Reserve Mechanical Corp. f.k.a. Reserve Casualty Corp. v. Commissioner

T.C. Memo. 2018-86

UNITED STATES TAX COURT

RESERVE MECHANICAL CORP., f.k.a. RESERVE CASUALTY CORP.,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14545-16. Filed June 18, 2018.

Val J. Albright and Michelle Y. Ku, for petitioner.

Thomas F. Harriman, Naseem Jehan Khan, Grubert Roger Markley, and

Justin D. Scheid, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

KERRIGAN, Judge: Respondent determined the following deficiencies in

petitioner’s Federal income tax for tax years 2008-10 (tax years in issue):
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[*2] Year Deficiency

2008 $144,538
2009 164,418
2010 168,305

Unless otherwise indicated, all section references are to the Internal

Revenue Code (Code) in effect for the tax years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure. All monetary amounts are

rounded to the nearest dollar.

The issues for consideration are: (1) whether transactions that petitioner

executed during the tax years in issue constituted insurance contracts for Federal

income tax purposes, and therefore, whether petitioner was exempt from tax as an

“insurance company” described in section 501(c)(15); (2) whether petitioner was

eligible to make an election under section 953(d) to be treated as a domestic

corporation; and (3) if petitioner was not an insurance company and was not

eligible to make an election under section 953(d), whether payments that it

received for the tax years in issue are subject to the 30% tax imposed by section

881(a).
 -3-

[*3] FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulation of facts and the

attached exhibits are incorporated herein by this reference. When petitioner filed

its petition, it was a corporation organized under the laws of Anguilla, British

West Indies. In our findings of fact we use the terms “insurance”, “risk”,

“coverage”, and similar terms to describe the form of the transactions, but our use

of those terms does not reflect any ruling as a matter of fact or law with respect to

insurance or insurance companies within the meaning of subchapter L of the Code.

I. Overview of Reserve Mechanical Corp.

Reserve Mechanical Corp. f.k.a. Reserve Casualty Corp. (hereinafter,

Reserve) was incorporated in Anguilla in 2008 under the provisions of section 9 of

the Companies Act. Anguilla is an overseas territory of the United Kingdom.

During the tax years in issue Reserve held a Class B General Insurance License

(Class B insurance license) issued by the Financial Services Commission of

Anguilla. The Financial Services Commission is the Anguillan governmental

entity authorized to license, regulate, and oversee the financial services industry in

Anguilla, including insurance companies.

During the tax years in issue Peak Casualty Holdings, LLC (Peak Casualty),

a Nevada limited liability company, owned 100% of Reserve’s stock. Norman L.
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[*4] Zumbaum and Cory Weikel each owned 50% of Peak Casualty. Zumbaum

and Weikel were U.S. citizens who resided in Idaho during the tax years in issue.

Zumbaum and Weikel served as directors for Reserve. Zumbaum was its

chief executive officer, president, treasurer, and assistant secretary. Weikel was

its vice president, secretary, and assistant treasurer.

A. Peak’s Operations

Peak Mechanical & Components, Inc. (Peak), was incorporated in 1997, and

its principal place of business was in Osburn, Idaho. Zumbaum and Weikel each

owned 50% of Peak’s outstanding stock, and Peak elected to be treated as an S

corporation for Federal income tax purposes. Peak engaged in the business of

distributing, servicing, repairing, and manufacturing equipment used for

underground mining and construction. By 2008 Peak had grown significantly. In

2008 and 2009 it had 17 employees, including management personnel, shop

managers and staff, and outside salespersons. In 2010 it had 13 employees.

Peak’s facilities were in Idaho’s Silver Valley, an active mining district, and

were within the Bunker Hill Mining & Metallurgical Complex, a “Superfund Site”

designated by the U.S. Environmental Protection Agency (EPA) (Bunker Hill

Superfund Site). See Bunker Hill Mining & Metallurgical Complex, Smelterville,

ID, https://cumulis.epa.gov/supercpad/SiteProfiles/index.cfm?fuseaction=
 -5-

[*5] second.Cleanup&id=1000195#bkground (last visited June 13, 2018). The

Bunker Hill Superfund Site was polluted with heavy metals, including zinc and

lead, as a result of historic mining practices. The site was subject to EPA

oversight and regulation. As part of its business Peak cleaned equipment used in

polluted mines, and it took measures to protect its employees and to control fluid

runoff containing pollutants and other hazardous materials.

During the tax years in issue Peak’s equipment was used in approximately

12 mines in Idaho, Nevada, and Washington, and it sold some products outside the

United States. It manufactured and serviced a line of submersible pumps used to

remove groundwater from working areas, and it supplied and serviced large

ventilation fans and air barrier doors, which are used to improve air quality and

control air flow in underground mines. It rebuilt and customized trucks to be used

as support vehicles in mining operations, and it manufactured and repaired guide

wheels for hoist conveyances, which are used in mine shaft elevators.

B. Peak’s Commercial Insurance Coverage

During all of the tax years in issue Peak maintained insurance coverage with

third-party commercial insurers. It held policies with third-party insurers that

covered general liability, worker’s compensation, commercial property, inland
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[*6] marine, and international risk. It maintained the following policies with the

following insurance companies:

Policy type &
Insurance provider limit categories Policy limits

Employers Mutual General liability
Casualty Co. (EMC) Each occurrence $1,000,000
Damage to rent premises 100,000
Medical expense 5,000
Personal & advertising injury 1,000,000
General aggregate limit 2,000,000
Products/completed
operations aggregate limit 2,000,000
EMC Commercial property
Blanket policy limit 914,940
EMC Commercial inland marine
(covering electronic data
processing equipment)
Limit for hardware 8,000
Idaho State Insurance Worker’s compensation
Fund employer’s liability
Each accident 100,000
Disease, each employee 100,000
Disease, policy limit 500,000
Ace American International risk policy
Insurance Co. Foreign general liability,
automobile liability,
employers liability 1,000,000
Foreign accidental death &
dismemberment 5,000
Kidnap & extortion 50,000

Peak also maintained auto insurance policies with State Farm for several

vehicles that its employees drove.
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[*7] For tax year 2006 Peak claimed a deduction on its Form 1120S, U.S.

Income Tax Return for an S Corporation, for insurance expenses of $38,810. For

tax year 2007 it claimed a deduction for insurance expenses of $95,828. Peak’s

income statement reflects that for the first six months of 2008 it incurred insurance

expenses of $57,300.

C. Peak’s History of Losses and Insurance Claims and Potential Losses

Sometime before the tax years in issue Peak engaged a large accounting

firm to review returns it had filed for previous years. Peak was advised that its

income had been underreported and that it needed to restate its income for three

tax years. It contacted the Internal Revenue Service (IRS) about restating its

income, and it paid additional tax as a result. The IRS waived penalties.

In years prior to the tax years in issue Peak had filed insurance claims under

its auto insurance policies for losses associated with company vehicles. In

February 2008 a snowstorm damaged the roof of one of Peak’s buildings, and it

filed a claim with EMC. EMC conducted an examination and concluded that the

repair would cost $2,000. Peak had a separate examination of the roof which

concluded that $2,000 would be insufficient to repair the roof. It tried to negotiate

with EMC for a larger payout, but after negotiations EMC agreed to pay only

$2,000. Peak paid $25,000 out of pocket to have the roof replaced.
 -8-

[*8] D. RocQuest and ZW Enterprises

During the tax years in issue Zumbaum and Weikel equally co-owned 100%

of the membership interests in two other entities: RocQuest, LLC (RocQuest), and

ZW Enterprises, LLC (ZW). RocQuest and ZW were Idaho limited liability

companies that were treated as partnerships for Federal income tax purposes.

RocQuest owned real estate in Osburn and Hayden Lake, Idaho, and Elko,

Nevada. It leased the properties in Osburn and Elko to Peak for Peak’s business

operations. It leased the property in Hayden Lake to Premier Electric Motor, Inc.

(Premier), an entity that Zumbaum and Weikel partially owned. Premier

conducted repair work on electrical motors and received most of its business from

Peak.

ZW was an entity that Zumbaum and Weikel organized to facilitate a loan to

an ex-employee. After leaving Peak the ex-employee wanted to purchase a bar in

Osburn, and Zumbaum and Weikel, through ZW, helped finance the purchase.

ZW held a 10% ownership interest in the bar. Zumbaum and Weikel organized

ZW so that Peak would not have any liability vis-a-vis the bar.

II. Formation of Reserve

Before forming Peak Zumbaum and Weikel worked for Mining Equipment,

Ltd. (MEL), based in Colorado. Robert Pope was the president and owner of
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[*9] MEL. Zumbaum and Weikel viewed Pope as a mentor. Pope recommended

that Peak should obtain more insurance, and he suggested forming a captive

insurance company. He advised Zumbaum and Weikel to contact Capstone

Associated Services, Ltd. (Capstone).

A. Overview of Capstone

In 1998 Stewart Feldman formed Capstone, a Texas limited partnership with

an office in Houston, Texas.1 Capstone offered insurance-related services,

including captive feasibility studies, assistance with regulatory filings, accounting,

and other services related to forming a captive insurance company. It offered a

“turnkey” administrative program to help small and intermediate size captives

overcome transaction costs.

Capstone employed insurance and accounting professionals, and it was

closely affiliated with the Feldman Law Firm, LLP (Feldman firm), which

provided legal services to Capstone clients. Feldman was the Feldman firm’s

managing partner and chief executive officer of Capstone’s corporate general

partner.

