US Tax Court Finds Deficiencies in "Reserve Mechanical" Captive Arrangement

In a US tax court opinion released on June 18, 2018, Reserve Mech. Corp. v. Commissioner, 2018 Tax Ct. Memo LEXIS 87, 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.

The tax court considered the following issues in its opinion.

• Did the transactions qualify as insurance for federal income tax purposes?
• Was the captive eligible to make a 953(d) tax election?

Houston-based Capstone Associated Services, Ltd. (Capstone) 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."

Editor's Note: a more in-depth summary from Evershed's Sutherland surrounding the tax court's decision and the issues considered by the tax court will be available on Captive.com later this week.

Capstone has issued the following statement regarding the matter.

Reserve and Capstone respectfully disagree with the Court's opinion and in particular the Court's reliance in deciding this case on the Avrahami opinion. Reserve had no loans, participated in a diversified pool, assumed unaffiliated, third-party reinsurance, reported and paid substantial losses, and had policies that were designed to meet the needs of the underground mining business that it insured. Additionally, a series of recognized experts, including an insurance commissioner, two credentialed actuaries, an independent auditor, a nationally-renowned insurance economist, and an underwriter, all testified on behalf of Reserve with scant testimony from the government's witness whose testimony the government admitted was discredited on the stand.

Oddly, the Court rejected the professionally-administered pooling arrangement which involved hundreds of third party insureds and hundreds of policies as being "circular" evidencing an unexpected rejection of a fundamental industry standard risk sharing mechanism dating back more than a century. The Court rejected Reserve's third- party reinsurance program which was fully in evidence because the more than one hundred thousand underlying direct written policies from a recognized admitted carrier, were not put into evidence but were only the subject of (unchallenged) testimony.

The Court gave no weight to the fact that the IRS had issued 39 favorable rulings involving similar captive insurance arrangements and the same reinsurance arrangements. Of even greater surprise, the Court called out for evidence that an insured had experienced a loss before a company could buy insurance covering such event.

The Court's opinion does a disservice to the captive insurance industry and the bona fide captive insurance companies like Reserve. We are evaluating the full range of additional relief available to rectify the Court's opinion.