Swift Becomes 6th Straight IRS Micro-Captive Victory

On February 1, 2024, Judge Patrick J. Urda continued the Tax Court trend of disallowing deductions for premiums paid to micro-captives in Swift v. Commissioner, Nos. 13705–16, 5354–18, 11261–19, 2024 Tax Ct. Memo LEXIS 13, at *1 (T.C. Feb. 1, 2024). Following is a brief summary of the case along with some statistical observations, with a more detailed analysis forthcoming.

Swift

In Swift, the Internal Revenue Service (IRS) disallowed deductions for premiums paid to a micro-captive insurance company and imposed accuracy-related penalties. The taxpayers included a physician who utilized captives for his medical practice, which included more than a dozen urgent care centers and physical rehabilitation facilities in and around San Antonio, Texas. Per Swift's Tax Court petition, the premiums at issue "were made to purchase insurance coverage for certain aspects of Petitioners' medical practice." The program also utilized a risk pool, and there were nonmedical malpractice policies issued (as the IRS alleged) "to meet the 30 percent perceived IRS requirement."

While the end result is not particularly surprising, some aspects of Judge Urda's rationale will continue to be troublesome for pending cases moving toward a Tax Court decision. These issues relate to the ability to set a tax-motivated premium percentage split between related and unrelated risk for purposes of risk pool operations. Another important issue pertains to whether the law of large numbers can ever be satisfied by an 831(b)-electing captive. With each 831(b) decision, the sufficient risk exposure threshold continues to move upward toward the amounts set forth in favorable taxpayer decisions. "The Swift captives' six or nine policies covered an operation spanning approximately 28 locations (as of 2015) and a workforce that ranged between 530 (2012) and 341 (2015) workers during the years at issue, including its independent-contractor physicians. The Swift captives' risk exposure pales in comparison with that we have deemed satisfactory for the law of large numbers to apply." While one can certainly argue the election is nonsensical if it can never be made, the Tax Court's response has not been "it can never be made" but all the more so, "you haven't reached the minimum threshold."

Through six opinions, there has yet to be a successful IRS assertion of nondisclosure of noneconomic substance penalties, or a Tax Court ruling on economic substance grounds. Interestingly, Judge Urda also found the invalid 953(d) election resulted in income to the foreign captives. In prior cases, the domestic insured (as a petitioner in Tax Court) would be found liable for failure to withhold on payments made to the foreign corporation, where the IRS successfully argued such payments were fixed or determinable annual or periodical gains, profits, and income received from US sources but not effectively connected with the conduct of a trade or business within the United States. "Therefore, the Swift captives' section 953(d) election is likewise invalid for the tax years at issue. We sustain the Commissioner's determinations with respect to the Swift captives, so the Swift captives must recognize the premiums they received as income for the years at issue."

Swift does not only reflect the IRS's sixth straight victory over micro-captive controversies taken to a decision. While the taxpayers in the first three micro-captive cases (Avrahami, Reserve Mechanical, and Syzygy) managed to avoid accuracy-related penalties, Swift reflects the third case in a row where the Tax Court upheld such penalties. On a slightly more positive note, it should be noted that although the IRS initially sought a 40 percent nondisclosure of noneconomic substance penalty in Swift under 6662(i), the IRS later conceded on this point. 

The decision to challenge an adverse IRS determination involving micro-captive deductions continues to be a substantial investment in time and money. The time between petition and opinion can take several years. The micro-captive battle requires the use of experts and at least a 1-week trial. All of this necessitates a cost-benefit analysis. Consequently, the merits of the case and potential for settlement should be compared to the litigation cost and potential outcome.