1
Feldman testified that Capstone was a Texas limited partnership. Exhibit
9-J includes a reference to “Capstone Associated Services, Ltd., a Florida limited
partnership”.
 - 10 -

[*10] Capstone would perform a feasability study for a client, which provided an

opinion as to the advisability of establishing a captive insurance company.

Generally, a feasibility study identified factors that would make a captive

insurance arrangement desirable for a particular client, including a discussion of

the client’s business operations and risks, insurance coverage that the client held

through third-party insurers, and potential coverage gaps (“exposures”) that might

be relevant to the client’s business. For clients that proceeded with the formation

of a captive insurance company, Capstone performed a comprehensive set of

captive management and administrative services.

Capstone provided the services of its insurance professionals, and it assisted

clients in selecting and administering policies that the captive entities issued. It

advised clients in selecting policies, drafted policies, and provided services to

handle claims adjustment and settlement. Capstone advised clients as to the

premiums that should be charged for policies. It charged Reserve approximately

$15,000 a quarter for services, including disbursements on Reserve’s behalf.

B. Onsite Visit of Peak’s Operations

Zumbaum and Weikel contacted Capstone to discuss forming a captive

insurance company. Peak provided documents relating to its business operations,

which Capstone compiled as “Client Background Documents” for a feasibility
 - 11 -

[*11] study. Peak provided financial and income statements, tax returns, and

documentation of insurance policies that it held with third-party insurers. A copy

of Rocquest’s partnership tax return for 2007 was included with the background

documents.

On August 13, 2008, Feldman and Lance McNeel, director of Capstone’s

insurance department, visited Peak’s facilities. Feldman and McNeel met with

Zumbaum and Weikel, and they toured locations where Peak conducted operations

in Osburn and the facility in Hayden Lake. McNeel took pictures of Peak’s

operations and inventory. Feldman and McNeel discussed with Zumbaum and

Weikel documents that Peak had provided and discussed products that Peak sold

and its repair and manufacturing operations. They discussed possible gaps in

Peak’s existing insurance coverage. The onsite visit of Peak’s facilities lasted six

to eight hours.

C. Feasibility Study for Peak

In August 2009 the finalized feasibility study for Peak was issued, about

nine months after the start of Reserve’s operations. The background documents

compiled to support the feasibility study included documents that reflected Peak’s

financial information through August 31, 2009, and the background file was

updated as late as December 14, 2009. Capstone’s feasibility study for Peak
 - 12 -

[*12] concluded that “as of the date of this report, the viability of a small captive

insurer * * * to address the insurance and risk management issues discussed herein

is feasible, reasonable, and practical, and is the best alternative risk mechanism

option for the proposed insured ”.

The feasibility study included an explanation of tax benefits for small and

intermediate-size captives under sections 831(b) and 501(c)(15). It included a

summary of Peak’s business operations, a table reflecting Peak’s commercial

insurance policies, and a list of “other risk management issues”. The study did not

provide detailed information regarding the other risks that conventional insurance

might not cover. The study provided brief descriptions of these risks, but it

included no information on the probability that these risks might occur. The study

did not include information about Rocquest and ZW. The study identified specific

policies that Peak could consider handling through a captive insurer. It identified

potential domiciles for Peak’s small captive and concluded: “Anguilla is the

preferred choice.”

Capstone and Willis HRH of Houston (Willis), an insurance broker and risk

management consulting firm that collaborated regularly with Capstone during the

tax years in issue, jointly issued the feasibility study. Robert Snyder signed the

study as senior vice president of Willis. McNeel was principal author of the study,
 - 13 -

[*13] and Snyder’s role was to review it. Snyder did not perform any independent

investigation of Peak’s business operations, and he based his review on the

background documents that Capstone compiled and an oral briefing from McNeel.

D. License Application & Organization

On October 10, 2008, Feldman wrote a letter to the Financial Services

Commission of Anguilla notifying the commission that Capstone would be

providing its “usual comprehensive set of captive administrative services” to

Reserve. On October 21, 2008, Zumbaum, Weikel, and Feldman endorsed and

submitted Reserve’s Application For a Class B Insurer’s License in Anguilla. The

application contained a business plan for Reserve. The business plan stated that in

its early years Reserve “is expected to be operated under section 501(c)(15) of the

U.S. Federal Tax Code which limits gross receipts to $600,000”.

On December 3, 2008, Reserve was incorporated in Anguilla, and on the

same date the Financial Services Commission granted it a Class B insurance

license valid through December 31, 2008. Reserve’s insurance license application

identified Capstone and Atlas Insurance Management (Anguilla) Limited (Atlas)

as key service providers. On December 10, 2008, Reserve received an initial

capitalization of $100,000, the minimum amount required for a Class B insurer

under Anguillan law.
 - 14 -

[*14] Capstone engaged Atlas to serve as the authorized representative and

resident insurance manager for Capstone clients in Anguilla. Atlas transmitted

documents that Capstone prepared for Reserve’s license application to the

Anguillan regulatory authorities. After Atlas submitted the license application, its

principal role was to provide a local business address for Reserve.

III. Reserve’s Direct Written Policies

During the tax years in issue Reserve issued direct written insurance

policies, with Peak, Rocquest, and ZW as the named insureds on each policy. All

of the policies that Reserve issued the insureds showed one premium price and did

not specify amounts to be paid by each insured. All of the policies contained the

following provision:

THE COVERAGES AFFORDED BY THIS POLICY ARE EXCESS
OVER ANY OTHER VALID AND COLLECTIBLE INSURANCE
POLICY ISSUED BY ANY OTHER INSURER * * *. THE LIMITS
AND DEDUCTIBLES STATED HEREIN ONLY APPLY AFTER
COVERAGE IS EXHAUSTED FROM ANY AND ALL OTHER
VALID INSURANCE POLICIES ISSUED BY ANY OTHER
INSURER.

During the tax years in issue Peak maintained its insurance coverage with third-

party insurers.

For the tax years in issue Capstone selected and drafted the policies that

Reserve issued for Peak and the other insureds. Zumbaum scanned the policies
 - 15 -

[*15] but did not review them in detail, and he was unaware of specific terms in

the policies. Capstone employees, including McNeel, determined the premiums

that Reserve charged for the policies. For each of the tax years in issue McNeel

prepared a rating worksheet that calculated the premiums for Reserve’s direct

written policies. Zumbaum and Weikel had ultimate authority to determine the

premiums, and they always approved the amounts that Capstone advised.

McNeel calculated the premiums using ratings bases specific to Peak’s

business; for most policies the ratings base was Peak’s annual projected sales. He

applied to the ratings base for each policy a base rate that varied according to the

type of insurance being provided, which yielded a base premium price for the first

$250,000 of coverage. Capstone maintained a spreadsheet of base rates for

“common policies” that it administered on behalf of its clients’ captive insurance

companies (Capstone entities). McNeel prepared the spreadsheet by reviewing the

premiums that all Capstone entities had charged in previous years, and the

spreadsheet provided both an average and a range of rates from which he could

choose for each type of policy. On Reserve’s rating worksheets McNeel adjusted

the base premium amounts using increased limit factors, which accounted for the

increased coverage limits in its policies.
 - 16 -

[*16] Capstone engaged persons employed by an outside firm, Mid-Continent

General Agency, Inc. (Mid-Continent), to develop premium quotations. A Mid-

Continent employee generated pricing indications using information that Capstone

compiled about its clients. McNeel relied on the Mid-Continent indications in

setting the premiums that Reserve and other Capstone entities charged for their

direct written policies.

In 2009 Mid-Continent wrote Capstone a letter which stated that “many of

the insurance coverages written by the [Capstone] captives are nonstandard lines

of insurance for which there is no ‘manual rating’”. The letter stated further that

“[u]nderwriting judgment, while ‘subjective,’ is a key component of evaluating

and pricing risk” in the methodology that Mid-Continent employees used to

generate pricing indications. Peak and the other insureds under Reserve’s policies

had insufficient histories of insurance claims and losses to use as bases for

determining premiums, and McNeel did not rely on loss data in calculating the

premiums for Reserve’s direct written policies.

A. 2008 Direct Written Policies

For 2008 Reserve issued 13 direct written insurance policies, with Peak,

RocQuest, and ZW as the named insureds. Each policy listed PoolRe Insurance

Corp. (PoolRe) as the stop loss insurer. These policies were effective from
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[*17] December 4, 2008, through January 1, 2009. The aggregate amount of

insurance was $13 million, and the premiums were $412,089. Reserve issued the

following direct written policies for 2008:

Name of policy Combined premium1 Aggregate policy limit

Excess Directors & Officers Liability $17,122 $1,000,000
Special Risk--Loss of Major Customer 7,268 1,000,000
Special Risk--Expense Reimbursement 31,312 1,000,000
Special Risk--Loss of Services 4,874 1,000,000
Special Risk--Weather Related 7,268 1,000,000
Business Interruption
Excess Pollution Liability 82,850 1,000,000
Special Risk--Tax Liability 65,408 1,000,000
Excess Intellectual Property Package 18,169 1,000,000
Special Risk--Regulatory Changes 64,899 1,000,000
Special Risk--Punitive Wrap Liability 55,233 1,000,000
Excess Employment Practices Liability 24,256 1,000,000
Excess Cyber Risk 28,343 1,000,000
Special Risk--Product Recall 5,087 1,000,000
Total 412,089 13,000,000

1
As noted, each of the direct written policies that Reserve issued showed only one
premium price for coverage to be provided to all three named insureds. According to additional
agreements executed by the parties, which are described in more detail below, a portion of the
premiums due for the direct written policies were to be paid to a stop loss insurer. It is unclear
from the record which of the insureds paid premiums under the direct written policies, in what
amounts they paid, and to whom. Accordingly, the table reflects only the combined premium
price shown on each of the policies.
 - 18 -

[*18] Seven of the 2008 policies had retroactive dates or look-back provisions.

