Reserve Mechanical Corp. v. CIR

Appellate Case: 18-9011         Document: 010110683986   Date Filed: 05/13/2022   Page: 1



                                          PUBLISH                     FILED
                                                          United States Court of Appeals
                           UNITED STATES COURT OF APPEALS         Tenth Circuit

                                 FOR THE TENTH CIRCUIT                      May 13, 2022
                             _________________________________
                                                                      Christopher M. Wolpert
                                                                          Clerk of Court
  RESERVE MECHANICAL CORP., f/k/a
  Reserve Casualty Corp.,

         Petitioner - Appellant,

  v.                                                          No. 18-9011

  COMMISSIONER OF INTERNAL
  REVENUE,

         Respondent - Appellee.

  --------------------------------

  ALABAMA CAPTIVE INSURANCE
  ASSOCIATION, INC.; ARIZONA
  CAPTIVE INSURANCE ASSOCIATON,
  INC.; DELAWARE CAPTIVE
  INSURANCE ASSOCIATION INC.;
  GEORGIA CAPTIVE INSURANCE
  ASSOCIATION, INC.; HAWAII
  CAPTIVES INSURANCE COUNCIL;
  KENTUCKY CAPTIVE ASSOCIATION,
  INC.; MISSOURI CAPTIVE
  INSURANCE ASSOCIATION;
  MONTANA CAPTIVE INSURANCE
  ASSOCIATION, INC.; NORTH
  CAROLINA CAPTIVE INSURANCE
  ASSOCIATION,; UTAH CAPTIVE
  INSURANCE ASSOCIATION; SELF
  INSURANCE INSTITUTE OF
  AMERICA,

         Amici Curiae.
                             _________________________________


                                              1
Appellate Case: 18-9011    Document: 010110683986         Date Filed: 05/13/2022    Page: 2



                  Appeal from the Commissioner of Internal Revenue
                                (CIR No. 014545-16)
                       _________________________________

 Val J. Albright, Foley & Lardner, LLP, Dallas, Texas (Michelle Y. Ku, Foley & Lardner,
 LLP, Dallas, Texas, E. John Gorman, Logan R. Gremillion, and Coby M. Hyman, The
 Feldman Law Firm LLP, Houston, Texas, with him on the briefs) for the Petitioner-
 Appellee.

 Geoffrey J. Klimas, Attorney, Tax Division (Richard E. Zuckerman, Principal Deputy
 Assistant Attorney General, Joshua Wu, Deputy Assistant Attorney General, Francesca
 Ugolini, Attorney, Arthur T. Catterall, Attorney, Tax Division, with him on the brief),
 Department of Justice, Washington, D.C., for Respondent-Appellee.

 Elizabeth J. Bondurant (Jonathan Reid Reich, with her on the brief), Womble Bond
 Dickinson (US) LLP, Atlanta, Georgia, filed a brief for Amici Curiae The Alabama
 Captive Insurance Association, Inc., Arizona Captive Insurance Association, Inc.,
 Delaware Captive Insurance Association Inc., Georgia Captive Insurance Association,
 Inc., Hawaii Captives Insurance Council, Kentucky Captive Association, Inc., Missouri
 Captive Insurance Association, Montana Captive Insurance Association, Inc., North
 Carolina Captive Insurance Association, Utah Captive Insurance Association, and Self
 Insurance Institute of America.
                         _________________________________

 Before HARTZ, HOLMES, and PHILLIPS, Circuit Judges.
                   _________________________________

 HARTZ, Circuit Judge.
                          _________________________________

       Reserve Mechanical Corp. appeals the decision of the Tax Court affirming the

 decision of the Commissioner of Internal Revenue that it did not qualify for an exemption

 from income tax as a small insurance company and that the purported insurance

 premiums it received must therefore be taxed at a 30% rate under I.R.C. § 881(a). We

 hold that the record supports the Tax Court’s decision that the company was not engaged

 in the business of insurance. The court had two grounds for deciding that Reserve was not

 an insurance company. First, it determined that Reserve had not adequately distributed

                                             2
Appellate Case: 18-9011     Document: 010110683986          Date Filed: 05/13/2022     Page: 3



 risk among a large number of independent insureds—a hallmark of any true insurance

 company. Virtually all the insured risk was that of one insured, a company that had the

 same ownership as Reserve itself. To appear to distribute risk, Reserve entered into an

 insurance pool with other purported insurance companies, each owned by an affiliate of

 its insured, but the arrangement lacked substance and the pool itself did not distribute

 risk. Second, the Tax Court determined that the policies issued by Reserve were not

 insurance in the commonly accepted sense. For example, the premiums were not the

 result of arm’s-length transactions and were not reasonable, and Reserve was not

 operated in the way legitimate insurance companies operate. In addition, Reserve argues

 that if it was not an insurance company, the premiums it received must be treated as

 nontaxable capital contributions. We also reject that argument.

        I.     OVERVIEW

        From 2008 to 2010, when Reserve Mechanical Corp. was known as Reserve

 Casualty Corp., it issued a number of insurance policies to Peak Mechanical Corp. Two

 men, Norman Zumbaum and Cory Weikel, owned both Reserve (through Reserve’s

 parent corporation, Peak Casualty) and Peak. Before these policies were issued, Peak had

 limited its insurance coverage to commercial policies that cost about $100,000 a year.

 Peak maintained those policies but also paid Reserve more than $400,000 a year for the

 supplemental insurance obtained through the new policies. The relationship between

 Reserve and Peak is often termed “captive” insurance. See 3 Steven Plitt et al., Couch on

 Insurance § 39:2 (3d ed. 2021) (“A captive insurer is a corporation organized for the



                                              3
Appellate Case: 18-9011       Document: 010110683986           Date Filed: 05/13/2022      Page: 4



 purpose of insuring the liabilities of its shareholders or their affiliates.” (internal

 quotation marks omitted)).

        Peak did not appear to get much in return for its $400,000 annual payment to

 Reserve. The appellate record indicates that Peak recovered on only one loss, receiving a

 payment of slightly less than $340,000; and even then, as we shall see, the bona fides of

 the claim were questionable and the handling of the claim was highly irregular. The high

 premiums on the policies could, however, be a significant financial benefit to Zumbaum

 and Weikel even if—indeed, especially if—Peak never suffered a loss covered by the

 policies issued by Reserve. The benefit arises from the tax treatment of small insurance

 companies, which has special consequences when the small insurer is a captive insurer,

 sometimes referred to as a “micro-captive.” As the Supreme Court recently explained:

        A micro-captive transaction is typically an insurance agreement between a
        parent company and a “captive” insurer under its control. The [Internal
        Revenue] Code provides the parties to such an agreement with tax
        advantages. The insured party can deduct its premium payments as business
        expenses. And the insurer can exclude . . . those premiums from its own
        taxable income, under a tax break for small insurance companies. The result
        is that the money does not get taxed at all.

