In Syzygy Insurance Co., Inc., et al. v. Commissioner, the Tax Court has held that a Delaware-domiciled captive insurance company (Syzygy), owned by John Jacob and Michael VanLenten (through disregarded entities) and electing to be treated as a small insurance company under Section 831(b), was not eligible to make the Section 831(b) election. The Court concluded that (i) payments made through a microcaptive insurance arrangement were not deductible as insurance premiums because the Syzygy was not an insurance company; (ii) the microcaptive could not make a Section 831(b) election because the arrangement did not constitute insurance; (iii) the purported premium payments are includable as income even though the arrangement is not considered insurance; and (iv) the petitioners are not liable for accuracy-related penalties because they had relied in good faith on their tax preparer. Further, the Court held that payments made by Highland Tank & Manufacturing Co. and its affiliates (HT&A) were not deductible as insurance or indemnity expenses.

The Tax Court's analysis of whether Syzygy's contracts qualify as insurance and whether Syzygy qualifies as an insurance company is similar in some respects to its analysis in Avrahami v. Commissioner (Avrahami) (Tax Alert 2017-1382) and Reserve Mechanical Corp. v. Commissioner (Reserve) (Tax Alert 2018-1321), both of which addressed the qualification of a captive insurance company as a "small" insurance company eligible under Section 831(b) to be taxed only on its net investment income. But Syzygy is notable as it addresses the tax treatment of premium payments and receipts in an onshore failed captive context. Reserve delivered conceptually comparable results in an offshore setting.

Background

Syzygy received payments, either directly or through a fronting arrangement, from HT&A. HT&A consists of family-owned businesses that are treated as S corporations for Federal income tax purposes and engaged in the business of manufacturing above and below-ground steel tanks. During the years in issue (2009–2011), HT&A had approximately 400 employees at six different locations. Additionally, it maintained extensive commercial insurance coverage. HT&A had an average rate-on-line¹ of 1.14% for its commercial policies.

During the years at issue, ownership changed slightly but remained within the Jacob and VanLenten families, which are related by marriage.

In 2008, HT&A hired Alta Holdings, LLC (Alta), a captive insurance services provider, to assist in determining whether forming a captive insurance company was viable. Alta's chief underwriter, Greg Taylor, sent an email to another Alta employee saying that he estimated $500,000 to $800,000 of premiums. Shortly thereafter, Jacob was advised by his CPA that he should consider proceeding with a captive insurance company. On December 15, 2008, Syzygy was incorporated in Delaware and capitalized with a $250,000 irrevocable letter of credit naming the State of Delaware Department of Insurance (DDI) as the beneficiary. Synergy received a certificate of authority from DDI on December 31, 2008. Taylor, who was not an actuary, set the 2009 premiums in his underwriting report. The report relied on information supplied by HT&A but was not supported by a rating model or detailed calculations or analysis on how the premiums were established.

The policies written by Syzygy were effective from December 31, 2008, through December 31, 2009, and provided an aggregate amount of insurance coverage of $7 million at a premium cost of $510,000; for seven lines of coverage, the policies were written on a claims-made basis. For policies issued covering Syzygy's second year in issue (effective December 31, 2009, through December 31, 2010), total premiums were $545,000, although this covered one additional line of business.² The premium amount for the 2011 year was $318,500.³ Jacob testified that the original intent of the captive was to obtain warranty coverage; although the coverage was never obtained during the years at issue but was procured for 2012.⁴ Experts calculated the average rate-on-line to be 6.08% to 6.2% for coverage obtained through Syzygy.

