certain principal criteria that had been developed by the case law, including whether the insurer distributed the risk among its policy holders, and whether the arrangement was “insurance in the commonly accepted sense”.[xxix]

Risk Distribution

Taxpayers argued that Captive distributed risk by participating in the fronting carriers’ captive insurance pools and reinsuring unrelated risks. In response, the Court stated that it had to decide whether those carriers were bona fide insurance companies in the first place.

The Court identified several following factors as relevant to determining whether an entity is an insurance company, including the following:

(1) there was a circular flow of funds;

(2) the policies were arm’s-length contracts;

(3) the entity charged actuarially determined premiums; and

(4) it was adequately capitalized.[xxx]

Circular Flow of Funds

Under the arrangements with the fronting carriers, Corp paid premiums to the carriers. The fronting carriers then reinsured all of the risk, making sure that

Captive received reinsurance premiums equal to the net premiums paid by Corp, less Captive’s liability for any Layer 2 claims. For the years in issue, this resulted in Corp’s paying the fronting carriers $1.37 million of gross premiums and the fronting carriers’ ceding $1.312 million of reinsurance premiums to Captive. “While not quite a complete loop,” the Court observed, “this arrangement looks suspiciously like a circular flow of funds.”

Arm’s-Length Contracts

The Court found that Corp paid upwards of five times more for its captive program policies than for its non-captive program policies.[xxxi]

In addition, various terms in the captive program policies indicated that Corp should have paid less for the captive program policies than the non-captive policies. For example, at least half of Corp’s captive program policies were for “excess coverage,” and others contained restrictive provisions, which should have resulted in a lower cost.

According to the Court, there was nothing to justify why Corp paid higher premiums for policies with more restrictive provisions than their commercial policies. The higher average rate-on-line coupled with the policies’ restrictive provisions led the Court to conclude that the policies were not arm’s-length contracts.

In addition, the Court pointed to Shareholders’ statement to Manager that one of the reasons Corp was leaving its captive program was the decrease in premiums, which reinforced the Court’s view that the policies were not arm’s-length contracts. It is fair to assume, the Court stated, that a purchaser of insurance would want the most coverage for the lowest premiums. In an arm’s-length negotiation, an insurance purchaser would want to negotiate lower premiums instead of higher premiums.

The main advantage of paying higher premiums, the Court found, was to increase deductions for Corp and the Shareholders, while shifting income to Captive, in whose hands the premiums were thought not to be taxable. With this, the Court concluded that the contracts were not arm’s-length contracts.

Actuarially Determined Premiums

The Court stated that premiums charged by a captive were actuarially determined when the company relied on an outside consultant’s “reliable and professionally produced and competent actuarial studies” to set premiums. The Court added that it would look favorably upon an outside actuary’s determination that premiums were reasonable. Premiums are not actuarially determined, it continued, when there is no evidence to support the calculation of premiums and when the purpose of premium pricing is to fit squarely within the limits of Section 831(b).

In the instant cases, the Court there were two issues with respect to the premiums: (1) the reasonableness of captive program premiums, and (2) the 49-percent to 51-percent allocation of premiums between Layer 1 and Layer 2 claims.

There was insufficient evidence in the record relating to how the premiums were set, and it was never determined whether they were reasonable. Accordingly, the policies issued by the fronting carriers did not have actuarially determined premiums.

There were also problems with the allocation of premiums between Layer 1 and Layer 2. Manager disregarded an actuarial firm’s conclusion that the majority of the premiums should be allocated to Layer 1. Moreover, Shareholders testified that they understood the purpose of the allocation was to take advantage of a tax-related safe harbor.

Accordingly, the Court found that the allocation of premiums was not actuarially determined.

Based on the foregoing factors, the Court concluded that the fronting carriers were not bona fide insurance companies for tax purposes, which meant that they did not issue insurance policies. In turn, this meant that Captive’s reinsurance of those policies did not distribute risk; therefore, Captive could not make the micro-captive election.

“Insurance” in the Commonly Accepted Sense

Although the absence of risk distribution by itself was enough to conclude that the transactions among Captive, Corp, and the fronting carriers were not insurance transactions, the Court nevertheless looked at whether these transactions might have constituted “insurance” in the commonly accepted sense. The Court indicated that the following factors should be considered in making this determination:

(1) the company was organized, operated, and regulated as an insurance company;

(2) it was adequately capitalized;

(3) the policies were valid and binding;

(4) premiums were reasonable and the result of arm’s-length transactions; and

(5) claims were paid.

Organization, Operation, and Regulation

Captive was organized and regulated as a Delaware insurance company. The question, however, was whether Captive was operated as an insurance company. In making this determination, the Court stated that it “must look beyond the formalities and consider the realities of the purported insurance transactions”.

