One of the first things that a first-year law student learns in law school is that bad facts make bad law. Well, the most recent example of the truth of that adage was delivered by the United States Tax Court in an opinion filed on March 10, 2021, in Caylor Land & Development, Inc., et al v. Commissioner T.C Memo. 2021-30, another victory for the IRS in a captive insurance case. However, the facts in this case were so bad and so untethered from the typical captive insurance arrangement that it is difficult to see how this case will have any negative impact on the captive insurance industry.
Findings of Fact
The lead petitioner in the case, Caylor Land & Development, Inc. (Caylor Land), was an Arizona corporation engaged in commercial and residential real estate development. Its owner, Rob, was the son of the founder of another general building contractor, Robert Caylor Construction Company (Caylor Construction). Over time, Rob bought Caylor Construction from his father and also formed a number of different entities representing different construction projects. The Tax Court found that this was not uncommon in the real estate business, where every project carries a separate risk. The Tax Court also found that Rob ran the “empire” through Caylor Construction.
It is important to note the relationship between Caylor Construction and Caylor Land and between Caylor Land and the other members of Rob’s “empire”. It appears that most of the revenue generated by Rob’s business ventures was concentrated in Caylor Construction. Those funds were then distributed to the other entities through “consulting fees” paid to Caylor Land. For example, the Tax Court found that, in 2009, Caylor Land had $1.4 million in gross revenue, of which $1.2 million were consulting fees paid by Caylor Construction. Caylor Land then paid much of what it received from Caylor Construction to the other entities, also as “consulting fees”. The “consulting fees” paid by Caylor Land to the other entities in Rob’s “empire” constituted a significant part of the revenue of those entities.
Why does this matter? First, the Tax Court questioned whether the payments called “consulting fees” were really consulting fees. There were no written agreements between any of the parties and no records of what consulting actually took place. In addition, the entities used almost all of the “consulting fees” to pay insurance premiums.
In 2007, Rob engaged Tribeca to form and manage a captive insurance company called Consolidated, Inc. (Consolidated). Consolidated was incorporated under the laws of Anguilla in December, 2007. Here is where the facts get a bit sketchy. The Tax Court found that Caylor Construction paid insurance premiums of $1.2 million in December, 2007, which it deducted on its 2007 tax return. It thought this unusual, because Caylor Construction had not yet provided any underwriting information to Tribeca and the actual insurance policies were not issued until sometime in 2008. The Tax Court found this strange, because the policies were “claims-made” policies but were not issued until after the policy coverage period had ended. In addition, it found that Caylor Construction had paid premiums of $1.2 million for, at most, ten days of coverage in 2007 and possibly for “none at all”.
What the Tax Court did not say in its opinion, but must be true, is that the policy coverage period was the calendar year. Otherwise, if the policy coverage period were December, 2007, to December, 2008, a policy delivered in early 2008, would not have been issued after the expiration of the policy coverage period. In addition, premiums paid in December, 2007, would not have been for ten days of coverage.
The IRS audited all of the entities for the 2009 and 2010 tax years. It denied Caylor Construction’s deduction for the “consulting fees” paid to Caylor Land. In addition, it denied a deduction for the payments made by the other entities to Consolidated. The cases of all taxpayers were consolidated were trial.
Since the years under audit were 2009 and 2010, whatever happened in 2007 should have been immaterial to the result in this case. However, the Tax Court clearly was affected by what happened in 2007. In addition, it found that this pattern repeated itself in subsequent years – premiums were paid before the policies were even priced, and the policies were not issued until after the expiration of the policy coverage period. In addition, the Tax Court found that, while premiums were paid by all of the entities, actual policies were issued to only a small number of the Caylor entities. If the other entities were even covered under the policies, they were covered as additional insureds.
The Tax Court’s Opinion
In the opinion, the Tax Court said that there are three issues in the case:
- whether the “consulting fees” paid by Caylor Construction to Caylor Land were deductible as ordinary and necessary business expenses;
- whether the payments to Consolidated were “insurance expenses”; and
- whether the IRS could impose accuracy-related penalties.