The policies for excess directors and officers liability, excess pollution liability,

excess intellectual property, punitive wrap liability, excess employment practices

liability, and excess cyber risk provided that the policies would cover claims

occurring after January 1, 2005. The tax liability policy provided that it would

cover all tax periods for tax returns whose due dates (without extensions) were

during the 2008 calendar year. The remaining six policies for loss of major

customer, expense reimbursement, loss of services, weather-related business

interruption, intellectual property package, regulatory changes, and product recall

had no retroactive dates.

B. 2009 Direct Written Policies

For 2009 Reserve issued 11 direct written insurance policies. Peak,

RocQuest, and ZW were the named insureds, and the policies were effective for

January 1, 2009, through January 1, 2010. Each policy listed PoolRe as the stop

loss insurer. The total premiums were $448,127. The direct written policies for

2009 did not include insurance for weather-related business interruption and

excess cyber risk as included in the 2008 direct written policies. Reserve issued

the following policies for 2009:
 - 19 -

[*19] Name of policy Combined premium Aggregate policy limit

Excess Directors & Officers Liability $17,075 $1,000,000
Special Risk--Loss of Major Customer 50,625 500,000
Special Risk--Expense Reimbursement 26,686 1,000,000
Special Risk--Loss of Services 62,791 1,000,000
Excess Pollution Liability 60,750 500,000
Special Risk--Tax Liability 45,562 500,000
Excess Intellectual Property Package 34,425 1,000,000
Special Risk--Regulatory Changes 47,588 500,000
Special Risk--Punitive Wrap Liability 40,500 500,000
Legal Expense Reimbursement 26,687 1,000,000
Special risk--Product Recall 35,438 500,000
Total 448,127 8,000,000

On January 1, 2009, an Atlas employee executed the 2009 policies on

Reserve’s behalf. During 2009 Capstone formed its own licensed insurance

management company in Anguilla, and Capstone replaced Atlas with its own

employee to serve as Reserve’s resident insurance manager and authorized

representative.

C. 2010 Direct Written Policies

For 2010 Reserve issued 11 direct written policies. Peak, RocQuest, and

ZW were the named insureds. Each policy listed PoolRe as the stop loss insurer.

On January 1, 2010, a Capstone employee executed the policies as Reserve’s
 - 20 -

[*20] authorized representative. The effective policy period for the 2010 policies

was January 1, 2010, through January 1, 2011, and the total premiums were

$445,314. Reserve issued the following policies for 2010:

Name of policy Combined premium Aggregate policy limit

Excess Directors & Officers Liability $17,075 $1,000,000
Special Risk--Loss of Major Customer 47,812 500,000
Special Risk--Expense Reimbursement 23,024 1,000,000
Special Risk--Loss of Services 62,791 1,000,000
Excess Pollution Liability 60,750 500,000
Special Risk--Tax Liability 45,562 500,000
Excess Intellectual Property Package 34,425 1,000,000
Special Risk--Regulatory Changes 47,588 500,000
Special Risk--Punitive Wrap Liability 40,500 500,000
Legal Expense Reimbursement 30,349 1,000,000
Special Risk--Product Recall 35,438 500,000
Total 445,314 8,000,000

D. Claims Under Direct Written Policies

The only claim made under one of Reserve’s direct written policies was

made in 2009. Peak made a claim under the policy for loss of a major customer.

The date of occurrence for the claim was January 5, 2009, according to a notice of

claim filed on April 6, 2009. The claim notice reported a reduction of orders from
 - 21 -

[*21] Stillwater Mining Co. that reportedly resulted in a 16% reduction in Peak’s

sales for that period. The claim as reflected on the claim notice was for $164,820.

On April 21, 2009, Reserve issued Peak a check for $150,000. The check

was drawn on Reserve’s bank account at AmericanWest Bank in Wallace, Idaho.

Jill Howard (Howard), a Peak employee, signed the check. On May 27, 2009,

Reserve and Peak executed a settlement and release agreement in which Reserve

agreed to pay the calculated value of $164,820 for Peak’s loss of customer claim.

On that date Reserve issued a second check, which Howard signed, from its

AmericanWest bank account to Peak for $14,820. The claim notice indicates that

on June 29, 2009, Reserve closed the claim for the Stillwater loss.

The claim notice states that Reserve reopened the claim for the Stillwater

loss on account of extended losses on August 25, 2009. On September 10, 2009, a

third check that Howard signed for $175,000 was issued from the AmericanWest

bank account to Peak. After the tax years in issue, on January 30, 2012, Reserve

and Peak executed an addendum to the settlement and release agreement, which

stated that the amount to be paid in connection with the Stillwater loss was

$339,820 and that the amount had been paid already. Reserve paid all amounts to

Peak for the Stillwater loss out of its own funds.
 - 22 -

[*22] IV. PoolRe, the Quota Share Arrangement, and the CreditRe Reinsurance
Arrangement

A. PoolRe’s Stop Loss Endorsements

In 2008 PoolRe was domiciled in the British Virgin Islands. Stephen

Friedman was the owner of PoolRe. In 2009 PoolRe redomiciled in Anguilla, and

starting on April 15, 2009, and through 2010 it held a Class B insurance license in

Anguilla. PoolRe had no employees in Anguilla or in the United States. Capstone

administered PoolRe’s operations and maintained the books and records for

PoolRe. Zumbaum was unaware of what Reserve did in Anguilla during the tax

years in issue.

For each of the tax years in issue Reserve and PoolRe executed a Joint

Underwriting Stop Loss Endorsement (stop loss endorsement), which by its terms

applied to all of the direct written policies that Reserve issued. Pursuant to the

stop loss endorsements, PoolRe agreed to serve as a joint underwriter and stop loss

insurer for the direct written policies. Reserve was the lead insurer with respect to

the policies, and PoolRe assumed an amount of excess risk.

According to the terms of the stop loss endorsement for each of the tax

years in issue, PoolRe would receive a percentage of the total combined premiums

due from the insureds under Reserve’s direct written policies. Pursuant to the
 - 23 -

[*23] 2008 and 2009 stop loss endorsements, 81.5% of the premiums charged for

the direct written policies was to be paid to Reserve as lead insurer, and the

remaining 18.5% was to be paid to PoolRe as stop loss insurer. The terms of the

2010 stop loss endorsement were modified and provided that Reserve would

receive 80.1% of the combined premiums under the direct written polices and

PoolRe would receive 19.9%.

Under the terms of the stop loss endorsements for all tax years in issue,

PoolRe’s obligation to pay on claims made against Reserve’s direct written

policies arose only if a total claims threshold was exceeded, and according to the

endorsements PoolRe was obligated to cover a certain amount of payments in

excess of that threshold. The 2008 and 2009 stop loss endorsements provided that

PoolRe would have no liability until claims reported under the direct written

policies exceeded 100% of the total combined premiums due under the policies

and one of four attachment points occurred.

Under the 2008 and 2009 stop loss endorsements attachment points were

triggered when a certain number of losses reached a set amount. For example, the

first attachment point described in the stop loss endorsements was reached when

the lead insurer received two original loss claims for events of $100,000 or more,

and the fourth attachment point was reached when the lead insurer received five
 - 24 -

[*24] claims of $20,000 or more for separate events. PoolRe’s participation level

under the 2008 and 2009 stop loss endorsements, i.e., the total amount it might

have to pay, was expressly limited to the lesser of: (1) the amount of the claim

that exceeded the appropriate attachment point, (2) 150% of the combined direct

written premiums, or (3) the named insureds’ pro rata share of the total current

year loss funding pool up to a maximum of 125% of the stop loss insurer’s

combined premium revenue from all current year stop loss coverage.

Under the modified 2010 stop loss endorsement PoolRe’s liability to pay on

claims made against Reserve’s direct written policies arose when all reported

claims exceeded 35% of total combined premiums. For reported claims above the

35% threshold the 2010 stop loss endorsement provided that PoolRe was liable to

pay 50%, and PoolRe’s participation level was limited to 100% of total combined

premiums.

PoolRe entered into stop loss endorsements for insurance policies that other

Capstone entities issued. During the tax years in issue PoolRe entered into

endorsements for around 400 policies that between 51 and 56 Capstone clients

issued and that covered in the aggregate around 150 insureds. The terms of the

stop loss endorsements that PoolRe executed with Reserve and with the other

Capstone entities were similar.
 - 25 -

[*25] B. Quota Share Policies

PoolRe pooled the premiums that it was entitled to receive under the stop

loss endorsements, and it executed reinsurance agreements designed to redistribute

them to the Capstone entities. For each of the tax years in issue Reserve and the

other Capstone entities each executed with PoolRe a Quota Share Reinsurance

Policy (quota share policy). Pursuant to their respective quota share policies

Reserve and each of the other Capstone entities agreed to assume coverage for a

specified portion (quota share) of the risks that PoolRe had assumed according to

the terms of the stop loss endorsements (stop loss pool).