 CIC Servs., LLC v. IRS, 141 S. Ct. 1582, 1587 (2021) (citations omitted). Thus, Peak

 could treat the $400,000 in annual premiums it paid to Reserve as a deductible business

 expense on its federal income-tax returns, while Reserve would be exempt from income

 taxation so long as it qualified as an insurance company under the tax laws. (Reserve

 relied on I.R.C. § 501(c)(15), which exempts insurance companies from income taxation

 under § 501(a) if they receive no more than $600,000 a year in premiums.) The $400,000

 moved from one entity owned by Zumbaum and Weikel to another entity they owned; so,

                                                 4
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022         Page: 5



 pre-tax, they had the same wealth despite the transfer. But their businesses paid

 significantly less tax. In particular, the more paid in premiums on the insurance policies,

 the greater the tax deduction, so there would be a strong financial incentive for those who

 owned both the business and its captive to set the premiums as high as possible, unlike

 the usual incentive for a business to reduce its expenses. Such tax benefits and incentives

 have led micro-captive transactions to come under scrutiny because of “their potential for

 tax evasion.” CIC Servs., 141 S. Ct. at 1587.

        Capstone Associated Services, Ltd., which consulted for and managed a number of

 captive insurance companies besides Reserve, advised Zumbaum and Weikel in creating

 Reserve and handled the technical and management issues, such as preparing policies and

 recommending premiums. It believed that for Reserve to be a qualified insurance

 company it would have to receive at least 30% of its premiums from companies not

 affiliated with it, a threshold we can assume to be correct for purposes of this appeal.

        In the Background section of this opinion we will describe in some detail how

 Reserve purported to obtain this diversification of risks. But it may be useful to orient the

 reader by sketching the key aspects of the arrangement now. Capstone ostensibly created

 diversification of risks in two ways, which together accounted for about 30% of the

 “premiums” received by Reserve. First, it arranged for 50-some captives under its

 management to, in essence, be liable on reinsurance policies issued to each other. In a

 reinsurance relationship one insurance company, the reinsurer, acts as an insurer of

 another insurance company; typically, the reinsured insurance company pays a premium

 to the reinsurer and the reinsurer assumes a portion of the liabilities of the reinsured

                                               5
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 6



 company on the insurance policies issued by the reinsured company—that is, the

 reinsured company “cedes” some of its liability to the reinsurer. See Black’s Law

 Dictionary 1539 (11th ed. 2019) (defining reinsurance as “[i]nsurance of all or part of

 one insurer’s risk by a second insurer, who accepts the risk in exchange for a percentage

 of the original premium”); 13A John Alan Appleman & Jean Appleman, Insurance Law

 and Practice § 7681, at 480 (1976) (“Reinsurance, to an insurance lawyer, means one

 thing only—the ceding by one insurance company to another of all or a portion of its

 risks for a stipulated portion of the premium, in which the liability of the reinsurer is

 solely to the reinsured, which is the ceding company, and in which contract the ceding

 company retains all contact with the original insured, and handles all matters prior to and

 subsequent to loss.”); but cf. Colonial Am. Life Ins. Co. v. Comm’r, 491 U.S. 244, 247

 (1989) (adopting a more expansive notion of reinsurance). For example, a company that

 issues homeowners insurance may pay a premium to a reinsurer to protect the

 homeowner-insurance company from unsustainable losses if a major fire destroys too

 many homes insured by the company.

        The reinsurance arranged by Capstone was accomplished through PoolRe

 Insurance Corp., another company managed by Capstone. Through PoolRe each of the

 captive insurers in effect reinsured, and was reinsured by, each of the other captives, with

 PoolRe acting as the intermediary. See Figure 1.




                                               6
Appellate Case: 18-9011     Document: 010110683986          Date Filed: 05/13/2022      Page: 7




                                Figure 1 – Capstone’s Role

 The process involved two steps. To begin with, on each policy issued by Reserve and the

 other captives, PoolRe provided what was termed stop-loss coverage (purportedly to

 protect the captive insurers from excess losses) through an endorsement on the policy that

 required PoolRe to assume a portion of the liability incurred by the captive insurer on the

 policy covering the insured (such as Peak). The restrictions on payment under the stop-

 loss coverage, which will be explored later, were sufficiently intricate and demanding

 that it appears they were never satisfied during the years in question (either on the stop-

 loss coverage for Reserve policies or the stop-loss coverage provided for the other

 captives), so there were no payouts on the coverage. For this stop-loss coverage, PoolRe

 received a fixed percentage (18.5% the first year) of the premiums paid on the policies

 issued by the captives. 1 As the second step, the captives in turn reinsured all of PoolRe’s




        1
          Strictly speaking this was not a reinsurance agreement since PoolRe was directly
 liable to the insured (such as Peak) under an endorsement on the policy from the captive
 insurer (such as Reserve) to the insured.

                                               7
Appellate Case: 18-9011     Document: 010110683986          Date Filed: 05/13/2022      Page: 8



 stop-loss coverage, with each captive receiving a premium from PoolRe equal to the

 premium its insured paid to PoolRe. See Figure 2.




                      Figure 2 – How the Reinsurance Pool Worked

        The net result of this arrangement was that each captive insurer received the full

 premium paid by its insureds—the 81.5 % paid directly to the captive by the insured plus

 the 18.5% paid to PoolRe, which in turn later paid that amount to the captive. Through

 this arrangement, all the captive insurers shared the entire risk of the stop-loss coverage

 provided by PoolRe. If one of the captives incurred liability that triggered the stop-loss

 coverage, PoolRe would pay its share of the loss but would be fully reimbursed through

 the reinsurance it obtained from the captives as a whole, with each captive paying its

 proportionate share. As previously mentioned, however, this risk apparently never

 materialized. At least during the period relevant to this appeal, PoolRe did not need to

                                               8
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 9



 pay on any stop-loss coverage, so the payments to and from PoolRe were a wash. But

 Reserve could argue that 18.5% of the premiums paid by Peak came to Reserve from

 PoolRe, rather than from its affiliate (Peak), and that it thereby distributed risk beyond its

 affiliates.

         The second way in which Capstone arranged for the captives to ostensibly

 diversify risks was by purportedly arranging for each captive to reinsure a small

 percentage of risk that PoolRe assumed from coinsuring thousands of vehicle-service

 contracts with another insurance company. See Black’s Law Dictionary 954 (11th ed.

 2019) (providing one definition of coinsurance as “[i]nsurance provided jointly by two or

 more insurers”). Reserve claimed to have received about 15% of its premiums through

 this arrangement. In each year for which we have a record, Reserve reported that it

 incurred liability from this reinsurance approximately equal to the amount it was owed in

 premiums. Taken together, the premiums from both these plans constituted more than

 30% of the premiums Reserve received from Peak and PoolRe.

