Captive Insurance under Fire: Recent Court Cases and IRS Regulations Reshape the Industry

Captive insurance taxation continues to face increased scrutiny from both the courts and the Internal Revenue Service (IRS), as highlighted during the recent Vermont Captive Insurance Association (VCIA) conference on August 14, 2024. The session, titled "Captive Taxation: What's New & What's Next," was presented by Allan Autry of Johnson Lambert LLP, Melissa Wiley of Lowenstein Sandler LLP, and Dan Kusaila of Crowe LLP, with Bailey Roese of Dentons serving as the moderator. 

Recent Court Cases and Legal Precedents

A series of recent Tax Court rulings have reinforced the IRS's rigorous stance on captive insurance companies making 831(b) elections (micro-captives).  

In Keating v. Commissioner (T.C. Memo 2024–2), the Tax Court examined the operations of Risk Retention, Ltd., a captive insurer domiciled in Anguilla and owned by the shareholders of Risk Management Solutions (RMS). The court determined that Risk Retention did not function as "insurance in the commonly accepted sense." A key issue was the retrospective issuance, renewal, and modification of policies, which were often issued midway through the coverage period, raising doubts about their validity. Policies were also added retroactively to cover specific claims, and the court found that premiums appeared deliberately engineered to maximize the 831(b) deduction limit, with rates set significantly higher than comparable commercial coverage and lacking actuarial support. The court also noted that Risk Retention operated more like a tax-free savings account, with funds diverted into undocumented and unsecured loans benefiting the owners, including the financing of life insurance policies, creating a circular flow of funds. Additionally, the court found the claims process lacked the rigor typical of a legitimate insurance company, with payments made without proper documentation or based solely on board resolutions rather than the policy terms. As a result, the court upheld the IRS's assessment of taxes and imposed a 20 percent accuracy-related penalty. 

In Swift v. Commissioner (T.C. Memo. 2024–13), the Tax Court scrutinized the insurance activities of Dr. Swift, the owner of Texas MedClinic, a healthcare provider with 18 locations in Texas and 75 doctors on staff. Dr. Swift had established two captives, Castlerock and Stonegate, domiciled in St. Kitts, which made 831(b) and 953(d) elections. These captives were involved in risk pools operated by Celia Clark, previously noted in the Avrahami decision. The court found that these captives did not meet the criteria of insurance in the commonly accepted sense and failed to achieve sufficient risk distribution. 

The court noted several critical issues, starting with the fact that the 3 insured entities—covering 6–9 types of risks across 28 locations with between 341–530 employees and independent contractors—were not sufficient to provide adequate exposure units for risk distribution. Dr. Swift argued that millions of patient interactions should be considered the relevant exposure unit, but the court rejected this claim, determining that the single geographic location and industry were not enough to support proper risk distribution. Furthermore, the court criticized the reinsurance pools, noting that over 94 percent of the reinsurance premiums were paid back to the participants, indicating a circular flow of funds rather than genuine risk transfer. The court found the premiums within the pool appeared to be arbitrarily set, and the low loss ratio further suggested that the pools were structured to discourage claims rather than manage risk effectively. 

Additional concerns included the lack of loss history, with premiums manipulated based on the taxpayer's requests rather than reflecting actual risk. The court highlighted that Dr. Swift personally drafted the medical malpractice policy, and claims were often reported after the policy period yet still paid, some even exceeding policy limits. The administrative process was also flawed, with Dr. Swift alone settling all claims without any meaningful oversight or adherence to policy terms. A particularly egregious example was the payment of IRS audit defense costs under an Administrative Action policy, which was the highest claim paid by the captive. 

Moreover, the court pointed out that the captives' premiums were invested in real estate, further distancing the operations from genuine insurance practices. Ultimately, the court concluded that these captives were primarily used for tax avoidance purposes, upholding the IRS's assessment of taxes and a 20 percent accuracy-related penalty.  

In the case of Patel v. Commissioner (T.C. Memo. 2024–34), the Tax Court further demonstrated its stringent approach to evaluating captives. Drs. Patel and McAnally-Patel, who owned an eye surgery center and two research centers in West Texas, had formed two captive insurance companies: Magellan Insurance Company, incorporated in St. Kitts in 2011, and Plymouth Insurance Company, incorporated in Tennessee in 2016. Both captives participated in the Capstone reinsurance risk pool, with Magellan making a 953(d) election and both captives making 831(b) elections. From 2013 to 2015, Drs. Patel and McAnally deducted over $1 million in premiums paid to Magellan, and in 2016, they deducted a similar amount in aggregate premiums paid to both Magellan and Plymouth. 