The quota share that Reserve assumed under the quota share policy for each

tax year in issue was calculated so that Reserve was entitled to receive payments

from PoolRe equal to the premiums that PoolRe was entitled to receive from Peak

and the other insureds pursuant to the stop loss endorsement. Pursuant to the stop

loss endorsement for 2008 PoolRe was to receive premiums of $76,236,

representing 18.5% of the total combined premiums that Peak and the other

insureds were charged under the direct written policies. Under the 2008 quota

share policy PoolRe agreed to pay Reserve reinsurance premiums of $76,236 for

assuming approximately 1.35% of PoolRe’s stop loss pool. Reserve’s general

ledger reflects that Reserve bore no losses under the quota share policy for 2008.
 - 26 -

[*26] It reflects that Reserve received payments from PoolRe for the 2008 quota

share policy that totaled $76,236, which were designated in the ledger as

reinsurance premiums.

For 2009 and 2010 Reserve recorded no losses in connection with the quota

share policies. Reserve’s general ledger reflects that it received payments

pursuant to the 2009 quota share policy of $82,903, which equaled the percentage

of premiums that PoolRe was entitled to receive for the 2009 stop loss

endorsement (i.e., 18.5% of $448,127) from Peak and the other insureds. PoolRe

was due to receive premiums of $88,617 under the 2010 stop loss endorsement

(i.e., 19.9% of $445,314) from Peak and the other insureds, and pursuant to the

2010 quota share policy PoolRe agreed to pay Reserve $88,617 for assuming

about 1.44% of the stop loss pool.

C. CreditRe Reinsurance Arrangement

For the tax years in issue Reserve executed with PoolRe a Credit Insurance

Coinsurance Contract (coinsurance contract), under which Reserve agreed to

assume a small portion of risk that PoolRe had agreed to assume from an unrelated

company, CreditRe Reassurance Corp., Ltd. (CreditRe). Gary Fagg owned

CreditRe, which had no employees. CreditRe had no knowledge of Reserve’s

formation or operations.
 - 27 -

[*27] The coinsurance contracts recited that, pursuant to a preexisting reinsurance

treaty, CreditRe ceded to PoolRe for the tax years in issue a pro rata share of the

liability and premiums associated with a large pool of vehicle service contracts.

According to statements in the coinsurance contracts, the vehicle service contracts

in the pool originated from Lyndon Property Insurance Co. (Lyndon), a large U.S.-

based direct writer of insurance. An exhibit prepared in connection with

Reserve’s Form 1024, Application for Recognition of Exemption Under Section

501(a), represents that Lyndon ceded the alleged vehicle contracts to ARIA

(SAC), Ltd. (ARIA), a Bermuda-domiciled insurance company.

According to Fagg ARIA then ceded a portion of the liability for the vehicle

service contracts to CreditRe, which ceded a small portion to PoolRe. The

coinsurance contracts provided that PoolRe would cede shares of its portion of the

liability for the vehicle service contracts to Reserve. The terms of the coinsurance

contracts required Reserve to reinsure 0.9946%, 1.1576%, and 0.9100% of the

annualized liability of PoolRe for the tax years in issue, respectively. PoolRe

executed similar coinsurance contracts involving the vehicle services contracts

with other Capstone entities during the tax years in issue.
 - 28 -

[*28] V. Reserve’s Tax Returns

On its tax returns filed for the tax years in issue Reserve reported that it

used the accrual method of accounting. For each of the tax years in issue Reserve

elected to be treated as a domestic insurance company pursuant to section 953(d).

For tax year 2008 it filed Form 990-EZ, Short Form Return of Organization

Exempt From Income Tax, and for tax years 2009 and 2010 it filed Forms 990,

Return of Organization Exempt From Income Tax.

On the Form 990-EZ for 2008 Reserve reported program service revenue of

$481,589 and total expenses of $179,811. It reported a small amount of revenue

attributable to investment income. All expenses reported for 2008 were “other

expenses” and were detailed on an attached schedule. The attached schedule

identified expenses for management and legal fees, office expenses, depreciation,

travel, reinsurance commissions, and loss expenses.

On its 2009 Form 990 Reserve reported program service revenue of

$524,627. It also reported revenue from investment income and “other revenue”.

For 2009 it reported total expenses of $517,514. Part IX, Statement of Functional

Expenses, of the 2009 Form 990 listed expenses for management and legal fees,

office expenses, depreciation, conferences, conventions, and meetings, reinsurance

commissions, loss expenses, licenses and Government fees, and “other expenses”.
 - 29 -

[*29] On its 2010 Form 990 Reserve reported program service revenue of

$511,314, and reported investment income and “other revenue”. For 2010 it

reported total expenses of $164,768. Part IX of the 2010 Form 990 listed

expenses for management and legal fees, office expenses, depreciation,

conferences, conventions, and meetings, reinsurance commissions, loss expenses,

licenses and government fees, and “other expenses”.

On August 31, 2009, Zumbaum submitted on behalf of Reserve a Form

1024, requesting recognition as a tax-exempt organization. At a later date Reserve

withdrew its application.

VI. Reserve’s Financial Statements

For tax years 2009 and 2010 statutory financial statements required by and

in compliance with Anguillan law were filed with the Financial Services

Commission on Reserve’s behalf.2 Liptz & Associates (Liptz) prepared and filed

these financial statements. David Liptz, a licensed certified public accountant,

was head of Liptz, and he and his firm performed audits of Reserve for the tax

years in issue. During the tax years in issue Reserve met the minimum solvency

margin requirements under Anguillan law.

2
The Anguilla Financial Services Commission waived the requirement to
file an audited financial statement for 2008 because Reserve was not incorporated
until the fourth quarter of that year.
 - 30 -

[*30] VII. Notice of Deficiency

On March 29, 2016, respondent issued Reserve a notice of deficiency for

the tax years in issue (notice). In the notice respondent determined that Reserve

was not a tax-exempt insurance company within the meaning of section

501(c)(15). Respondent determined that Reserve’s insurance and reinsurance

transactions lacked economic substance and in the alternative that it was not an

insurance company within the meaning of subchapter L of the Code because its

predominant activity was not insurance.

Respondent determined that Reserve was not eligible to make an election

under section 953(d) to be treated as a domestic corporation and that Reserve was

required to file Forms 1120-F, U.S. Income Tax Return of a Foreign Corporation,

for the tax years in issue. The notice stated that substitutes for returns had been

prepared for Reserve for the tax years in issue. The notice determined that the

amounts that Reserve reported as program service revenue for the tax years in

issue constituted taxable income.

The proposed tax liabilities in the notice were based on respondent’s

determination that the 30% withholding tax imposed by section 881(a) applied to

income that Reserve received for the tax years in issue. Respondent determined

that because Reserve had failed to file Forms 1120-F for the tax years in issue
 - 31 -

[*31] within 18 months of their respective due dates (as provided in section 6072)

it was barred from claiming all deductions and credits in computing its taxable

income.

OPINION

Generally, the taxpayer bears the burden of proving that the Commissioner’s

determinations set forth in the notice of deficiency are incorrect. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). Under section 7491(a) in certain

circumstances the burden of proof may shift from the taxpayer to the

Commissioner. Reserve does not contend that the burden of proof shifts to

respondent under section 7491(a) as to an issue of fact.

Both parties presented experts to support their respective positions. We

focus on the degree to which experts’ opinions are supported by the evidence. We

do not use titles because we do not wish to imply a greater deference to academic

experts than to industry experts. We do not discuss the opinion of any expert

which does not pertain to our factual conclusions.

I. Applicable Statutes

Section 501(a) and (c)(15) provides for the tax-exempt treatment of income

received by insurance companies that meet certain criteria. An insurance company

as defined in section 816(a) (other than a life insurance company) shall be exempt
 - 32 -

[*32] from tax if (1) its gross receipts for the taxable year do not exceed $600,000

and (2) more than 50% of its receipts consist of premiums. Sec. 501(a),

(c)(15)(A). Section 816(a) defines an insurance company as any company “more

than half of the business of which during the taxable year is the issuing of

insurance * * * or the reinsuring of risks underwritten by insurance companies.”

Pursuant to section 953(d) a foreign insurance company that is a controlled

foreign corporation, and which would qualify as an insurance company under

subchapter L of the Code if it were a domestic corporation, may make an election

to be treated as a domestic corporation for Federal income tax purposes. Reserve

made an election under section 953(d) for the tax years in issue. It filed returns

taking the position that it qualified as a tax-exempt insurance company under

section 501(c)(15).

Generally, section 881(a) imposes a 30% tax on amounts received from

sources within the United States by a foreign corporation as interest, dividends,

rents, salaries, wages, premiums, annuities, compensations, remunerations,

emoluments, and other fixed or determinable annual or periodical gains, profits, or

income. This withholding tax is limited to the amount not effectively connected

with the conduct of a trade or business within the United States. Sec. 881(a).
 - 33 -

[*33] II. Insurance Requirements

Reserve contends that it was engaged in the business of issuing insurance

and that it was a bona fide insurance company. Respondent contends that Reserve

was not an insurance company because its arrangement with Peak and the other

insureds was not insurance.

Neither the Code nor the regulations define insurance, and we are guided by

caselaw in determining whether a particular transaction constitutes insurance for

Federal income tax purposes. Avrahami v. Commissioner, 149 T.C. __, __ (slip

op. at 49) (Aug. 21, 2017). Courts have looked to four criteria in deciding whether

an arrangement constitutes insurance: (1) the arrangement involves insurable

risks; (2) the arrangement shifts the risk of loss to the insurer; (3) the insurer

distributes the risk among its policy holders; and (4) the arrangement is insurance

in the commonly accepted sense. Harper Grp. v. Commissioner, 96 T.C. 45, 58

(1991), aff’d, 979 F.2d 1341 (9th Cir. 1992); AMERCO & Subs. v. Commissioner,

96 T.C. 18, 38 (1991), aff’d, 979 F.2d 162 (9th Cir. 1992). These four

nonexclusive criteria establish a framework for determining the existence of

insurance for Federal income tax purposes. AMERCO & Subs. v. Commissioner,

96 T.C. at 38. We consider all of the facts and circumstances in the light of the
 - 34 -

[*34] criteria outlined above. See Rent-A-Center, Inc. v. Commissioner, 142 T.C.