         Questioning the bona fides of Reserve’s various arrangements, the IRS rejected

 Reserve’s claim to be a qualified insurance company and assessed it for back taxes.

 Reserve challenged the assessment in the United States Tax Court but lost. Reserve has

 appealed to this court. Exercising jurisdiction under 26 U.S.C. § 7482(a), we affirm. 2 In

 the Tax Court proceedings Reserve had the burden of proving that the IRS’s assessment




         Reserve appealed to this circuit, perhaps because it filed its tax return in Utah.
         2

 See 26 U.S.C. § 7482(b)(1)(B). The Commissioner has not challenged venue.

                                               9
Appellate Case: 18-9011      Document: 010110683986           Date Filed: 05/13/2022      Page: 10



  was incorrect. On the record before it, the court could properly find that Reserve had not

  satisfied its burden—in particular, Reserve had not proved that its purported insurance

  transactions were truly arrangements for insurance. We also reject Reserve’s challenge to

  the Tax Court’s refusal to accept Reserve’s claim that its receipts from Peak were, if not

  insurance, nontaxable capital contributions.

         Our discussion will proceed as follows: First, we describe at length the facts

  relevant to the issues before us. Second, we review the applicable law and the decision of

  the Tax Court holding that Reserve was not an insurance company. Third, we explain

  why we affirm that holding. Fourth, we reject Reserve’s argument that it owes no taxes

  even if it was not an insurance company because the “premium” payments from Peak

  must then be deemed nontaxable contributions of capital.

         II.    BACKGROUND

         In this section we will discuss the formation of Reserve, the policies it issued to

  Peak, the reinsurance arrangements it made with PoolRe that ostensibly allowed it to

  distribute risk to entities not affiliated with Peak, and the tax claim instituted against

  Reserve.

         We recite the evidence of record in some detail. The amicus brief submitted to this

  court, as well as the briefs of Reserve itself, suggest that the decision of the Tax Court

  undermines perfectly proper practices in the creation and operation of captive insurance

  companies. But the specific evidence presented can make all the difference. Two

  transactions that appear similar in form may be treated quite differently under the law

  because of differences in the underlying substance. We do not hold that the forms of the

                                                 10
Appellate Case: 18-9011     Document: 010110683986         Date Filed: 05/13/2022     Page: 11



  transactions involving Reserve are improper (for example, insurance pools such as

  PoolRe may be perfectly legitimate in other circumstances); we hold only that the Tax

  Court could properly conclude that they were not insurance transactions in substance.

                A.     Formation of Reserve

         Zumbaum and Weikel formed Peak in the mid-nineties to operate near deep

  underground mines in Idaho’s Silver Valley. Peak continues to do business in Idaho,

  primarily on the Bunker Hill Superfund Site, but also in other locations in Idaho and

  Nevada. It manufactures and sells equipment that supports underground mining

  operations. This equipment includes ventilation fans that control the temperature of the

  mines, submersible pumps that remove the groundwater from the mines, and vehicles that

  transport workers, explosives, and fuel to, from, and within the mines. Peak also repairs

  and cleans mining equipment that is often contaminated with hazardous waste like lead or

  zinc. Because the cleaning operations risk creating hazardous-waste runoff, Peak employs

  various measures, such as the use of cleaning bays, sumps, and containment areas, to

  prevent spreading the contaminants.

         In 2008 and 2009 Peak had 17 employees, including two shop managers, ten shop

  staff, and two outside salespersons. By 2010 it was down to 13 employees. Zumbaum and

  Weikel also owned two other business entities: RocQuest holds the real estate that Peak

  leases for its operations, and ZW was created by Zumbaum and Weikel to lend money to

  Zumbaum’s secretary when she wanted to buy a bar in Silver Valley. At trial Zumbaum

  described the operations of RocQuest and ZW as insignificant.



                                              11
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 12



           Before obtaining insurance from Reserve, Peak relied on several commercial

  policies for its insurance needs: Most recently it had paid premiums of $95,828 for 2007,

  and $57,300 for the first half of 2008. The coverage limits for the policies ranged from

  $5,000 to $2 million. Peak filed few claims under these policies—some claims under its

  auto-insurance policies and a claim under its commercial-property policy for snowstorm

  damage to the roof of one of Peak’s buildings (Peak spent $25,000 to replace the roof but

  recovered only $2,000 from the insurer). Although Peak claimed that it was unhappy with

  its insurers’ handling of these claims, Peak continued its policies with them, even after

  procuring the additional coverage from Reserve.

           Zumbaum and Weikel reached out to Capstone after a mentor recommended

  taking a look at forming a captive insurance company. Stuart Feldman, chief executive

  officer of Capstone’s general partner, Capstone Holdings Corp., and Lance McNeel,

  Capstone’s director of insurance operation, conducted an on-site visit of Peak in August

  2008. Before the visit Peak provided Capstone with background documents on Peak’s

  finances, taxes, and current insurance. The visit lasted six to eight hours. McNeel and

  Feldman toured Peak’s facilities and discussed Peak’s business operations and insurance

  risks.

           After the visit Capstone began preparing a “Captive Insurance Company

  Feasibility Study” to “evaluate[] Peak’s desire to explore the option of forming a captive

  insurer for the purpose of writing coverages that are generally unavailable or impractical

  to obtain in the conventional insurance marketplace.” Aplt. App., Vol. 7 at 2027, 2030

  (emphasis added). For reasons not explained in the record, Capstone did not produce the

                                              12
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022       Page: 13



  final version of the study until August 2009. The study outlined advantages of captives,

  such as “lower risk costs,” investment income, tailored policies, coverage prices that

  “track closely with the risks inherent in an insured’s own exposures,” access to

  reinsurance, and “complete control over the operation of [the] captive[].” Id. at 2040–42.

  It said that “[c]overage lines that address reasonably predictable, non-catastrophic

  exposures are good candidates for coverage by a captive,” and that other “unpredictable

  exposures may also be good candidates,” but that those exposures would likely require

  “pooling or reinsurance.” Id. at 2040.

         As for Peak specifically, the study noted that Peak’s “current conventional policies

  . . . offer broad and comprehensive coverage that is appropriately designed and priced,”

  id. at 2047, and it acknowledged that Peak “had no losses of any significance” on its

  current policies, id. at 2061. But it stated that a captive could insure against additional

  risks, and it mentioned 13 categories of such risks, describing each in one to four

  sentences. There was no discussion of the likelihood of any risk. The study did not

  mention either ZW or RocQuest.

         Zumbaum and Weikel did not wait for the final feasibility study before beginning

  their insurance project. On December 3, 2008, about four months after the site visit, they

  incorporated Reserve (as a subsidiary of their holding company named Peak Casualty) in

  Anguilla, British West Indies, with an initial capital investment of $100,000. Reserve had

  no employees and was managed by Capstone. Also in December, Reserve issued its first

  set of policies.