Syzygy & HT&A participated in Alta's captive insurance program, which included other unrelated operating businesses and captive insurance companies. Typically, participants would purchase insurance from a fronting carrier related to Alta. In 2009 and 2010, Syzygy participated in the U.S. Risk Associates Insurance Co. (SPC), Ltd. (U.S. Risk) pool and in 2011 the Newport Re, Inc. (Newport Re) pool. Both U.S. Risk and Newport Re would cede 100% of premiums received from all participants. Syzygy assumed premiums from the fronting carrier in two separate layers. Each policy issued contained a maximum aggregate benefit of $1 million and was a 12-month claims-made policy. 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. When a premium payment was received, Alta would allocate 49% of each captive participant's premiums to layer 1 and 51% to layer 2. Layer 1 coverage was quickly ceded to Syzygy, while layer 2 claims were ceded on a quota-share basis. The ratio was (i) the net premium HT&A paid to the insurance portfolio to (ii) the aggregate net premiums the portfolio received for the insurance period. Layer 2 reinsurance was made up of approximately 857 policies issued to between 40-50 unrelated companies.

Alta hired Taylor-Walker & Associates, Inc. (Taylor-Walker), an actuarial consulting firm, to provide input on the allocation of premiums between layers 1 and 2. In an April 2007 email to Alta's CFO, Randall Ross, an actuary for Taylor-Walker, commented that a review of industry experience suggests allocating premiums 57%-78% to layer 1 and the remaining to layer 2, depending on the type of coverage offered. Ross also commented that a lower attachment point than $250,000 or an increased limit beyond $1 million would better support the 49%/51% split being used. Ross testified that he did not know why a split of 49%/51% was being used and never asked. Jacob testified that the purpose of the allocation was to take advantage of a tax-related "safe harbor." A later email from Ross in May 2007 stated that 70% of the losses would occur in layer 1 and 30% in layer 2.

Alta engaged Taylor-Walker to prepare a feasibility study for Syzygy. The study was signed and dated on December 15, 2008, the same day as Syzygy was formed. Ross prepared the study but did not have a role in pricing the insurance coverage. He focused on whether Syzygy was feasible from a solvency perspective, which he opined that it was.

During the years in issue, HT&A did not file any claims with Syzygy but did file several claims under its commercial insurance policies. HT&A paid $99,458 in deductibles that would have been covered under the deductible reimbursement policy with Syzygy if claims had been submitted. Syzygy paid $20,106 to settle a layer 2 claim submitted to the fronting carrier by a third party. The claim was settled even though it was likely the loss was not covered by the policy terms. Syzygy did not investigate.

For the years 2010 and 2011, Syzygy's listed assets included two life insurance policies, which were owned by the 2008 Jacob Trust and the 2008 VanLenten Trust. The trusts, not Syzygy, were listed as beneficiaries on the policies. Syzygy was entitled to the greater of premiums paid or the cash value of the policy. The day on which the split-dollar life insurance agreements were entered, Matthew Michael Jacob was appointed special investment adviser to both trusts. He had sole authority to direct each trust's respective trustee regarding all life insurance policies. Syzygy was prohibited from accessing cash values, borrowing, surrendering or cancelling the policies. The agreements could only be terminated with the consent of Syzygy, the respective insured and the trust.

The Tax Court's opinion

Two questions were before the Tax Court: (1) whether the amounts Syzygy received as premiums were excludable from its gross income, and (2) whether the individual petitioners were entitled to claim Section 162 business expense deductions that had been claimed by their S corporations.

The petitioners contended that the premiums Syzygy received constituted payments for insurance and therefore: (1) were excludable under Section 831(b) from Synergy's income and (2) the individual petitioners could claim Section 162 deductions for the premiums as payments for insurance. The IRS countered that the premiums Synergy received were not insurance premiums, excludable under Section 831(b) or deductible under Section 162 as payments for insurance.

Although the income of non-life insurance companies is generally taxed under Section 831(a) in the same manner as other corporations, Section 831(b) provides an alternative tax structure for some small insurance companies. (During the years at issue, small insurance companies were considered those with net written premiums that did not exceed $1.2 million for the year.)

Companies that make a Section 831(b) election are subject to tax only on investment income (Section 831(b)) and are referred to as microcaptive insurance companies. Amounts paid for insurance are generally deductible business expenses under Section 162(a), including amounts paid for microcaptive insurance premiums.