1, 13-14 (2014). We will first look at the criterion of risk distribution.

A. Risk Distribution

Generally, risk distribution occurs when the insurer pools a sufficiently

large number of unrelated risks. Id. at 24. From the insurer’s perspective

insurance is a risk-distribution device, a mechanism by which the insurer pools

multiple risks of multiple insureds in order to take advantage of the “law of large

numbers”. R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. 209, 228 (2015).

Insuring many independent risks for numerous premiums serves to distribute risk.

Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987),

aff’g 84 T.C. 948 (1985). Risk distribution allows the insurer to reduce the

possibility that a single claim will exceed the amount taken in as premiums and set

aside for the payment of such a claim. Id.

In past cases we have focused on both the number of insureds and the total

number of independent risk exposures to determine whether an insurer distributed

risk. See Avrahami v. Commissioner, 149 T.C. at __ (slip op. at 64). We have

held that a captive insurer may effectively distribute risk even though it insures

only the risks of its commonly owned brother-sister entities. See Rent-A-Center,
 - 35 -

[*35] Inc. v. Commissioner, 142 T.C. at 24; Securitas Holdings, Inc. v.

Commissioner, T.C. Memo. 2014-225, at *26-*27.

In Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 24, we concluded that

the captive assumed and pooled premiums for “a sufficient number of statistically

independent risks” and achieved risk distribution because it issued policies for its

affiliates that covered more than 14,000 employees, 7,100 vehicles, and 2,600

stores in all 50 States. We found that the captive in Securitas Holdings v.

Commissioner, at *26-*27, distributed risk effectively where it provided worker’s

compensation coverage for more than 300,000 employees, automobile coverage

for more than 2,200 vehicles, and other coverages for more than 25 separate

entities. By contrast, in Avrahami v. Commissioner, 149 T.C. at __ (slip op. at

65), we found that the captive’s issuance of seven types of direct policies covering

exposures for four related entities was insufficient to distribute risk.

1. Direct Written Policies

During the tax years in issue Reserve issued between 11 and 13 direct

written policies for three insureds. According to Reserve, one company, Peak,

was the primary insured under all of the policies, even though the policies listed

Peak, Rocquest, and ZW. Peak operated two facilities in Osburn, had a maximum

of 17 employees, and maintained some machinery used to repair and fabricate
 - 36 -

[*36] mining equipment. It sold or serviced equipment used in 12 mines, and it

sold some equipment outside the United States.

The record establishes that the operations of the other two insureds were

insignificant. Only one document relating to either of these entities was included

with the background documents that Capstone used to produce the feasability

study. Rocquest owned real estate in three locations, all of which it leased to Peak

or another entity partly owned by Zumbaum and Weikel, and it had no employees.

ZW had no employees and owned no assets other than a small interest in a local

bar.

Reserve issued direct written policies for the tax years in issue that covered

between $8 and $13 million in potential losses, and most or all of the risk of loss

was associated with the business operations of just one insured. We conclude that

the number of insureds and the total number of independent exposures were too

few to distribute the risk that Reserve assumed under the direct written policies.

Like the taxpayer in Avrahami, Reserve in this case failed to achieve risk

distribution through the policies that it issued for its affiliated entities. See id.

2. The Reinsurance Agreements

Reserve contends that it distributed risk through the stop loss endorsements

and the quota share policies with PoolRe. During the tax years in issue around 55
 - 37 -

[*37] Capstone entities executed these same contracts with PoolRe, and these

contracts were referred to as the quota share arrangement. Under the quota share

arrangement PoolRe gave stop loss endorsements for the captives’ direct written

policies and agreed to assume an excess portion of the risks associated with those

policies. Simultaneously, the captives agreed to reinsure, and to receive premiums

for reinsuring, a share of blended risk from PoolRe’s stop loss pool. Reserve

contends that pursuant to the quota share arrangement it “insured hundreds of

unaffiliated insureds under hundreds of unaffiliated insurance policies.”

Reserve contends that it distributed risk through the coinsurance contracts.

According to the terms of these contracts it assumed liability for a fraction of the

pool of vehicle service contracts that CreditRe ceded to PoolRe for the tax years in

issue. Reserve contends that through the coinsurance contracts it earned

premiums for assuming risks “related to a large pool of many thousands of risks”.

Because of the payments that PoolRe agreed to make pursuant to the quota

share arrangement and the payments called for under the coinsurance contracts,

Reserve contends that over 30% of its gross premiums for each of the tax years in

issue was from providing insurance to unrelated parties. Reserve cites Harper

Grp. in support of its argument that its percentage of nonaffiliated premium

income is sufficient to satisfy the requirements of risk distribution. In Harper Grp.
 - 38 -

[*38] v. Commissioner, 96 T.C. at 59-60, we determined that the captive insurer

distributed risk because, in addition to insuring affiliated entities, the captive

provided coverage to and collected premiums from a “relatively large number of

unrelated insureds”. We considered the percentage of the captive’s gross

premiums that was derived from unrelated insurance business, and we found that

approximately 30% of the captive’s business came from insuring unrelated parties.

Id. We concluded that this fact demonstrated that the captive had “a sufficient

pool of insureds to provide risk distribution.” Id. at 60.

In cases where we held that the captive insurer achieved risk distribution by

insuring a sufficient number of unrelated parties, we also determined that the

transactions with the unrelated parties were insurance transactions for Federal

income tax purposes. Avrahami v. Commissioner, 149 T.C. at __ (slip op. at 66);

see also Harper Grp. v. Commissioner, 96 T.C. at 59-60; AMERCO & Subs. v.

Commissioner, 96 T.C. at 39-42. Before we can determine whether Reserve

effectively distributed risk through these agreements, we must determine whether

PoolRe was a bona fide insurance company. See Avrahami v. Commissioner, 149

T.C. at __ (slip op. at 66-67). In determining whether an entity is a bona fide

insurance company we have considered a number of factors, including:

(1) whether it was created for legitimate nontax reasons;
 - 39 -

[*39] (2) whether there was a circular flow of funds;

(3) whether the entity faced actual and insurable risk;

(4) whether the policies were arm’s-length contracts;

(5) whether the entity charged actuarially determined premiums;

(6) whether comparable coverage was more expensive or even available;

(7) whether it was subject to regulatory control and met minimum
statutory requirements;

(8) whether it was adequately capitalized; and

(9) whether it paid claims from a separately maintained account.

Id.; Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 10-13. We address the most

relevant factors in our analysis below.

PoolRe engaged in two sets of transactions during the tax years in issue: the

quota share arrangement and the coinsurance contracts. We will consider the facts

surrounding both in determining whether PoolRe was a bona fide insurance

company.

a. Quota Share Arrangement

Capstone managed PoolRe, and only Capstone entities participated in the

quota share arrangement. PoolRe had no employees. Reserve contends that

PoolRe’s stop loss pool was a mechanism whereby risks associated with the stop
 - 40 -

[*40] loss endorsements were pooled and blended and that blended risk was ceded

back to the Capstone entities. Reserve’s expert Neil Doherty concluded that

“virtually all the exposure assumed by any captive under the quota share

reinsurance is entirely unrelated to the captive’s affiliate”.

Doherty explained that the pooled insurance risk of PoolRe is reinsured

back to the Capstone captives on a proportional basis, which has the effect that the

captives, such as Reserve, insure the smaller losses of their affiliates, but pool the

larger losses so that each captive ends up bearing less than one-fiftieth of the

larger loss. He concluded that this arrangement enabled Reserve to spread its risks

across a large pool of unrelated parties, providing a wide distribution of risk.

Respondent contends that the quota share arrangement provided the

appearance of risk distribution without actually distributing any risk. Respondent

argues that PoolRe is not a bona fide insurance company because Reserve’s

arrangement with PoolRe did not distribute risk. Respondent argues that

Reserve’s arrangement with PoolRe did not distribute risk because PoolRe was not

a bona fide insurance company.

i. Circular Flow of Funds

Under its quota share policies Reserve was to receive reinsurance premiums

equal to the direct written premiums that its affiliated insureds owed PoolRe under
 - 41 -

[*41] the stop loss endorsements. Reserve never recorded and it does not contend

that it had any losses or expenses in connection with its purported quota share

liabilities. Accordingly, the end result for each tax year under the quota share

arrangement was that Reserve would receive payments from PoolRe in exactly the

same amount as the payments that PoolRe was entitled to receive from Peak and

the other insureds for the stop loss coverage. In considering a very similar set of

circumstances in Avrahami v. Commissioner, 149 T.C. at __ (slip op. at 68), we

concluded that “[w]hile not quite a complete loop, this arrangement looks

suspiciously like a circular flow of funds.”

ii. Arm’s-Length Contracts

The perfect matching of payments under the corresponding stop loss

endorsements and quota share policies (from insureds to PoolRe, and from PoolRe

to captives) indicates that the quota share arrangement was not the product of

arm’s-length considerations. Peak’s risks that were insured through PoolRe were

different from the risks that PoolRe ceded to Reserve under the quota share

policies. The risks that PoolRe purported to assume under the stop loss

endorsements related to various unrelated business activities and to policies

covering various unrelated lines of insurance. Reserve has not shown that the

risks were comparable in scale.
 - 42 -

[*42] The same amount that Peak and the other insureds were obligated to pay

PoolRe for the stop loss coverage was to be paid to Reserve pursuant to the quota

share arrangement. Reserve has not explained why these amounts were the same.