                                                13
Appellate Case: 18-9011     Document: 010110683986         Date Filed: 05/13/2022     Page: 14



               B.     Reserve’s Direct Policies

        Reserve issued 13 policies to Peak (RocQuest and ZW were also named insureds,

  but we will generally refer only to Peak) on December 4, 2008:

        1)     Excess Directors & Officers Liability (for liability for wrongful acts
               committed by directors and officers acting in such capacity)
        2)     Special Risk – Loss of Major Customer (for reduction in net income caused
               by loss of major customer)
        3)     Special Risk – Expense Reimbursement (for expenses to mitigate adverse
               publicity arising from incidents such as a liability incident, product recall,
               labor dispute, or bankruptcy; and civil-liability defense costs if there was no
               underlying insurer or all defense expenses have been exhausted)
        4)     Special Risk – Loss of Services (for loss of services of employees to be
               specifically named)
        5)     Special Risk – Weather Related Business Interruption (for losses from
               interruption of business caused by weather)
        6)     Excess Pollution Liability (for cost of cleaning up on-site pollution and
               liability for creating pollution)
        7)     Special Risk – Tax Liability (if tax liability exceeds 115% of filed tax
               liability)
        8)     Excess Intellectual Property Package (for liability for wrongful acts by
               Peak and for damage to Peak’s intellectual property caused by wrongful
               acts of others)
        9)     Special Risk – Regulatory Changes (for damages to business from changes
               in the law)
        10)    Special Risk – Punitive Wrap Liability (for punitive damages that would be
               paid by one of the other Reserve policies to Peak except that a law or
               judicial ruling precludes insuring punitive damages)
        11)    Excess Employment Practices Liability (for liability for wrongful
               discharge, workplace harassment, retaliation for exercising employment-
               related legal rights, breach of employment contract, etc.)
        12)    Excess Cyber Risk (for liability and for business and property loss caused
               by others)
        13)    Special Risk – Product Recall (for expenses of recall of products
               manufactured or sold by Peak)

        For each policy the policy period was less than a month, extending from December

  4, 2008, to January 1, 2009, and the liability limit was $1 million. The total premium was

  $412,089.02. The policies were claims-made policies: The claim must have been based

                                              14
Appellate Case: 18-9011      Document: 010110683986           Date Filed: 05/13/2022      Page: 15



  on acts, errors, or omissions after the policy inception date or, if applicable, after the

  earlier retroactive date set forth in the policy. And the claim must have been made and

  reported to Reserve after the policy inception date and during the policy period or, if

  applicable, during the extended reporting period set forth in the policy. Policy # 7—the

  tax-liability policy—had special provisions on retroactivity and reporting, apparently

  intending to cover tax returns due before 2009 if covered losses were reported within four

  years of the due date. Six policies (1, 6, 8, 10, 11, 12) had a retroactive date of January 1,

  2005 (so the act or omission giving rise to the claim could have predated the policy by as

  much as four years) and an extended reporting period of three or four years (so the claim

  could have been made and reported to Peak as late as December 2012). The remaining

  policies had no retroactive date but extended reporting periods of one year or, in one case

  (policy #13), four years. Each policy contained an other-insurance clause, which

  provided, “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,”

  Reserve Mech. Corp. v. Comm’r, T.C. Memo. 2018-86 at 14, 115 T.C.M. (CCH) 1475

  (T.C. 2018) (Reserve) (capitalization omitted); 3 so if Peak suffered a loss that could be

  covered by both a Reserve policy and one of its commercial policies, Reserve would pay




        For simplicity and uniformity we refer to the pagination of the Tax Court’s
         3

  memorandum opinion throughout this opinion.

                                                15
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 16



  nothing unless the claim exhausted the benefits under the commercial policy.

         Several of these policies were executed with singular carelessness. For example,

  two of the policies erroneously listed Pacific Arts Entertainment, LLC and Pacific Arts

  Presents, LLC as the insureds, rather than Peak, RocQuest, and ZW. And although the

  directors-and-officers policy stated that it covered the specific officers and directors listed

  in Schedule 1-A, an attachment to the policy, Schedule 1-A did not list a single insured

  person, so the policy—for which Peak paid $17,122—would provide no coverage. Also,

  in the apparent rush to issue the policies (and pay premiums that would be deductible in

  2008), Peak paid for three policies—employment-practices liability, weather-related

  business disruption, and cyber risk—that apparently were deemed unnecessary after a

  little further consideration, as they were dropped in 2009, after being in place for less

  than one month. 4 (Notably, the later-issued feasibility study described one of the

  discontinued coverages—employment-practices liability—as a “major liability

  concern[]” for Peak. Aplt. App., Vol. 7 at 2062.)

                       1.      Policy Premiums

         There are also remarkable errors in pricing the premiums on two policies. McNeel,

  Capstone’s director of the insurance operation, prepared a rating worksheet for each of



         4
            Besides dropping the three policies in 2009, Peak replaced the expense-
  reimbursement policy by two policies covering the same risks—one to mitigate adverse
  publicity and one to provide for civil-liability defense costs. Also, on six policies the
  liability limit was reduced from $1 million to $500,000, so the total limit of liability
  dropped from $13 to 8 million. Peak paid premiums of $448,127.03 on the 11 policies in
  2009. Peak kept the same 11 policies and paid $445,314.01 in 2010.

                                                16
Appellate Case: 18-9011     Document: 010110683986          Date Filed: 05/13/2022     Page: 17



  the policies. On the 2008 worksheet, for example, one column set the annual premium for

  each policy, and an adjacent column contained a pro rata percentage to account for how

  premiums calculated on an annual basis should be adjusted for retroactive and partial-

  year coverage. For those policies with retroactive coverage the pro rata percentage was

  usually 95%. For four of the policies (loss of major customer, loss of services, product-

  recall reimbursement, and weather-related business interruption) with no retroactive

  coverage (so the occurrence had to be during December 2008) the pro rata percentage

  was 10% (presumably reflecting that the coverage was for occurrences during less than

  10% of a full year). But for Special Risk – Regulatory Changes, which also had no

  retroactive coverage, the pro rata percentage was 95%. When asked about this at oral

  argument, counsel for Reserve responded, “It certainly strikes me as an error.” Oral Arg.

  at 37:30. 5 A similar error was made with respect to the policy for Special Risk – Expense

  Reimbursement.