1. Consulting Fees
The Tax Court resolved this issue fairly easily. It found that there was no consulting agreement between Caylor Construction and Caylor Land, no invoices for consulting services and no evidence that consulting services were actually provided. As a result, the money transferred from Caylor Construction to Caylor Land was more like a distribution of profits and not an ordinary and necessary business expense.
The Tax Court’s analysis of whether the payments made by the various Caylor entities to Consolidated were insurance premiums should be familiar to anyone who has read the opinions in the Avrahami, Reserve Mechanical and Syzygy cases. In fact, the judge in the Caylor case is the same judge who decided Avrahami.
The Tax Court repeated that insurance premiums are generally tax deductible as ordinary and necessary business expenses. However, money set aside as “a loss reserve or a form of self-insurance are not”. So, the issue in the case was whether the amounts paid to Consolidated were insurance premiums or a loss reserve.
The Tax Court also repeated the familiar refrain that the Internal Revenue Code does not define the term “insurance”. That has been left to case law, and the Supreme Court has said that insurance has four characteristics:
- insurance risk; and
- whether an arrangement looks like commonly accepted notions of insurance.
Finally, the Tax Court said that it would focus on two of those factors – risk-distribution and commonly accepted notions of insurance – as it had done in Avrahami, Reserve Mechanical and Syzygy.
a. Risk Distribution
Risk distribution depends upon the concept of the “law of large numbers”. By accepting premiums and risk from a large number of insureds, an insurance company protects itself against the adverse experience of a small number of insureds. In Avrahami, Reserve Mechanical and Syzygy, the captives used a reinsurance pool to establish risk distribution. In each of those cases, the Tax Court had found that the pool was not insurance, so it could not be used to establish risk distribution. The implication is that, if the pool had been properly managed and, as a result, had been found to be insurance, it could have been used to establish risk distribution.
However, in the Caylor case, this issue was moot. Although Tribeca maintained an “insurance pool” and told its clients that they had to participate in the “insurance pool” in order to have adequate risk distribution, Consolidated chose to not participate in the pool. Of all the bad facts in this case, this is perhaps the worst and most curious. It is also the reason why this case may have little impact on the captive insurance industry as a whole. Why would a captive insurance company make the conscious decision to forego the best tool available to distribute risk among other captives and other insureds?
Instead of participating in a reinsurance arrangement to distribute risk, Consolidated chose to rely on the fact that it was providing insurance to twelve brother and sister entities. This argument was based on the holding of Revenue Ruling 2002-90, in which the IRS said that there would be sufficient risk distribution, if a captive provided insurance to at least twelve related entities and no entity represented less than 5% or more than 15% of the total risk insured by the captive.
Unfortunately for the petitioners, the Tax Court did not buy this argument. First, the Tax Court said that the number of related entities is not determinative. Instead, the issue is the number of risk exposures assumed by the captive that matters. This position is very troubling for a couple of reasons. First, the Tax Court relied on cases that involved captives that were not microcaptives to support its position. These cases involved multi-national corporations and thousands of insureds. No microcaptive could possibly satisfy that test. Second, and perhaps, most importantly, the Tax Court completely ignored Revenue Ruling 2002-90, which is one of the few pieces of guidance that the IRS has issued in the area of captive insurance and has never been withdrawn. If a court can overrule the stated position of the IRS, no taxpayer can be safe from persecution.
What’s even more disturbing is that the Tax Court did not even have to ignore the holding of Revenue Ruling 2002-90 in order to achieve its desired, and probably pre-determined, result. The Tax Court found that Caylor Construction represented more than 30% of the risk assumed by Consolidated. So, Consolidated could not satisfy the requirements of Revenue Ruling 2002-90, even if the Tax Court were to have given effect to that guidance.
b. Commonly Accepted Notions of Insurance
The Tax Court next discussed whether Consolidated was operated in accordance with the commonly accepted notions of insurance. The Tax Court acknowledged that it did not have to reach this issue, since the failure of risk distribution would be enough to uphold the tax deficiency. However, this did not stop the Tax Court from discussing this issue.