It has not explained how all Capstone clients in the quota share arrangement

would be able to transfer a particular set of risks (i.e., those associated with their

affiliated insureds) and assume in exchange a blended portion of completely

different risks for exactly the same premium price.

Reserve did not produce evidence which shows the risks of other Capstone

entities. It did not provide evidence regarding their industries, locations,

operations, types of risks, and exposure to risk. The evidence shows that the stop

loss pool was divided among the captives so that reinsurance premiums equaled

the portion of direct premiums paid by each captive’s affiliated insureds. We

conclude that the amounts that PoolRe was to pay Reserve under the quota share

arrangement were not determined at arm’s length or using objective criteria.

iii. Actuarially Determined Premiums

According to a letter from Glicksman Consulting, LLC, to Capstone,

PoolRe charges premiums that are a flat percentage of the gross direct written

premiums. Reserve produced no evidence to support the calculation of the

premiums. There is no evidence regarding the other Capstone entities that
 - 43 -

[*43] participated in the quota share arrangement which shows the industries and

the risks involved and the specific amounts of exposure.

According to the evidence, all participants in the quota share arrangement

agreed to direct their affiliated insureds to pay the same percentage of direct

written premiums to PoolRe. As in Avrahami v. Commissioner, 149 T.C. at __

(slip op. at 69), we are concerned with a one-size-fits-all rate for all the

participants in the quota share arrangement.

iv. Faced Actual and Insurable Risk

Under the terms of the direct written policies Reserve was liable for claims

not covered by “any other valid and collectible insurance policy issued by any

other insurer”. Peak maintained extensive commercial insurance coverage with

third-party insurers. Under the stop loss endorsements PoolRe was liable on

claims made under the direct written policies only after a substantial claims

threshold was exceeded.

Coverage under the stop loss endorsements was not triggered until claims

reached 100% of total combined premiums in 2008 and 2009 and 35% of total

combined premiums in 2010 (after which PoolRe would be obligated to pay 50%

of claims made). The total combined premium amounts for the tax years in issue

were $412,089, $448,127, and $445,314, respectively. Reserve could identify
 - 44 -

[*44] only one occurrence before the tax years in issue when Peak tried to collect

on an insurance claim with its third-party commercial insurers. EMC agreed to

pay only $2,000 and Peak had to pay $25,000 for repairs to the damaged roof.

This amount was significantly below the combined total premiums to be paid by

the insureds for each tax year in issue and significantly below the claims threshold

that would trigger PoolRe’s liability under the stop loss endorsements.

Reserve cited the additional taxes that Peak paid after its returns were

reviewed by an accounting firm, and it contends that this was a loss that the direct

written policies and stop loss endorsements were designed to cover. However,

Reserve provided no evidence of the amount of that purported loss or the

likelihood that something like it would happen again. The available history of

losses for Peak and the other insureds shows that before the tax years in issue they

never suffered any losses that would even come close to triggering the stop loss

coverage provided for in the stop loss endorsements. PoolRe was removed far

from any actual risk associated with the business or operations of Reserve’s

insureds.

v. Licensed and Regulated as an Insurance Company

Reserve provided evidence that PoolRe obtained a Class B insurance license

after it redomiciled in Anguilla, starting April 15, 2009. However, it did not
 - 45 -

[*45] provide evidence that PoolRe was a licensed and regulated insurer before

that time. The record establishes only that PoolRe was a corporation in good

standing in the British Virgin Islands before it reincorporated in Anguilla.

Reserve executed both its 2008 and 2009 reinsurance agreements with PoolRe

before it obtained an insurance license in Anguilla.

vi. Created for Legitimate Nontax Reasons

Reserve contends that PoolRe, through the quota share arrangement,

operated for the purpose of distributing risk for the Capstone entities. All the facts

and circumstances in this case indicate that Reserve did not enter into the quota

share arrangement with the intention of distributing its risk. For each of the tax

years in issue the arrangement cycled a portion of the premiums that Peak paid

under the direct written policies from one controlled entity to another, Reserve,

and Reserve was not taxed on the income pursuant to section 501(c)(15). The

only purpose PoolRe served through the quota share arrangement was to shift

income from Peak to Reserve. Reserve has not established that PoolRe was

created or operated for legitimate nontax reasons.

vii. Conclusion

We conclude that the facts surrounding Reserve’s quota share policies with

PoolRe establish that those agreements were not bona fide insurance agreements.
 - 46 -

[*46] The quota share arrangement involved a circular flow of funds. The

premiums were not negotiated at arm’s length. All the insureds of the participants

in the quota share arrangement were obligated to pay the same percentage of

premiums to PoolRe. There is no evidence that the premiums Peak and the other

insureds were obligated to pay PoolRe and the premiums that PoolRe was

obligated to pay Reserve were actuarially determined. PoolRe’s activities as they

relate to those policies were not those of a bona fide insurance company.

b. Coinsurance Contracts

The risks associated with the coinsurance contracts purportedly related to a

large pool of vehicle service contracts that a large insurance provider had

originally underwritten. According to documents that Reserve provided and

testimony of its witnesses, the liabilities for these vehicle service contracts were

pooled and ceded down a chain of entities, and ultimately CreditRe ceded a

portion of the pooled risk to PoolRe. The coinsurance contracts provided that

PoolRe ceded portions of its liability for the vehicle service contracts to Reserve.

Reserve contends that liability for the pool of vehicle service contracts

generated losses that offset premiums received during the tax years in issue. It

failed to provide evidence that the vehicle service contracts, which formed the

basis for the reinsurance that PoolRe re-ceded in the coinsurance contracts,
 - 47 -

[*47] actually existed. Fagg described a series of ceding transactions (i.e., from

Lyndon to ARIA, from ARIA to CreditRe, and from CreditRe to PoolRe). Even if

we agree with Reserve about the validity of the coinsurance contracts, any actual

risk that PoolRe had in connection with the vehicle service contracts was de

minimis, because PoolRe assumed liability for a small, blended portion of the

overall pool of vehicle service contracts, and it re-ceded most or all of that liability

to the Capstone entities. The amount ceded to Reserve was also de minimis.

On the basis of the relevant facts and circumstances we conclude that the

coinsurance contracts were not bona fide reinsurance agreements. Reserve has not

established that the contracts underlying the purported reinsurance transactions

existed or that the transactions involved actual risk.

c. Conclusion

We conclude that PoolRe was not a bona fide insurance company. The

purported reinsurance agreements between it and Reserve did not allow Reserve to

effectively distribute risk. Neither through the policies it issued for its affiliated

entities nor through its agreements with PoolRe did Reserve achieve risk

distribution. Risk distribution is a necessary component of insurance, and its

absence in this case is sufficient for us to conclude that Reserve’s transactions

during the tax years in issue were not insurance transactions. See Avrahami v.
 - 48 -

[*48] Commissioner, 149 T.C. at __ (slip op. at 76); see also AMERCO & Subs. v.

Commissioner, 96 T.C. at 40 (holding that risk-shifting and risk-distributing “are

necessary to the existence of insurance” (citing Gulf Oil Corp. v. Commissioner,

89 T.C. 1010, 1023 (1987), aff’d, 914 F.2d 396 (3d Cir. 1990))).

B. Insurance in the Commonly Accepted Sense

The absence of risk distribution is enough to conclude that the transactions

between Reserve and its insureds were not insurance transactions. An alternative

ground for this holding is that they did not constitute insurance in the commonly

accepted sense. See Avrahami v. Commissioner, 149 T.C. at __ (slip op. at 76).

To determine whether an arrangement constitutes insurance in its commonly

accepted sense we look at a number of factors, including whether the company

was organized, operated, and regulated as an insurance company; whether it was

adequately capitalized; whether the policies were valid and binding; whether the

premiums were reasonable and the result of an arm’s-length transaction; and

whether claims were paid. R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. at

231; Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 24-25; Harper Grp. v.

Commissioner, 96 T.C. at 60.

Reserve contends that it was formed for a valid business purpose, the

issuance of insurance contracts. It further contends that each of the contracts at
 - 49 -

[*49] issue meets all the requirements for an arrangement that constitutes

insurance in the commonly accepted sense. In support of its argument Reserve

contends that we should consider 39 determination letters that the Commissioner

issued to other unrelated taxpayers concerning tax-exempt status under section

501(c)(15). Reserve contends that its captive insurance arrangement is similar to

the 39 other arrangements for which the Feldman firm received approval of an

application for tax-exempt status.

Respondent contends that Reserve did not provide insurance in the

commonly accepted sense. Respondent further contends that Peak’s premium

payments to Reserve were made at the direction of Zumbaum and Weikel in order

to reduce Peak’s profits.

We will not rely upon the 39 determination letters in our consideration of

whether Reserve offered insurance in the commonly accepted sense. These

determinations cannot be used as precedent, see sec. 6110(k)(3), but they may be

instructive for revealing the “interpretation put upon the statute by the agency

charged with responsibility of administering the revenue laws”, Hanover Bank v.