The Court observed that during the years in issue, Corp did not submit a single claim to a fronting carrier or to Captive. Shareholders testified that there were various claims that were eligible for coverage under the deductible reimbursement policy that were not submitted. Because this policy was one of Corp’s most expensive insurance policies, Corp’s failure to submit claims after paying deductibles indicated that the arrangement did not constitute insurance in the commonly accepted sense.

Additionally, Shareholders testified that Corp had no claims process for the captive program claims, but did have “different processes” for their other claims.

Captive’s investment choices were also troubling. The life insurance policies insuring Shareholders totaled more than 50-percent of Captive’s assets and were its largest investments. Under the terms of the split-dollar agreements, however, Captive could neither access the cash value of the policies, borrow against the policies, surrender or cancel the policies, nor unilaterally terminate the agreements.

The Court did not think that an insurance company, in the commonly accepted sense, would invest more than 50-percent of its assets in an investment that it could not access to pay claims.

Valid and Binding Policies

The Court explained that policies were valid and binding when “[e]ach insurance policy identified the insured, contained an effective period for the policy, specified what was covered by the policy, stated the premium amount, and was signed by an authorized representative of the company.”

During the years in issue, neither Captive nor the fronting carriers timely issued a policy to Corp. The policies for some years were not even issued until after the policy years ended.[xxxii] What’s more, the policies issued to Corp had ambiguities and conflicts as to which entities were insured and what the policies covered.

Arrangement Not Insurance

Although Captive was organized and regulated as an insurance company and met Delaware’s minimum capitalization requirements, these insurance-like traits did not overcome the arrangement’s other failings. Captive was not operated like an insurance company. The fronting carriers charged unreasonable premiums, and issued policies with conflicting and ambiguous terms.

The arrangement among Corp, Captive, and the fronting carriers lacked risk distribution and was not insurance in the commonly accepted sense. Thus, the arrangement was not insurance for income tax purposes.

Because the arrangement was not insurance, Captive’s Section 831(b) election was invalid, and Captive had to recognize as income the premiums it received.

What’s more, Corp could not deduct the purported premium payments because the payments were not for insurance.

“This Will Never End ‘Cause I Want More”

We began this post by taking some liberty with the refrain from the theme sing to the “Vikings” television series. We end it with the first line from that song.

As was indicated earlier, a micro-captive can play an important role in a business’s management of its insurable risks. Moreover, Congress has recognized this role, and has sought to encourage businesses to utilize micro-captives.

In contrast to this legislative intent, we have advisers and taxpayers for whom the insurance benefits offered by the micro-captive do not appear to take precedence over the income tax benefits – as in the case of the Taxpayers described above – and the estate planning opportunities that captives may present.

These folks have it all backwards. The income tax benefits are not the goal to be attained – they are the incentives that Congress provided businesses that have a bona fide non-tax reason for creating a captive. Some taxpayers become so blind to this, they forget that the arrangement must actually constitute insurance. The same is true as to estate planning benefits that many identify as a reason for using a captive; these weren’t even on the table when the micro-captive was conceived (which explains the 2015 and 2018 legislatively-imposed diversification requirements that sought to limit the use of captives for that purpose).

With that, we return to our own refrain: the principal purpose for a transaction has to be a business purpose; assuming there is a valid business purpose, one is free to structure the transaction in a tax efficient manner. Without the business purpose, you can’t have more.

* Variation on Fever Ray’s “If I Had A Heart,” the theme from the History Channel’s “Vikings.”

[i] Undoubtedly, you’ve heard the comments about the legislation’s being a boon for tax advisers – a full-employment act, as it were. Although I cannot deny that there is much to be admired in the legislation (and even more so in the IRS’s efforts to implement it), it is undeniable that the haste with which it was drafted and enacted resulted in the diversion – should I say “misallocation?” – of resources by both the government and taxpayers.

[ii] As they should, considering that they became effective almost immediately after enactment, and considering further that some of their benefits will expire in just a few years – the victims of budget constraints.

[iii] The so-called “transactions of interest” and the “dirty dozen” list of suspect transactions.

[iv] Anyone remember Wile E. Coyote?

[v] Hopefully unused.

[vi] The captive, which is created as a C corporation, must operate like an insurance company; for example, it will reinsure some of its risk with other insurance companies, it will set aside appropriate reserves for the risks it does not cede, and it will invest the balance of the premiums received. Any investment income and gains recognized by the captive will be taxable to the captive.

[vii] The actuarial “law of large numbers” – meaning that the premiums received by the captive are pooled with the premiums received by other insurers, and this pool of premiums is used to satisfy the losses suffered by one of their insureds. The IRS has issued several rulings over the years regarding these requirements, including some so-called “safe harbors” (see below).