Because insurance premiums may only be deducted if they "were truly payments for insurance," the five cases consolidated in Syzygy "hinge on whether the captive insurance arrangement meets the definition of insurance," the Tax Court explains.

Does the arrangement constitute insurance?

Case law provides four criteria for determining whether an arrangement qualifies as insurance for federal income tax purposes:

1. The arrangement involves insurable risks
2. The arrangement shifts the risk of loss to the insurer
3. The insurer distributes the risk among policy holders
4. The arrangement is insurance in the commonly accepted sense

To determine whether Syzygy distributed risk through the fronting carriers, the Court first needed to determine whether the U.S. Risk and Newport Re constituted "bona fide insurance companies" by evaluating nine factors:

1. Whether they were created for legitimate nontax reasons
2. Whether a circular flow of funds existed
3. Whether each entity "faced actual and insurable risk"
4. Whether the policies were arm's-length contracts
5. Whether each entity charged actuarially determined premiums
6. Whether comparable coverage was more expensive or available at all
7. Whether each entity was subject to regulatory control and met minimum statutory requirements
8. Whether each was adequately capitalized
9. Whether each paid claims from a separately maintained account

Looking at these factors, the Tax Court found: a circular flow of funds was evident; HT&A overpaid for its captive program policies, indicating that the policies were not arm's-length contracts; and the allocation of premiums between layer 1 and layer 2 was not actuarially determined. These findings led the Court to conclude that U.S. Risk and Newport Re did not qualify as bona fide insurance companies, and therefore did not issue insurance policies. As a result, Syzygy's reinsurance of the policies did not distribute risk.

To determine whether the transactions constituted insurance in the commonly accepted sense, the Court considered factors such as whether:

• Syzygy was organized, operated and regulated as an insurance company
• Syzygy was adequately capitalized
• Policies the company issued were valid and binding
• Premiums were reasonable and the result of arm's-length transactions
• Claims were paid

Despite being organized and regulated as an insurance company, the Court concluded, Syzygy did not operate like an insurance company. For example, the Court noted that HT&A did not submit any claims to a fronting carrier or to Syzygy during the years at issue. In addition, more than 50% of Syzygy's assets, from which it would be expected to pay claims, were illiquid investments (life insurance policies on Jacob and VanLenten). Additionally, policies issued to HT&A for the years at issue were (i) not timely, being issued after the policy years ended, and (ii) ambiguous regarding which company (HT&A or Highland Tank) was insured.

Ultimately, the Court concluded that the "arrangement among HT&A, Syzygy, and the fronting carriers lacked risk distribution and was not insurance in the commonly accepted sense." Having found that the arrangement at issue was not insurance, the Court held that Syzygy's Section 831(b) election was invalid and the premiums it received constituted taxable income.

Effect on individual petitioners

Although the Court concluded that the individual petitioners were not entitled to deduct the purported premium payments or any fees as payments for insurance, the petitioners argued that the purported premium payments were deductible business expenses as "payments for indemnification." The Court found "little precedent addressing whether amounts paid for an invalid insurance arrangement can nevertheless be deductible under [Section] 162(a)." For business expenses to qualify as ordinary and necessary in this case, they should be "appropriate and helpful to the development of the taxpayer's business," the Court explained. At "the bare minimum," this means that "the indemnified party must intend to seek indemnification if a covered event occurs," the Court stated. Because HT&A failed "to file claims that [it] thought were covered under the deductible reimbursement policies," the Court found "there was no intent to seek indemnification for covered losses," so the payments were not deducible as business expenses.

Penalties

The Court held the petitioners were not liable for Section 6662(a) accuracy-related penalties because they relied in good faith on their accountant for professional advice on the matters at issue.