Commissioner, 369 U.S. 672, 686 (1962).
 - 50 -

[*50] 1. Organization, Operation, and Regulation

Reserve was incorporated as an insurance company in Anguilla, and it was

regulated by the Financial Services Commission of Anguilla. Generally, it

complied with the requirements of Anguillan law. It obtained an insurance

license, filed financial statements with regulators, satisfied minimum capitalization

requirements, and maintained a business address in Anguilla. Apart from

observing these formalities, however, the facts demonstrate that Reserve was not

operated as an insurance company.

Reserve’s planning, incorporation, and operations during the tax years in

issue were managed entirely by Capstone. Reserve had no employees of its own

that performed services. Zumbaum, Reserve’s 50% owner, president, and chief

executive officer, knew virtually nothing about its operations. At trial he showed

very little knowledge of provisions in the policies that Peak and his other entities

held with Reserve. Zumbaum did not know how claims were made or handled,

and he did not know where or how Reserve’s records were kept. Reserve’s

operations were managed at Capstone’s direction. It maintained an address in

Anguilla, but there is no evidence that any activities were ever performed there.

Other than the feasibility study that Capstone produced, there is no evidence

that any due diligence was performed for the policies that Reserve issued. The
 - 51 -

[*51] feasibility study gave an overview of Peak’s operations, and some

background documents relating to Peak’s operations were attached to the

feasibility study. However, many of the background documents covered periods

after Reserve’s incorporation. The feasibility study was not complete when

Reserve issued the direct written policies for 2008 or 2009. The feasibility study

did not provide details about the other insureds, Rocquest and ZW, and they were

parties under every policy that Reserve issued. These two entities were named as

insureds on policies that did not seem to apply to their limited activities.

There is no evidence that Reserve performed any due diligence with respect

to the reinsurance agreements that it executed with PoolRe. With respect to the

quota share arrangement it agreed to assume risks relating to a number of different

businesses and a number of different lines of insurance. Nothing in the record

indicates that Reserve or anyone performing activities on Reserve’s behalf

evaluated these risks before executing the quota share policies.

Capstone managed both Reserve and PoolRe, and they were both parties to

the quota share policies and the coinsurance contracts. Reserve contends that the

reinsurance agreements allowed it to distribute risk. However, Reserve did not

show that anyone with a financial interest in its operations considered the details

of the quota share policies and the coinsurance contracts and considered whether
 - 52 -

[*52] risk was distributed. Zumbaum did not understand the details of Reserve’s

operations and relied upon Capstone’s advice. There is no evidence that Reserve

engaged in any due diligence to determine whether it was adequately distributing

risk.

Only one claim was filed under Reserve’s direct written policies. A claim

notice was generated for the Stillwater loss, but no supporting documentation

accompanied the claim notice. Peak did not submit and Reserve did not insist on

obtaining any documents to substantiate the occurrence or the amount of the

claimed loss. The first payment for the Stillwater loss was made out of Reserve’s

bank account more than a month before Reserve and Peak executed the settlement

and release agreement. Peak received another large payment out of Reserve’s

bank account several months after the execution of the settlement and release

agreement. Reserve did not execute an addendum to the settlement and release

agreement reflecting this payment until years after the tax years in issue. All

payments for the Stillwater loss were made by checks that Howard, a Peak

employee, signed.

In considering whether Reserve operated as an insurance company, we

“look beyond the formalities and consider the realities of the purported insurance

transactions”. Hosp. Corp. of Am. v. Commissioner, T.C. Memo. 1997-482, slip
 - 53 -

[*53] op. at 59 (citing Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835,

842-843 (6th Cir. 1995), rev’g T.C. Memo. 1989-604). In reality the interested

parties to Reserve’s insurance transactions did not participate in structuring or

executing those transactions; little or no due diligence was performed with respect

to the direct written policies or the reinsurance agreements; and for all of the tax

years in issue only one claim was filed under Reserve’s policies, and that claim

was handled in an irregular manner. Capstone directed Reserve’s activities and

directed a series of transactions between its managed entities so that Reserve

appeared to be engaged in the business of issuing insurance contracts. The facts

establish that Reserve was not operated as an insurance company in the commonly

accepted sense.

2. Adequate Capitalization

During the tax years in issue Reserve met the minimum capitalization

requirements of Anguilla. Generally our caselaw holds that meeting the statutory

requirements of the captive’s domicile jurisdiction is sufficient to show that the

captive was adequately capitalized. See Avrahami v. Commissioner, 149 T.C. at

__ (slip op. at 80-81); R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. at 231;

Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 13, 23-24; Harper Grp. v.

Commissioner, 96 T.C. at 50, 60.
 - 54 -

[*54] 3. Valid and Binding Policies

To be valid and binding an insurance policy should, at a minimum, identify

the insured, define an effective period for the policy, specify what is covered by

the policy, state the premium amount, and be signed by authorized representatives

of the parties. See Avrahami v. Commissioner, 149 T.C. at __ (slip op. at 81);

Securitas Holdings v. Commissioner, at *28. In R.V.I. Guar. Co. & Subs. v.

Commissioner, 145 T.C. at 231, we held that policies were valid and binding

where the insureds filed claims for all covered losses and the captive paid them.

Generally, Reserve’s direct written policies contained the necessary terms to

make them valid and binding insurance, and they were signed by representatives

of Reserve and the insureds. We agree with respondent, however, that the direct

written policies were “cookie cutter” policies. The policies on their face indicate

that they were the copyrighted material of Capstone, and Capstone employees

testified at trial that they administered many of the same policies for all of their

clients. In many instances the policies were not reasonably suited to the needs of

the insureds, particularly Rocquest and ZW, both of which had extremely limited

operations.

Peak did file one claim under one of the direct written policies, and Reserve

paid the claim. However, the evidence of this claim that Reserve provided does
 - 55 -

[*55] not show that either party performed due diligence to determine whether the

claim was actually covered by the relevant policy. Payment of the claim on

Reserve’s behalf was handled by an employee of Peak. Evidence regarding the

validity of Peak’s policies is mixed, and we conclude it is a neutral factor.

4. Reasonableness of Premiums

Reserve put forward experts to opine that the premiums charged for its

direct written policies during the tax years in issue were reasonable. Capstone

employees, particularly McNeel, were responsible for determining the premium

amounts for the policies. Zumbaum and Weikel always approved the amounts that

Capstone advised, and Zumbaum testified that he was aware that the amounts

would generate substantial deductions for Peak.

In preparing the rating worksheets for Reserve’s policies, McNeel used

rating bases specific to Peak’s business, and he applied base rates that were within

ranges shown on Capstone’s base rate spreadsheet. McNeel produced the base

rate spreadsheet by reviewing the premiums that other Capstone entities had

charged for various lines of coverage. Capstone obtained pricing indications from

employees of Mid-Continent. McNeel testified that these indications were critical

to Capstone’s pricing methodology and were used to establish the base rates for

policies shown on the base rate spreadsheet.
 - 56 -

[*56] Despite the methodology that Reserve has shown Capstone used internally

to calculate premiums, there are a number of factors which indicate that the

premiums that the insureds were required to pay under the direct written policies

were not reasonable in relation to the risk of loss. For 2007 Peak paid insurance

expenses of $95,828. For 2008 Peak and two affiliates that had no active business

operations were obligated to pay premiums of $412,089, and this was in addition

to the premiums that Peak continued to pay for third-party commercial insurance.

Reserve’s policies covered only losses that were not covered by Peak’s third-party

policies. Peak’s general liability policy with EMC had a policy limit of $2 million

and covered several major categories of risks, including personal injury and

products/completed operations liability.

Seven of the 2008 policies had retroactive dates. For 2008 the punitive

wrap liability policy was retroactive, and it had a combined premium of $55,233

and a policy limit of $1 million. For both 2009 and 2010 the premium for the

punitive wrap liability policy was $40,500 and the aggregate coverage was

$500,000. Reserve provided no explanation as to why the policy limit was

decreased to $500,000 and why a policy for four years with greater coverage cost

only approximately $15,000 more than a policy for one year with half the

coverage.
 - 57 -

[*57] Six of the 2008 policies had no look-back provisions. For 2008 the

regulatory changes policy had a policy period from December 4, 2008, to January

1, 2009, and the premium was $64,899 and the policy limit was $1 million. For

both 2009 and 2010 the premium for the regulatory changes policy had a premium

of $47,588 and a limit of $500,000. Reserve provided no explanation for why the

limit was reduced from $1 million for one month of coverage to $500,000 for a

year of coverage. It also provided no explanation why more was spent for one

month of insurance coverage than a year of coverage.

Reserve contends that Peak was on a Superfund site and could have been

exposed to pollution liability, for which no third-party coverage was available.

Peak itself did not engage in mining practices that spread pollutants, and it already

had systems in place to control the fluid runoff when it cleaned equipment used in

polluted mines. In 2008 Peak had operated in Osburn continuously for over 10

years. Reserve provided no evidence that Peak had ever incurred costs during that

time for excess pollution liability.

In his testimony Zumbaum indicated that EMC’s refusal in 2007 to cover

the full amount needed to repair Peak’s damaged roof was a reason for obtaining

additional insurance in 2008. He testified that Peak incurred a $25,000 expense to

repair the roof, although no documentation was produced to substantiate the
 - 58 -

[*58] amount of the loss. Zumbaum also testified about having to pay additional

taxes for tax years prior to the tax years in issue. His testimony did not include

how much additional tax was owed.