[viii] This is how risk distribution is effectuated.

[ix] For example, by permitting a larger deductible thereon.

[x] Corp was an S corporation.

[xi] The Court explained that a “fronting company” issues fronting policies, which are “a risk management technique in which an insurer underwrites a policy to cover a specific risk but then cedes the risk to a reinsurer.”

[xii] To cover large deductibles payable by the insured under commercial policies.

[xiii] Manager did not change the 51-49-percent premium allocation in response to the actuarial firm’s findings. Shareholders testified that the purpose of the allocation was to take advantage of a tax-related “safe harbor”.

According to the Court, “the safe harbor is almost certainly Rev. Rul. 2002-89, 2002-2 C.B. 984.”

This ruling addressed a captive insurance arrangement between a parent corporation and its wholly-owned captive subsidiary.

In Situation 1, the premiums that the subsidiary earned from its arrangement with the parent constituted 90% of its total premiums earned during the taxable year on both a gross and a net basis. The liability coverage the subsidiary provided to the parent accounted for 90% of the total risks borne by the subsidiary. The IRS found that the arrangement lacked the requisite risk shifting and risk distribution to constitute insurance for federal income tax purposes.

In Situation 2, the premiums that the subsidiary earned from its arrangement with its parent constituted less than 50% of the total premiums it earned during the taxable year on both a gross and a net basis. The liability coverage it provided to its parent accounted for less than 50% of the total risks borne by the subsidiary. The premiums and risks of the parent were thus pooled with those of unrelated insureds. The requisite risk shifting and risk distribution required to constitute insurance for federal income tax purposes were present. The IRS found that the arrangement was insurance for tax purposes.

[xiv] Reinsurance is an agreement between an initial insurer (the ceding company) and a second insurer (the reinsurer), under which the ceding company passes to the reinsurer some or all of the risks that the ceding company assumes through the direct underwriting of insurance policies. Generally, the ceding company and the reinsurer share profits from the reinsured policies, and the reinsurer agrees to reimburse the ceding company for some of the claims that the ceding company pays on those policies. Think of it as insurance for the risks “assumed” by an insurer.

[xv] A Layer 1 claim.

[xvi] The ratio of: (1) the net premium Corp paid to that portfolio to (2) the aggregate net premiums the portfolio received for the insurance period.

[xvii] Manager conducted an actuarial feasibility study for Captive for the purpose of determining Captive’s ability to remain solvent, not to price the premiums or to determine whether they were reasonable.

[xviii] The LLAE ratio is the cost of losses and loss adjustment expenses divided by the total premiums.

[xix] Premiums for risks that were not ceded to a reinsurer.

[xx] An “equity” type split-dollar arrangement. Reg. Sec. 1.61-22.

[xxi] The split-dollar agreements could be terminated only through the mutual consent of Captive, the insured, and the trust. Within 60 days of termination, the owner had the option to obtain a release of Captive’s interest in the policy. To obtain the release, the policy owner was required to pay Captive the greater of: (1) the premiums that it paid with respect to the policy or (2) the policy’s cash value. If the policy owner did not obtain a release, ownership of the policy reverted to Captive.

[xxii] Yes, you heard right. In fact, at trial, Shareholder testified the he was disappointed in the premium decrease because there were fixed costs associated with a captive manager and it made the most sense to have as much coverage as possible with the captive manager.


[xxiv] Because Corp was an S corporation, the deductions flowed through to the Shareholders.

[xxv] “Ordinary and necessary” under Sec. 162 of the Code.

[xxvi] The 2015 amendments to sec. 831(b) increased the premium ceiling to $2.2 million (adjusted for inflation) and added new diversification requirements that an insurance company must meet to be eligible to make a Sec. 831(b) election. The Protecting Americans from Tax Hikes Act of 2015, P.L. 114-113. The 2018 amendments clarified the diversification requirements. Consolidated Appropriations Act of 2018, P.L. 115-141.

[xxvii] Sec. 831(b)(1).

[xxviii] Reg. Sec. 1.162-1(a).

[xxix] The other criteria: was there an insurable risk, and was risk of loss shifted to the insurer?

[xxx] Other factors included: the entity was created for legitimate nontax reasons; it was subject to regulatory control and met minimum statutory requirements; it paid claims from a separately maintained account; it faced actual and insurable risk comparable coverage was more expensive or not available.

[xxxi] The captive policies had a higher “rate-on-line.” A higher rate-on-line means that insurance coverage is more expensive per dollar of coverage.

[xxxii] An insurance binder is a “written instrument, used when a policy cannot be immediately issued, to evidence that the insurance coverage attaches at a specified time and continues . . . until the policy is issued or the risk is declined and notice thereof is given.”