Captive Insurance Industry Insights into the "Reserve Mechanical" Case

In a US tax court opinion released on June 18, 2018, on the case Reserve Mech. Corp. v. Commissioner, 2018 Tax Ct. Memo LEXIS 87, (T.C. June 18, 2018), Judge Kathleen Kerrigan wrote that Reserve Mechanical Corp. (Reserve), a captive insurer incorporated in Anguilla in 2008 and owned by Peak Casualty Holdings, LLC, failed to qualify as an insurance company for federal income tax purposes under Internal Revenue Code section 501(c)(15), resulting in Internal Revenue Services (IRS) tax deficiencies being assessed against Reserve for $477,261 over tax years 2008, 2009, and 2010.

In a recent Captive.com article, Tax Court Issues Second Small Insurance Company Case, Eversheds Sutherland provided a more in-depth summary surrounding the tax court's decision and the issues considered by the tax court.

Houston-based Capstone Associated Services, Ltd., served as the captive manager for the arrangement in which Reserve issued direct written insurance policies to Peak Mechanical & Components, Inc.; RocQuest, LLC; and ZW Enterprises, LLC. Reserve also participated in a risk pool administered by PoolRe Insurance Corp., in addition to a second reinsurance program involving vehicle service contracts. Reserve entered into a quota share reinsurance arrangement where it and other captive insurers assumed a blended risk in exchange for reinsurance premiums. In the opinion, the tax court contended that the quota share arrangement did not distribute risk and that risk distribution is "a necessary component of insurance."

Capstone has issued its own statement about the matter, which is available in the recent Captive.com article US Tax Court Finds Deficiencies in "Reserve" Captive Arrangement.

As a follow-up, Captive.com recently touched based with a number of captive insurance industry professionals to share their insights. Here are their thoughts on the tax court's decision.

The tax court's decision offers important insight into its view of risk distribution, one of the critical inquiries in assessing whether an arrangement gives rise to insurance for US federal income tax purposes. The tax court's analysis of this issue again looked not only to the number of insured legal entities, but also to the number and independents of the risks themselves.   

In addition, the tax court's decision emphasizes the importance of ensuring that an arrangement results in bona fide insurance (e.g., insurance in the commonly accepted sense) by offering a checklist of best practices for developing, implementing, and maintaining the insurance company, including an insurance company participating in a risk pool.

— Kristen E. Hazel, partner at McDermott Will & Emery LLP

While the tax court found the captive issued insurance policies to be valid and binding insurance and concluded that policy validity presented a neutral factor, the court stated that "in many instances the policies were not reasonably suited to the needs of the insureds" due to their "extremely limited circumstances." Thus, it bears noting that taxpayers should be certain the policies put in place under their captive are "needed" coverages (in this case, excess commercial property coverage). Otherwise, such policies are likely to stand out in an IRS audit.

— Jeremy Colombik, CPA, president at Management Services International

One clear takeaway from the tax court's decision in Reserve Mechanical is the importance of demonstrating that there is a true risk management reason for entering into a captive insurance arrangement. There either needs to be true risk of loss for coverages not covered by the taxpayer's commercial policies, or meaningful changes made to the insurance the taxpayer purchases from the commercial marketplace. Either of these lend credence to the proposition that the captive arrangement is being entered into for nontax, business reasons.

— Alan Fine, CPA, JD, partner, Insurance Advisory Services group at Brown Smith Wallace

Some will argue that nothing new was gained from the opinion in Reserve Mechanical due to the negative fact patterns delineated from the case. Albeit true from a direct guidance perspective, it does provide a continual paradigm into how the IRS and courts view captive structures for federal tax purposes. Ultimately, this is a good thing for the industry, regardless of whether in favor of the taxpayer or the IRS, as it validates best practices a captive should embrace if it wishes to preserve its tax position.

A negative fact pattern finding by the court can be used to edify folks as to what a good set of facts should embody. In this case, the court's finding of an absence of a legitimate nontax business purpose, Reserve's apparent lack of due diligence, its failure to demonstrate compliance with the arm's-length concept, as well as other issues involving common notions of insurance, proved problematic enough to sink the ship. The case also involved the use of a risk pool to achieve third-party business from a risk distribution perspective, which the court found could not be substantiated. In the end, Reserve likely would have benefited from performing more due diligence.

— Matt T. Gravelin, CPA, principal at Johnson Lambert LLP

It would seem that this tax court case bears no resemblance to the Avrahami case, as Reserve Mechanical cites numerous reasons and transactions showing how its business was insurance-related. If the court gave no weight to more than three dozen previous rulings in favor of captives and similar arrangements, as it seems to have happened, I expect this will not be the last we hear of this case.

Even as the captive insurance industry continues to mature, captives and the people that serve them should continue to follow best practices in using a risk financing arrangement that has overwhelmingly proved legitimate and necessary for business.

— Anne Marie Towle, executive vice president and captive consulting practice leader at JLT Insurance Management (USA) LLC