         5
            In a letter to the court sent a few days after oral argument, counsel for Reserve
  retracted this statement, stating that there was no proration error. The letter asserts that
  the proration factor on the worksheet reflected McNeel’s “judgment of the percentage of
  risk of the policy remaining,” and notes that the premium was comparable to that on a
  document provided by Mid-Continent General Agency, Inc., which purportedly was
  produced independently and provided premiums that “were pro-rated for short term
  policies.” Appellant Reserve Mechanical Corp.’s Suppl. Letter Br., at 2. What is absent
  from the retraction, however, is any plausible explanation of why the regulatory-changes
  premium for one month of coverage was essentially the same as the premium for a year’s
  coverage, particularly when the premiums for the other non-retroactive policies were
  treated so differently. The loss-of-major-customer premium jumped from $7,268 (for a
  policy limit of $1 million) for the one-month coverage in 2008 to $50,625 (for a
  $500,000 limit) for the year-long coverage in 2009; the loss-of-services premium jumped
  from $4,874 ($1 million policy limit) in 2008 to $62,791 ($1 million limit) in 2009; and
  the product-recall-reimbursement premium jumped from $5,087 to $35,438 even though
                                               17
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022        Page: 18



         Perhaps more important, the manner of arriving at the premium prices on

  McNeel’s rating worksheet was questionable. The core task in setting premiums for an

  insurance policy is predicting risk: the size and frequency of losses covered by the policy.

  See Owens v. Aetna Life & Cas. Co., 654 F.2d 218, 240 (3d Cir. 1981) (“The [insurance]

  company must set its premiums based on its prediction of two cost variables: the

  probability of a particular risk of loss occurring and the magnitude of the loss if it

  occurs.”). But the record is devoid of evidence of the necessary risk assessment by

  Reserve. Peak had no history of any losses that would be covered by the Reserve policies,

  so the premiums could not be based on Peak’s actual experience. The feasibility study

  briefly described the risks that would be covered by the policies, but it contained no

  discussion of the probability or size of the risks. For example, when the feasibility study

  discussed Peak’s need for employment-practices liability coverage, it merely stated that

  this liability “has become a hot topic over the past several years as complaints and legal

  action nationwide have skyrocketed for wrongful termination, discrimination,

  harassment, and other employment-related practices.” Aplt. App., Vol. 7 at 2056. (Again,

  Peak dropped its excess-employment-practices-liability coverage after one month, before

  the feasibility study was issued.)


  the policy limit dropped from $1 million to $500,000. (The weather-related-business-
  interruption policy was not continued in 2009.) In contrast, for the regulatory-changes
  coverage, the one-month premium in 2008 of $64,899 (for a $1 million policy limit)
  dropped to $47,588 for annual coverage in 2009 (with a $500,000 policy limit). In
  examining whether the Tax Court properly determined that Reserve did not satisfy its
  burden of establishing that it was providing insurance, we are not inclined to give any
  weight to an ipse dixit by counsel.

                                                18
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 19



         One source of information would have been insurance-industry data. Yet even

  though one of Reserve’s expert witnesses testified that commercial insurance policies

  were available as an alternative to several of the Reserve policies, there is no evidence

  that anyone compared the rates on such policies or otherwise considered industry

  standards. Instead, the record suggests that McNeel based the rates on the premiums

  charged by other captive insurers managed by Capstone. For the most part those

  premiums were apparently based solely on the annual projected sales revenue of the

  insured—for example, regardless of the particulars of the business (nature of the

  business, location, etc.) the premium for the coverage depended only on the projected

  sales revenue. The only exception was employment-practices-liability coverage, the

  premiums for which were based on the number of employees. McNeel prepared a

  document that summarized the premium rates per $250,000 of coverage on all the

  different policies issued by Capstone entities. The document, in the words of the Tax

  Court, “provided both an average and a range of rates from which [McNeel] could choose

  for each type of policy.” Reserve, at 15. But McNeel’s testimony contained no suggestion

  that he looked at the businesses insured under the other policies to see if they would be

  likely to have risks comparable to those of Peak. On the contrary, he acknowledged that

  he was unaware whether the other captives were in a business similar to Peak, or were

  similar in other respects to Peak. Nor was there any evidence showing that the premiums

  charged by the other Capstone entities (who likely had the same tax incentive as Reserve

  to charge as high a premium as possible) were themselves reasonable.



                                               19
Appellate Case: 18-9011       Document: 010110683986            Date Filed: 05/13/2022       Page: 20



         Reserve claims that McNeel’s proposed premiums were supported by the

  independent work of Mid-Continent General Agency, Inc., “a managing general

  underwriter,” which provided what are called “pricing indication[s],” Aplt. App., Vol. 5

  at 1209, 1242, that closely correlated with McNeel’s suggested premiums. But how these

  indications were generated was left unexplained. McNeel testified that someone from

  Mid-Continent visited Capstone’s office for about 10 days and looked at its files, but

  what files in particular are not specified. No representative from Mid-Continent testified

  at trial. And the only documentation offered to show how Mid-Continent arrived at these

  prices was a letter from Mid-Continent to McNeel that purported to “comment on the

  methodology [Mid-Continent] use[s] to assist in developing premium quotations.” Aplt.

  App., Vol. 12 at 3560. The letter, however, stated merely that Mid-Continent’s methods

  “involve[] the evaluation of exposures for a given line of insurance, examination of

  historic loss date [sic], if any, the consideration of increased limits factors[6] . . . , and

  acknowledgement of market rate adjustments.” Id. at 3560–61. The letter did not provide

  further details, and it did not mention Peak or Reserve’s policies.

         We recognize that Reserve called two experts as witnesses to defend the pricing of

  the Peak policies, Esperanza Mead and Michael Solomon. Although Mead testified that


         6
            Limit factors are used to compute what the premium should be for a particular
  liability limit based on the premium already determined for a different liability limit.
  Because the likelihood of a large loss is generally significantly less than the likelihood of
  a smaller loss, the premium is not proportional to the liability limit. For example, if the
  proper premium for $250,000 of coverage is $1,000, one could calculate the proper
  premium for $1 million coverage by multiplying $1,000 by the appropriate limit factor
  (3.4 in McNeel’s calculations) to arrive at a premium of $3,400.

                                                  20
Appellate Case: 18-9011     Document: 010110683986          Date Filed: 05/13/2022     Page: 21



  the Reserve premiums were reasonable, her conclusions rested on questionable

  assumptions. Reserve had no loss data for her to use nor did she use any risk information

  from general industry sources. And to the extent that she relied on the premise that the

  premiums for the policies issued by the other Capstone captive insurers were reasonable,

  that premise was not supported by loss data from those insurers. Mead’s report does

  tabulate the claims payments by Capstone captives for a five-year period; but she

  assessed this information as having “low credibility” for actuarial purposes because so

  few claims were paid, and the information had no material effect on her conclusions.

  Aplt. App., Vol. 5 at 1256. She instead reached her conclusion that the premiums charged

  by Reserve and the other Capstone captives were reasonable only by making the

  assumption, unsupported by any data, that the captives would ultimately pay claims equal

  to about 75% of the premiums. She employed that figure solely because it is standard in

  the insurance industry (which means merely that 25% of insurance premiums ordinarily

  go to overhead, administrative expenses, and profit). Under this assumption one would

  expect Peak, a business with almost no history of insurance losses and only general

  concerns about the future, to average over $300,000 in submitted claims per year going

  forward. Neither Reserve nor its experts offered data, or even an explanation, to justify

  this assumption.

