Takeaways from the IRS's Latest Micro-Captive Tax Court Victory

The IRS recently secured its sixth micro-captive insurance Tax Court win in Swift v. Commissioner, T.C. Memo 2024-13. The case involved two captive insurance companies affiliated with the taxpayer's urgent care centers and physical rehabilitation facilities. The captives were formed in 2010, were domiciled in St. Kitts, and made elections under sections 831(b) and 953(d). The captives participated in risk pools associated with Celia Clark, the attorney who assisted the taxpayer in forming the captives (and whose practices, including in forming and operating risk pools for captive insurance companies, were discussed at length in Avrahami v. Comm'r, 149 T.C. 144 (2017)).

The Tax Court held that the captives were not insurance companies for federal tax purposes for the years at issue, 2012–2015, based on its analysis of two elements of the insurance characterization test: risk distribution and insurance in the commonly accepted sense. The taxpayer's deductions taken for premiums paid to the captives and fees paid to lawyers and advisers for the captives were disallowed.

The coverages written directly by the captives failed the risk distribution test because the number of entities, the number of lines of coverage, the number of locations, and the number of employees did not constitute a sufficient number of independent risk units. The risk pools in which the captives participated also failed to provide sufficient risk distribution. Among other reasons, the court noted that the risk pools set premium rates that were clearly tax-motivated rather than actuarially determined and characterized the arrangements between the pools and the participants as a circular flow of funds.

The court additionally found a number of factors that weighed against a finding of insurance in the commonly accepted sense, including significant investments in real estate developments related to the insured businesses (the illiquidity of which would have hampered the captives' ability to pay claims), rates on line that were as much as 1400 times the rates charged by commercial insurers for comparable coverages, and a lack of due diligence into the need for two captive insurance companies or for the coverages offered or premiums charged.

While the court's holding was in line with the prior five decisions addressing section 831(b), the opinion still offered a number of novel takeaways, particularly in the risk distribution analysis.

• The court's risk distribution analysis provided new quantitative guideposts on independent risk units (when considered collectively): three insured entities¹ (later two), between six and nine lines of coverage, 28 locations, and as many as 530 employees were insufficient risk units to satisfy the law of large numbers.
• The court explicitly rejected the taxpayer's proposed scope of risk units—millions of doctor-patient interactions—instead focusing solely on the number of employee doctors.
• With regard to the quantity and scope of the policies and lines of coverage, the court noted the interrelatedness of the nature of these coverages and the potential for multiple coverages to respond to the same loss.
• Finally, the court considered the narrowness of industry (medical) and geography (the greater San Antonio area) in finding insufficient risk distribution.

Thus, the opinion provides some additional insight as to how the Tax Court may analyze future micro-captive cases.

Footnote

1. Compare Rent-A-Center, Inc. & Affiliated Subsidiaries, et al v. Comm'r, 142 T.C. No. 1, and Securitas Holdings, Inc. & Subsidiaries v. Comm'r, T.C. Memo. 2014-225 (each case with a similarly limited number of insureds).