Recent Captive Tax Court Ruling – Syzygy Insurance vs. Commissioner

On April 10, the US Tax Court released its ruling in Syzygy Insurance v Commissioner of Internal Revenue. This is the third case related to micro-captive insurance companies and whether it qualified as a small insurance company. Similar to Avrahami v. Commissioner and Reserve Mechanical v. Commissioner, the Court ruled against the taxpayer.

Yet again, the taxpayer approached the Court with a poor set of facts that we will outline below. We view these rulings to affirm the importance of the following criteria:

  1. Is there a valid, non-tax business purpose for establishing the captive?
  2. Is there insurance in the commonly accepted sense?
  3. Is there sufficient risk distribution?

The Court paid particular attention as to whether this insurance transaction had characteristics similar to traditional insurance transactions. There were apparently significant losses incurred in the insured companies that should have been covered by Syzygy Insurance’s policies. Those claims were never filed to the captive by the owner whereby he testified that he was essentially too busy to do so. He did have a process to file all of his commercial claims, however. In all the years they issued coverage, there was only one filed claim. Unfortunately, that claim was paid out with no formal claims process, back up or investigation.

Apparently, Syzygy Insurance did not issue actual policies to the insureds in certain years. When it did, it often wasn’t on a timely basis. The captive also had life insurance as a significant portion of its assets on the balance sheet. The insurance policies themselves were not even owned by the company, but in separate trusts established by the owners. In this arrangement, the assets were not available to cover captive losses. These deficiencies were noted by the Court that there was not insurance in the commonly accepted sense.

In all three court cases, the issue of risk distribution played a prominent role. In the case of Syzygy Insurance, there was a reinsurance arrangement where the risk was divided into two layers. Apparently the allocation of premiums and loss layers ran contrary to the captive manager’s own actuary. Within this pool, there was only one claim filed over a number of years out of the hundreds of different policies issued to the various pool participants. Without adequate risk distribution, the Court ruled that the premiums were not tax deductible to the insured and the captive wasn’t an insurance company. Thus Syzygy cannot make an 831(b) election and would need to pay taxes on income.

It is critically important for the captive owner to understand the structure and have active participation. The owner of Syzygy Insurance testified that he initially wanted to offer warranty insurance through his captive as the business purpose. However, no warranty insurance was ever issued. The owner also emailed the captive manager wanting to fire them for having a renewal premium that was much lower than he desired. These facts clearly were not well received by the Court.

As we mentioned before, there are hundreds of other cases pending in Tax Court. We will continue to monitor them and inform you of any relevant news. The IRS continues to state that there are valid 831(b) arrangements. However, these cases remind us that it is critically important to form and operate a captive with the highest level of integrity.

This summary should not be construed as tax advice and you should consult with your tax advisor and/or counsel regarding your specific circumstances.

If you have any questions or would like to schedule an appointment, please call us at (310) 697-1500.

Reprinted with permission from R. Wesley Sierk III of Risk Management Advisors, Inc.

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