         As for Solomon, at least he looked at real-world data—for example, he assessed

  the risk of loss to Peak from recall of products it manufactured or sold by looking at the

  “annual economic impact of food safety outbreaks.” Aplt. App., Vol. 16 at 4724. But he

  opined on only six of the 13 policy coverages; and rather than assessing the

                                              21
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022       Page: 22



  reasonableness of the premiums for each coverage, he said only that the total premium

  for the reviewed coverages was “reasonable in the aggregate.” Aplt. App., Vol. 13 at

  3889. In any event, his report (and Mead’s as well) was prepared many years after

  issuance of the policies of concern on this appeal, and there is no evidence in the record

  that the premiums for those policies were based in any way on the data he used (much of

  which in fact postdated the policies). Neither expert examined what the real risks to Peak

  were.

          As summarized in the Commissioner’s brief:

          [N]either Solomon nor Mead compared taxpayer’s premiums to premiums
          charged by unrelated third-party insurers; therefore, neither had a basis to
          determine whether taxpayer’s premiums were commercially reasonable.
          Solomon merely opined that the aggregate premiums charged by taxpayer
          were reasonable when compared to Capstone’s internal pricing guidelines.
          Similarly, Mead merely opined that the aggregate premiums charged by
          taxpayer were reasonable when compared to rates charged by other
          Capstone-managed captives.

  Aplee. Br. at 60–61 (citations omitted). Reserve’s reply brief does not respond to, much

  less challenge, the quoted statement. Although the testimony of the two experts is quite

  technical, our understanding of the testimony supports what the Commissioner says.

                        2.     Comparison to Commercially Available Policies

          Nor is there evidence of any effort to determine what other insurers might have

  charged Peak as premiums for similar policies. True, Capstone’s feasibility study stated

  that Peak wanted to create a captive insurer “for the purpose of writing coverages that are

  generally unavailable or impractical to obtain in the conventional insurance

  marketplace.” Aplt. App., Vol. 7 at 2030 (emphasis added). But the report of another of


                                               22
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 23



  Reserve’s experts, Robert Snyder, who in fact co-authored that feasibility study, said that

  at least six coverages provided to Peak by Reserve—pollution liability, intellectual

  property, “commercial property gap,” “punitive damages wrap,” cyber risk, and tax

  liability coverages—were available in the commercial market. Aplt. App., Vol. 12 at

  3582–85 (capitalization omitted).

         Zumbaum and Weikel were apparently not particularly interested in Peak’s saving

  money on insurance premiums. Zumbaum admitted that he did not explore coverage on

  the commercial insurance market before creating Reserve. And although McNeel and

  Feldman both testified that Zumbaum and Weikel were the most significant people in

  determining the policies, pricing, and coverage, McNeel could not recall whether

  Zumbaum or Weikel questioned the premium numbers. Zumbaum testified that he did

  not review the Reserve policies in detail; instead, he testified that he “[p]robably scanned

  through them.” Aplt. App., Vol. 4 at 1134. Zumbaum also admitted that he relied on “Mr.

  McNeel, Mr. Feldman or other folks from Capstone” to tell him about the policies and

  that he would “believe[]” whatever they told him. Id.

         Aside from the premium calculations, there is also no evidence in the record that

  the choice of policies, or their specific contents, was based on an assessment of Peak’s

  particular needs. The feasibility study stressed that captive insurers are ideal for

  providing so-called “manuscript[]” policies, which it defined as policies with “coverage[]

  to address specific concerns.” Aplt. App., Vol. 7 at 2031. And Feldman testified that one

  advantage of captive insurers was that captives “design[] coverages not with a blunt

  instrument but with a scalpel”—effectively “tailoring coverages directly to the needs of

                                                23
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 24



  the business.” Aplt. App., Vol. 5 at 1372. But there is no evidence of such tailoring for

  the policies issued to Peak. McNeel acknowledged that Capstone “had policies that were

  common to a lot of different clients.” Id. at 1250. And the Tax Court described these as

  “‘cookie-cutter’” policies, noted testimony from Capstone employees that “they

  administered many of the same policies for all of their clients,” and observed that “[i]n

  many instances the [Peak] policies were not reasonably suited to the needs of the

  insureds, particularly Rocquest and ZW.” Reserve, at 54. (Of course, form policies have a

  very large, and quite proper, role in the insurance industry. In themselves, they do not

  suggest impropriety.) 7

                       3.     Claim-Handling

         In addition, Reserve’s claims-handling operations were, to say the least, far from

  businesslike. Reserve handled only one claim during the years at issue—a claim from

  Peak under the special-risk policy for partial loss of a major customer. That policy, as the

  name suggests, reimbursed Peak for business losses “as a result of the loss of or reduction

  of services of a [m]ajor [c]ustomer.” Aplt. App., Vol. 12 at 3302. But the policy imposed

  significant restrictions on when coverage would be provided. For example, it would not

  cover the loss of a major customer if Peak “initiate[d] the termination,” or if Peak did


         7
          Altogether, Reserve did not provide the advantages touted by the feasibility
  study. Rather than Peak having “complete control” over Reserve, Aplt. App., Vol. 7 at
  2042, Reserve was managed entirely by Capstone. Rather than Reserve providing
  “manuscript” coverage, id. at 2041, it issued boilerplate policies. And rather than
  providing insurance that is “generally unavailable or impractical to obtain in the
  conventional insurance marketplace,” id. at 2030, at least six of Peak’s policies were
  commercially available.

                                               24
Appellate Case: 18-9011     Document: 010110683986         Date Filed: 05/13/2022        Page: 25



  “not attempt or intend to replace” the customer, or if Peak caused the customer to leave

  by breaching the terms of its contract with the customer. Id. And the claim would not be

  paid under the policy if the insured had knowledge of the loss before the effective date of

  the policy.

         Peak filed its claim under the major-customer policy on April 6, 2009, about four

  months into the coverage period. Reserve’s initial notice of claim dated the loss as

  occurring during the first week of the policy period, on January 5, 2009. It described the

  claim as arising from a “[s]ignificant reduction of orders from Stillwater Mining

  Company, a customer representing 35% of sales.” Aplt. App., Vol. 19 at 5407. It said that

  “[t]he reduction in orders from Stillwater represents 16% of the insured’s sales for the

  period,” and said that its net income had dropped from $422,440 in the first quarter of

  2008 to $232,620 in the first quarter of 2009, a drop of about 45%. Id. After subtracting

  the $25,000 deductible, the claim value for lost net income was $164,820. The underlying

  claim document that Peak allegedly submitted to Reserve to substantiate and explain

  these numbers is not in the record. In fact, the record contains no supporting

  documentation from Peak whatsoever. And Zumbaum gave conflicting testimony about

  whether Peak submitted the claim to Reserve or to Capstone. Moreover, there is no

  evidence that Reserve investigated the claim to determine if the loss was covered under

  the policy—did Peak know of the coming reduction in sales by January 1, 2009, the




                                              25
Appellate Case: 18-9011     Document: 010110683986          Date Filed: 05/13/2022     Page: 26



  effective date of the policy; 8 was the reduction caused by a breach of contract by Peak;

  etc.?