Despite Zumbaum’s purported discontent with EMC’s coverage, Peak

subsequently kept its policies with EMC. Reserve has failed to explain why Peak

would maintain its full set of third-party commercial insurance coverage, which it

contends was insufficient, even after it paid roughly 400% more for additional

coverage from Reserve. Zumbaum did not know which of Peak’s policies with

Reserve would have covered a loss like the one that was not covered by EMC in

February 2008.

Zumbaum testified that in 2007 Peak’s business was growing and that he

expected it to continue growing during the next few years. He testified that he and

Weikel had concerns about additional risks as the business grew. However, the

rating worksheets that Capstone produced for calculating Reserve’s premiums

reflect that Peak’s projected sales stayed the same for all of the tax years in issue.

Peak actually had fewer employees in 2010 than it did in 2008.

Reserve contends that if one of Peak’s products had failed then Peak would

have been liable. There is no convincing evidence that legitimate concerns about

this kind of liability should have been greater in 2008 than in previous years, and
 - 59 -

[*59] during the tax years in issue Peak continued to maintain substantial

commercial insurance coverage with third-party insurers. The feasibility study

provided no information on the probability of a loss event that the direct written

policies covered. It also did not explain in detail how the direct written policies

would supplement Peak’s existing insurance.

Peak filed only one claim under Reserve’s policies during the tax years in

issue, which occurred about one month after Reserve’s incorporation. For the

remainder of the tax years in issue Peak and the other insureds did not file any

claims or report any additional losses. This supports our conclusion that any

purported concerns about increased risks for the insureds were unfounded.

In cases involving brother-sister captive arrangements in which we

determined that the premiums charged were reasonable, we have also found that

the arrangement under scrutiny was undertaken principally to achieve a business

purpose. See, e.g., Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 3-5 (the

principal objective of the arrangement was to reduce costs, improve efficiency,

obtain otherwise unavailable coverage, and provide accountability and

transparency); Securitas Holdings v. Commissioner, at *7-*8 (finding the captive

insurance arrangement at issue provided more cost-effective insurance coverage

than would have otherwise been available). Generally, we conclude that
 - 60 -

[*60] premiums are reasonable when it can be shown that the amounts agreed

upon by the parties were the result of arm’s-length negotiations. See R.V.I. Guar.

Co. & Subs. v. Commissioner, 145 T.C. at 231-232; Harper Grp. v. Commissioner,

96 T.C. at 60. In determining whether an arrangement constitutes insurance in the

commonly accepted sense we consider more than whether the premiums chosen

can be arrived at by actuarial means. We consider whether the facts demonstrate

that the terms of the arrangement were driven by arm’s-length considerations. See

R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. at 234-235 (finding the

subject policies constituted insurance in the commonly accepted sense because the

policies’ terms “correspond to, and are driven by, the characteristics and business

needs of the underlying * * * transactions”).

The facts do not reflect that Peak had a genuine need for acquiring

additional insurance during the tax years in issue. There was no significant history

of losses that would justify such a drastic increase, and Zumbaum’s testimony that

he was concerned about increased risks beginning in 2008 did not support a

significant increase in insurance coverage. All the direct written policies included

a provision that the coverage afforded by the policy would be valid only after

insurance coverage from other insurers was exhausted. Peak had never come close

to exhausting the policy limits of its third-party commercial insurance coverage.
 - 61 -

[*61] With respect to premiums, the facts and circumstances of this case

demonstrate that the direct written policies were not the result of arm’s-length

negotiations. Taking into consideration all the surrounding facts and

circumstances, we conclude that no unrelated party would reasonably agree to pay

Reserve the premiums that Peak and the other insureds did for the coverage

provided by the direct written policies. Although Capstone calculated Reserve’s

premiums using objective criteria and what appear to be actuarial methods, the

absence of a real business purpose for Reserve’s policies leads us to conclude that

the premiums paid for the polices were not reasonable and not negotiated at arm’s

length.

5. Payment of Claims

Reserve paid the one claim that Peak filed during the tax years in issue. As

we noted in connection with other factors, the circumstances surrounding the

payment of that claim were unusual. Although this factor weighs slightly in

Reserve’s favor, we do not regard the payments made in connection with the

Stillwater loss as overwhelming evidence that Reserve’s direct written or

reinsurance policies constituted insurance in the commonly accepted sense.
 - 62 -

[*62] 6. Conclusion

Reserve was organized and regulated as an insurance company, and it

satisfied the regulatory requirements of its domicile jurisdiction. It also paid a

claim filed under one of its policies. However, it was not operated as a bona fide

insurance company, and there was no legitimate business purpose for the policies

that Reserve issued for the insureds. The direct written policies increased Peak’s

insurance coverage and expenses for the tax years in issue, when it also continued

to hold policies with third-party insurers. In the light of all the facts and

circumstances the premiums charged for the policies were unreasonable. We

conclude that Reserve’s transactions were not insurance transactions in the

commonly accepted sense.3

III. Taxability of Reserve’s Revenue

We concluded that Reserve did not issue insurance or reinsurance contracts

during the tax years in issue and therefore it did not receive more than 50% of its

gross receipts from insurance premiums. See secs. 501(c)(15), 816(a). Because

Reserve is not an insurance company, it is not eligible to make an election under

section 953(d). Section 953(d) applies only to a foreign company which would

3
Since we conclude Reserve’s transactions were not insurance transactions,
we do not need to address respondent’s argument that Reserve’s insurance and
reinsurance arrangements lack economic substance.
 - 63 -

[*63] qualify as an insurance company under subchapter L of the Code if it were a

domestic corporation. See sec. 953(d)(1)(B).

Because Reserve was not eligible to make an election under section 953(d),

for the tax years in issue it should be treated as a foreign corporation. See sec.

953(d). For each of the tax years in issue Reserve reported the gross premiums for

the direct written policies and the reinsurance agreements as program service

revenue on Forms 990. For each of the tax years in issue Reserve also reported

revenue from investment income, and for 2009 and 2010 it reported “other

revenue”.

Section 881(a)(1) generally imposes a tax of 30% on “fixed or determinable

annual or periodical” income (FDAP income) received by a foreign corporation

from sources within the United States if the income is not effectively connected

with the conduct of a U.S. trade or business. FDAP income includes interest,

dividends, rents, salaries, wages, premiums, annuities, compensations,

remunerations, and emoluments. Sec. 881(a)(1). It includes all income included

in gross income under section 61, except for items specifically excluded by the

regulations. Sec. 1.1441-2(b)(1)(i), Income Tax Regs. The U.S. payors of FDAP

income are generally required to deduct and withhold therefrom an amount equal

to the tax imposed by sections 881. See secs. 1441 and 1442.
 - 64 -

[*64] In the notice respondent determined that the amounts reported as Reserve’s

program service revenue were taxable as FDAP income from sources within the

United States and were subject to the 30% withholding tax pursuant to section

881. Respondent conceded that the withholding tax should not apply to the

amounts for the tax years in issue which Reserve contends were gross premiums

received for the coinsurance contracts, which are $69,500, $76,500, and $66,000,

respectively. Respondent maintains that the remainder of Reserve’s self-reported

program service revenue is taxable under section 881.

Reserve contends that if the payments it received for the tax years in issue

were not for insurance, then amounts received from its affiliated insureds should

be treated as contributions to capital or nontaxable advances or deposits. It

contends that if we conclude that it had taxable revenue, then it is entitled to

deductions in computing its taxable income.

Reserve bears the burden of showing that the income it received is not

FDAP income as respondent determined in the notice. See Rule 142(a). Reserve

did not produce evidence which showed that the amounts at issue are not FDAP

income subject to the 30% tax. We reject Reserve’s contention that the amounts it

received during the tax years in issue were capital contributions or nontaxable

deposits.
 - 65 -

[*65] Zumbaum and Weikel capitalized Reserve shortly after its organization with

$100,000, as required by Anguillan law. The record does not reflect that the

parties to the purported insurance transactions treated or intended the amounts

paid to Reserve as additional capital contributions. See Bd. of Trade v.

Commissioner, 106 T.C. 369, 381 (1996) (holding that a payor’s motive controls

whether a payment is a contribution to capital). Reserve failed to specify why the

payments might otherwise be treated as nontaxable deposits. There is no evidence

indicating that the parties intended the payments as loans or gifts. See Neely v.

Commissioner, 85 T.C. 934, 952 (1985) (holding that the most critical

consideration in determining whether a transfer is a gift is the transferor’s

intention); Beaver v. Commissioner, 55 T.C. 85, 91 (1970) (holding that an

essential element of a loan is that the recipient intends to make repayment and the

person advancing the funds intends to enforce such repayment).

Reserve contends it should be allowed deductions for the tax years in issue.

It bears the burden of proof on this issue. See INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934). It contends that under section 1.882-4(a)(3)(ii), Income Tax Regs., it had

reasonable cause for filing Forms 990 rather than Forms 1120-F.
 - 66 -

[*66] However, even if Reserve established that it had reasonable cause for filing

incorrect returns, we would not conclude that it is entitled to deductions. Section

1.882-4(b)(1), Income Tax Regs., provides generally that deductions are allowed

to a foreign corporation only to the extent they are connected with gross income

which is effectively connected, or treated as effectively connected, with the

conduct of a trade or business in the United States. Reserve failed to establish that

it was engaged in or received income treated as income effectively connected with

a trade or business within the United States.

We sustain respondent’s determination in the notice that for the tax years in

issue Reserve had FDAP income from sources within the United States which is

subject to the 30% tax under section 881. Reserve has not met its burden of

proving its entitlement to any deductions.

To reflect the foregoing,

Decision will be entered

under Rule 155.