There are five factors that a court takes into consideration when trying to determine whether an arrangement looks like insurance:
- whether the company was organized, operated and regulated as an insurance company;
- whether the company is adequately capitalized;
- whether the policies were valid and binding;
- whether the premiums were reasonable and the result of arm’s-length bargaining; and
- whether claims were paid.
i. Organized, Operated and Regulated
The Tax Court acknowledged that Consolidated was organized as an insurance company under the laws of Anguilla, although there was some question whether Anguilla had ever actually regulated the company. Apparently, the taxpayer did not even introduce a copy of Consolidated’s insurance license into evidence. However, the Tax Court found that did not matter whether Consolidated was regulated like an insurance company, because it found that Consolidated was not operated like an insurance company.
First, the Tax Court was troubled by the way in which the policies were issued. There was expert testimony that Consolidated backed into the premiums. According to the expert, no other insurance company priced policies as Consolidated had. In addition, the expert testified that no other insurance company would issue a policy after the expiration of the policy coverage period, as Consolidated uniformly did.
Second, the Tax Court was troubled by the way in which Consolidated paid claims. The Tax Court found that, over a period of four years, the insureds had submitted two claims. In each case, Tribeca, as captive manager, had requested documentation to support the claims. However, instead of providing such documentation, Rob simply overruled Tribeca and ordered Consolidated to pay the claims. The Tax Court found that no insurance company would pay a claim without an adequate showing that the claim was covered by the policy.
ii. Adequately Capitalized
The Tax Court found that Consolidated met the minimum capitalization requirements of Anguilla and that is all that is required.
iii. Valid and Binding Policies
As discussed above, the Tax Court found that the policies written by Consolidated were “claims-made” policies. This means that the policies only cover claims that occur during the policy coverage period and are reported to the insurance company during the policy coverage period or within sixty days thereafter. However, the Tax Court also found Consolidated did not issue the policies until after the expiration of the policy coverage period. The Tax Court found this to be abnormal. No insurance company issues a policy after the expiration of the policy coverage period when there is no longer a risk of loss.
iv. Reasonable Premiums
The Tax Court found that the premiums were not actuarially determined. Instead, they were “backed into” in order to add up to $1.2 million. The biggest issue was that Tribeca did not ask for “loss runs” from the insured. In addition, Tribeca did not review the loss history of any prior policy coverage period before renewing a policy at the same premium as before. No insurance company would determine premiums, let alone issue a policy, without reviewing an insured’s loss history.
v. Payment of Claims
As discussed above, the Tax Court found that Consolidated’s claims procedure was abnormal and unlike any real insurance company’s.
For all of the foregoing reasons, the Tax Court found that Consolidated was not an insurance company in the commonly accepted notions of insurance.
The IRS imposed accuracy-related penalties under section 6662 of the Code. The Tax Court upheld the penalties, and this is, perhaps, the most important takeaway of the case.
Penalties can be imposed in a tax deficiency case if the taxpayer understates the amount of its taxable income by a certain percentage or if the taxpayer is negligent in asserting a tax position. The Tax Court found that both apply in this case.
However, a taxpayer can avoid penalties if it can establish “reasonable cause” for its position. In most cases, reasonable cause requires a taxpayer to show that it reasonably relied upon the advice of an independent tax professional. The tax professional may not have a conflict of interest, must have knowledge and experience in the area and must have all of the facts.
The taxpayers claimed that they consulted with Tribeca, their CPA and their tax attorney before participating in the captive insurance transaction. However, there were problems. First, Tribeca was the captive manager and had an obvious conflict of interest. A taxpayer cannot rely on the advice of the promoter of a transaction to establish reasonable cause. Second, both the CPA and the tax attorney had advised the taxpayers that they were not familiar with captive insurance and that they were not comfortable with the transaction. In addition, both testified at trial that they provided no advice to the taxpayers.
A captive insurance company is a complex undertaking. Taxpayers are always advised to seek independent, knowledgeable advice before entering into the arrangement, if for no other reason than to make sure that they understand the nature of the transaction. However, Caylor provides another reason to seek independent advice. It is the only way for a taxpayer to avoid penalties.