Key takeaways

One of the standout issues presented in this case includes the treatment of the purported insurance payments as income to Syzygy with no offsetting insurance or indemnity deduction to the payer. This creates an unbalanced transaction when viewed from a net basis of all parties involved. As previously mentioned, the result is conceptually similar to that of the Reserve case, albeit Reserve involved an offshore captive insurance company. This asymmetrical application of the payments could have wider implications. For instance, in certain circumstances, it is accepted that captive insurance structures do NOT meet the definition of insurance due to their specific facts; this is often the case in the tax-exempt industry. What does Syzygy mean for captives intentionally not meeting the definition of insurance, specifically those operating as part of tax-exempt structures? Those captives generally treat premiums as capital contributions⁵ — a position the petitioners attempted to argue applied to them in the event the transactions were not deemed to be insurance. The court, however, found that recharacterizing the transaction as capital was not appropriate.

HT&A also argued that, if the payments made did not constitute insurance, they should be deductible as indemnification payments. The Court found there was no intent to treat the payments as indemnification payments because HT&A had failed to file claims that appeared to be covered under the deductible reimbursement policies. Similar issues regarding a lack of submitted claims were also at the core of the Avrahami and Reserve cases. While concluding the payments were not deductible, as they could not be considered ordinary and necessary business expenses due to the failures of the policyholders, the Court did not offer a technical analysis of how the disbursements should actually be treated for taxation purposes.

Similar to Avrahami and Reserve, the IRS raised the issue of achieving risk distribution through use of a risk pool. The pool was designed to facilitate third-party risk and help Syzygy meet the IRS safe harbor for risk distribution.⁶ This was acknowledged by Jacob as part of his testimony. In successfully proving that U.S. Risk and Newport Re were not bona fide insurance companies, the IRS was able to assert that risk distribution was not present. Without adequate risk distribution, Syzygy cannot be considered a bona fide insurance company.

Additionally, the IRS was able to prove that the arrangement with Syzygy was not insurance in the commonly accepted sense. Although Syzygy operated in some respects like an insurance company, negative factors outweighed the positive. Consistent with Avrahami and Reserve, unreasonable premiums were a focal point in Syzygy. Specifically, a one-size-fits-all approach was employed when allocating premiums between layers 1 and 2, in spite of actuarial advice indicating a higher percentage should be allocated to layer 1. This was a key factor in concluding the premiums charged by the insurance pools were not actuarially determined. The Court also cited the large gap in the average on-line rate between coverage HT&A obtained from the commercial markets and that of the more expensive coverage obtained from Syzygy. Policy issuance timing and various contract terms also presented challenges that were tough for the petitioners to overcome.

Based on this string of cases, it appears the IRS has developed a blueprint with which it plans to scrutinize microcaptives, specifically those using a risk pool to help achieve risk distribution. Step one is to prove that the involved risk pool is not a bona fide insurance company. Often, this will be enough to conclude the microcaptive also has failed to meet the risk distribution test. Step two is to prove the microcaptive does not meet the definition of insurance in the commonly accepted sense. This appears to be the methodology used in Syzygy, as well as in Avrahami and Reserve. Microcaptives utilizing risk pools should now be revisiting their insurance arrangements to ensure they comply with precedents established in these three cases. Failing any of the four required criteria — (i) risk distribution, (ii) risk shifting, (iii) insurance in the commonly accepted sense, and (iv) presence of insurance risk — is enough to determine that an insurance arrangement does not qualify as insurance. In Avrahami, Reserve and now Syzygy, all decided in the Commissioner's favor, the Court has held that the captive in question does not meet the requirements of risk distribution and insurance in the commonly accepted sense.

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ENDNOTES

¹ Rate-on-line equals policy premium divided by the occurrence limit.

² Administrative actions policy was added in 2010.

³ In 2011 the intellectual property enforcement policy was directly written by Syzygy.

⁴ A complete list of the coverages offered by Syzygy during the years in issue includes: administrative actions, bankruptcy preference, cyber liability, deductible reimbursement, legal expense, intellectual property defense, intellectual property enforcement and property difference in conditions.

⁵ Revenue Ruling 2005-40, 2005-2 C.B. at 5

⁶ Revenue Ruling 2002-89, 2002-2 C.B. 984.