          Reserve paid $150,000 on the claim on April 21, 2009—about two weeks after

  Peak filed the claim. One month later, on May 27, Reserve and Peak executed a

  settlement agreement. The agreement (which misstates the coverage limit for the relevant

  policy as $1 million, rather than the actual $500,000) stated, among other things, that

  Reserve would pay Peak the full value of the claim—$164,820—and in return, Peak

  would “completely release[] and forever discharge[] [Reserve] from any and all past or

  present claims, demands, obligations, actions, causes of action, judgments, expenses and

  compensation . . . [that] may in any way grow out of the specified loss.” Aplt. App., Vol.

  12 at 3553. Reserve then issued a second payment of $14,820 the same day as the

  agreement. Four months later, however, on September 10, 2009, Reserve issued a third

  check to Peak for $175,000. The sole possible explanation in the record is a line dated

  August 25, 2009, on the Notice of Claim form stating: “Re-open claim due to extended

  losses from lost customer.” Aplt. App., Vol. 19 at 5407. There is no supporting

  documentation for the $175,000 sum. All three checks from Reserve to Peak were signed


          8
           The December 2008 policy indemnified Peak “for any Business Interruption loss
  of up to twelve (12 months) suffered as a result of losing the services of a Major
  Customer.” Aplt. App., Vol. 11 at 3126 (emphasis added). The 2009 policy, which took
  effect five days before the “date of occurrence” stated on the Notice of Loss, changed the
  language to encompass “any Business Interruption loss . . . suffered as a result of the loss
  of or reduction of services of a Major Customer.” Aplt. App., Vol. 12 at 3302 (emphasis
  added). The loss on which Reserve paid Peak—which was not for the total loss of
  services but just a reduction of services—may not have been covered under the language
  of the December 2008 policy.

                                               26
Appellate Case: 18-9011     Document: 010110683986        Date Filed: 05/13/2022       Page: 27



  by a Peak employee. More than two years later, on January 30, 2012, the parties executed

  an addendum to the settlement agreement, which stated in full: “In consideration of the

  release set forth above, the Insurer agrees to pay the Insured the sum of Three Hundred

  Thirty Nine Thousand, Eight Hundred Twenty Dollars ($339,820.00). The foregoing

  sum [has] been paid by Insurer through two checks made payable to ‘Peak Mechanical &

  Components, Inc.’” Aplt. App., Vol. 12 at 3556.

               C.     Reserve’s Reinsurance Policies

        Capstone believed that Reserve would need to obtain at least 30% of its premiums

  from insureds not related to it—that is, from insureds other than Peak—in order to

  receive favorable tax treatment as a qualified insurance company. To meet the 30%

  threshold Reserve therefore engaged in two arrangements with PoolRe, each of which

  contributed about 15% of the total premiums it received. PoolRe managed similar

  arrangements for some 50 other captive insurance companies that issued about 400

  policies altogether. As previously noted, these captive insurance companies as well as

  PoolRe were all managed by Capstone.

                      1.     Stop-Loss and Quota-Share Agreements

        The first arrangement involved stop-loss coverage provided by PoolRe to Peak.

  Through endorsements on all of Reserve’s direct policies with Peak, PoolRe received

  18.5% of the premiums paid by Peak on each policy in 2008 and 2009, and 19.9% of the

  premiums in 2010. See Figure 3 (showing the 2008 and 2009 arrangements). In return,

  PoolRe assumed (through an endorsement on the policy) some of Reserve’s exposure on

  each policy. A financial backstop for Reserve was ostensibly important because it could

                                             27
Appellate Case: 18-9011       Document: 010110683986            Date Filed: 05/13/2022   Page: 28



  face liabilities exceeding $8 million per year on the policies issued to Peak; at least for

  the first few years of its operation, such liabilities could not be covered by the

  combination of Reserve’s $100,000 initial capitalization and the additional capital

  acquired from annual premium payments. But PoolRe did not provide much of a

  backstop. The amount that PoolRe could be required to pay each year on the stop-loss

  coverage was strictly limited, and the requirements for it to make any payment at all were

  intricate, restrictive, and highly unlikely to materialize.




                       Figure 3 – Reserve’s Reinsurance Relationship

         We describe in some detail the limits with respect to the 2009 policies to illustrate

  the general issues. First, PoolRe incurred no liability under the stop-loss coverage until


                                                28
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022     Page: 29



  Reserve received claims from Peak in excess of the total premiums paid by Peak (18.5%

  of which went to PoolRe). Thus Peak needed to submit claims to Reserve in excess of

  $448,127.03 to trigger the stop-loss coverage. If that condition was satisfied, PoolRe

  would then pay amounts exceeding the total premiums, but only up to a maximum of

  150% of those premiums. PoolRe could therefore not be required to pay more than about

  $672,000 in stop-loss coverage on the 2009 policies, even though the liability of Reserve

  to Peak could have been as high as $8 million on those policies.

         The amount that PoolRe would have to pay on Reserve’s policies was also

  restricted by an additional requirement that had little to do with Reserve. PoolRe’s total

  liability on all its stop-loss coverage for the captive insurers was limited to 125% of the

  total yearly premiums paid for stop-loss coverage by all the captive insurers. In 2009

  PoolRe received just under $83,000 in premiums on the Reserve policies; from all the

  captive insurers together, it received about $6 million. If a number of the other captive

  insurers suffered large losses in the same year, the amount that Reserve could recoup

  from PoolRe for that year could be further reduced.

         Another feature of the PoolRe coverage, however, made the above limitations

  more theoretical than real. The limitations were unlikely to ever come into play because

  PoolRe would incur liability only if what the policy called an “Attachment Point” were

  satisfied. Aplt. App., Vol. 12 at 3411. There were four possible attachment points, each

  requiring at least two significant losses. Thus, a single catastrophic loss on one of the

  Reserve policies would not trigger any payments by PoolRe. The first attachment point

  was that Peak suffer at least two losses where (1) each loss was caused by a separate

                                               29
Appellate Case: 18-9011       Document: 010110683986          Date Filed: 05/13/2022       Page: 30



  event and (2) each loss cost Peak at least $100,000. A second attachment point would be

  triggered only when Peak experienced three losses, each caused by a separate event, that

  caused the loss of at least $60,000. The third required four separate losses of $36,000 or

  more; and the fourth required five separate losses of $20,000 or more. 9 Even then,

  PoolRe would pay no more than the amount that exceeded the attachment point on the

  claim where the attachment point was first satisfied (and for all later claims). For

  example, if the first claim was for $1 million, and the second was for $125,000, PoolRe

  would pay only $25,000, the amount by which the second claim exceeded the $100,000

  threshold. The other captive insurers in the program had similar arrangements with

  PoolRe, which made no payments under the stop-loss coverages to any of the 50-odd

  captive insurers (on their 400-plus policies) for at least the period at issue in this case.