The court found that these captives failed to distribute risk adequately and did not function as legitimate insurance entities. Specifically, the court held that having 3 or fewer insured entities—with 7–8 offices, 5 doctors, and fewer than 100 employees—was insufficient to achieve proper risk distribution. The court also rejected the argument that patient visits and procedures could serve as the relevant risk unit, concluding that these interactions were not applicable to the coverages provided by the captives. The limited geographic area and single industry of the insured entities further underscored the lack of sufficient risk distribution, according to the court. 

Moreover, the court criticized the Capstone reinsurance pool for not performing "the functions of an insurance company," noting issues such as the circular flow of funds, contracts that were not conducted at arm's length, and premiums that were not actuarially determined. The court also found that the premiums charged by the captives were out of line with commercial rates, discounting the actuary's calculations due to ill-defined factors. Additionally, no feasibility study was conducted for either captive, and there was no analysis justifying the need for two captives. The court was troubled by the apparent intent of the taxpayers to maximize their tax deductions, particularly as no claims were made during the years in question, with most claims submitted only after the IRS audit began. While the court deferred its decision on penalties, it made clear that the captives did not meet the necessary standards for insurance in the commonly accepted sense. 

IRS Trends in Captive Insurance

The IRS has been increasingly focused on captive insurance arrangements involving micro-captives. This intensified scrutiny is fueled by a significant increase in funding and a strategic shift towards auditing high-income individuals, large corporations, and complex partnerships. The IRS's recent $60 billion funding boost through 2031, provided by the Inflation Reduction Act (IRA), is enabling a substantial expansion of its enforcement capabilities. As part of this expansion, the IRS has grown its workforce to approximately 90,000 full-time employees, up from 79,000 in 2022—an increase of about 14 percent. In 2024 alone, the IRS hired approximately 2,000 new revenue agents, a 9 percent increase from the previous year, with an additional 1,000 candidates currently in the onboarding process. Looking ahead, the IRS plans to add another 14,000 full-time employees by 2029, bringing its total workforce to 102,500, even after accounting for attrition. This workforce expansion is directly linked to the IRS's aim to nearly triple audit rates for large corporations by tax year 2026, along with significantly increasing audits of wealthy individuals and complex partnerships.

A key development in the regulation of Section 831(b) captives is the proposed regulations issued by the IRS on April 11, 2023. These regulations, which affect most captive insurance companies making a Section 831(b) election, introduce specific criteria for determining when a micro-captive is considered a listed transaction or a transaction of interest, with a particular focus on factors such as loss ratios and financing arrangements. The proposed regulations have sparked significant concern within the industry, as evidenced by the 110 comments filed by industry associations, state captive insurance associations, captive managers, captive owners, and domiciles by the June 12, 2023, deadline. The feedback primarily centered on the regulation of insurance, the appropriateness of designating certain transactions as "listed" in a highly fact-specific environment, and the impact of arbitrary loss ratio thresholds. A public hearing on these regulations took place on July 19, 2023, but despite the IRS initially indicating that the regulations would be finalized by the end of 2023, they remain in limbo. The IRS must still address the extensive comments received, and while there have been some updates suggesting the IRS intends to finalize the regulations, their final form and implications for the viability of many captives remain uncertain. 

According to the VCIA panelists, once the IRS concludes its focus on micro-captives, the insurance-trained agents involved will likely be redeployed to other areas of scrutiny, potentially broadening the scope of captive insurance audits. The panelists also highlighted concerns with the Tax Court's application of certain insurance concepts, such as risk distribution and the expectation that all insurance must be separately priced, warning that such interpretations could lead to misguided legal precedents. Additionally, the IRS chief counsel's lack of understanding of captive insurance was evident in the proposed regulations, which have seen little progress over a year after public hearings. The regulations, which presume that any captive with a loss ratio of less than 65 percent over a decade is inherently suspect, fail to consider the natural variances in loss ratios across different lines of business, insured locations, or coverages with long-tail risks. The IRS's approach appears to be geared towards disallowing premium deductions based on arbitrary metrics without a more nuanced analysis and seems to overlook the specialized knowledge and expertise of actuaries and state departments of insurance.