         Because it was so unlikely that any money would ever be paid under the stop-loss

  coverage provided by PoolRe, one might infer that it was of very little financial utility to

  Peak or Reserve. But PoolRe was an essential part of the mechanism that created the

  appearance that Reserve had substantially diversified its risks beyond those faced by its

  affiliate Peak. What created that appearance was Reserve’s reinsurance of liabilities of

  PoolRe. Not only did PoolRe provide stop-loss coverage for the insureds of Reserve and



         9
           In 2010 the conditions for payment under the stop-loss coverage were revised.
  For that year the stop-loss insurance from PoolRe would have been triggered if the total
  claims submitted from Peak to Reserve reached 35% of the total, aggregate premiums for
  all of Reserve’s direct policies. Above that threshold, PoolRe would pay 50% of the
  claims, though it would not pay more than the total premiums themselves. There were no
  longer any separate Attachment Points that needed to be satisfied.

                                                30
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022       Page: 31



  the 50 other captive insurers, but Reserve and the other captives in turn reinsured

  PoolRe’s stop-loss coverage for all the captives’ insureds (such as Peak), thereby

  assuming all the liability of PoolRe for the stop-loss coverage. In other words, PoolRe

  was essentially only an intermediary. The liability for paying for stop-loss claims

  incurred by a captive insurer ultimately rested on all the captive insurers as a group. This

  risk-pooling reinsurance arrangement, which was called a quota-share agreement, gave

  the appearance that each captive insurer (such as Reserve) was spreading its risk beyond

  its affiliated companies (such as Peak) by incurring liability on the stop-loss coverage

  provided for the benefit of the other captive insurers.

         For participating in the reinsurance pool, each captive received from PoolRe a

  premium equal to the amount that PoolRe itself had received from that captive’s insureds

  for the stop-loss coverage, so that, in effect, the captive insurer (such as Reserve)

  ultimately received all the premiums paid by its insured (such as Peak). For example, in

  2009 Peak paid 18.5% of its premiums (about $83,000) directly to PoolRe for the stop-

  loss coverage, but PoolRe then paid Reserve that same amount ($83,000) for its

  reinsurance of stop-loss coverage, so Reserve ended up receiving 100% of what Peak

  paid for insurance. See Figure 3 above. In return for receiving this premium from PoolRe,

  the captive insurer was liable for a corresponding percentage of the liability incurred on

  the reinsurance provided to PoolRe by the captive insurers as a group. If the captive

  insurer received 3% of the total premiums paid by PoolRe for reinsurance, it was liable

  for 3% of what PoolRe had to pay on its stop-loss coverage.



                                               31
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022        Page: 32



         The nature of the arrangement can be illustrated by a simplified example. Say, the

  PoolRe risk pool had three captives, A, B, and C, which respectively reinsure 50%, 30%,

  and 20% of the total stop-loss risk, because A’s insureds pay 50% of the premiums to

  PoolRe for the stop-loss coverage, B’s pay 30%, and C’s pay 20%. If Captive B’s insured

  has a covered claim that requires PoolRe to pay it $100, then Captive A must pay PoolRe

  $50, Captive B must pay $30, and Captive C must pay $20. B ends up reducing its

  potential $100 loss to $30, while the other pool members are out $50 and $20. No matter

  which captive insurer incurs the loss, the loss is ultimately borne in the same 5:3:2

  proportions by the three captives.

         In the actual PoolRe arrangement for 2009, the percentage of the total reinsurance

  paid by a captive ranged from 0.0984% (for a captive whose insureds paid $5,550 in

  stop-loss premiums) to 3.3235% (for a captive whose insureds paid $187,434 in

  premiums). Reserve’s percentage was about 1.47%, based on Peak’s paying PoolRe

  $82,904 in premiums for the stop-loss coverage on Peak’s policies with Reserve. PoolRe

  then paid Reserve the identical sum as the premium for reinsurance.

         Although Reserve ultimately received premiums precisely matching the combined

  total that Peak paid to Reserve and PoolRe, the reinsurance arrangement gave the

  appearance that Reserve was receiving only 81.5% of the premiums paid by Peak and a

  substantial premium paid by PoolRe (equal to 18.5% of the premiums paid by Peak) for

  reinsurance of stop-loss coverage for about 400 businesses (the insureds of the other

  captives) who were not affiliated with Reserve. (Recall that Capstone believed that for

  Reserve to be qualified as an insurer under the tax laws, Reserve needed to receive at

                                               32
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022       Page: 33



  least 30% of its premiums from its insurance of unaffiliated insureds, and the quota-share

  arrangement purportedly provided about half of that amount.) We recognize that a

  legitimate pool with a similar arrangement might properly distribute risk among insurers,

  even captive insurers. Here, however, the question was whether the stop-loss coverage

  was a legitimate risk. As previously noted, no claims under that coverage were made

  during the years in question by any of the 400 or so companies insured by the captive

  insurers participating in the PoolRe pool.

         In addition, even assuming that the stop-loss coverage provided by PoolRe was

  not illusory, the only support in the record for the pricing of this coverage for the 2008

  and 2009 policies is a 2005 letter signed by Robert Snyder, the director of risk consulting

  for the firm Myron Steves, who later served as one of the authors of Reserve’s 2009

  feasibility study, and eventually as a director of PoolRe itself. The letter was in response

  to a request from PoolRe to comment on the reasonableness of its Stop-Loss/Reinsurance

  premium structure, under which PoolRe would receive 18.5% of the premium paid by the

  insured. The letter concluded that “both the quota share premium retained by PoolRe and

  the quota share reinsurance premium(s) ceded to the captives via the pooling mechanism

  are reasonable.” Aplt. App., Vol. 12 at 3568. The letter explains, however, that its

  “analysis and observations are limited to general commentary regarding stop loss

  insurance and the reinsurance pooling concept, and specifically, our assessment of the

  proposed premium structure.” Id. at 3567. It does not indicate that Snyder had undertaken

  any specific assessment of the risks arising from the underlying insurance policies of the

  PoolRe captives or examined how any particular provisions of the stop-loss coverage,

                                               33
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022       Page: 34



  such as the highly restrictive attachment points, affected the insurer’s risks. It noted that a

  review of the premiums was “necessarily subjective,” id., and stated that the premiums

  employed by PoolRe are reasonable, “recognizing that in our judgment stop loss

  coverage in general might fairly be priced at anywhere from 2.5% to 30% of written

  premium.” Id. at 3568. Talk about going out on a limb.

         There is no evidence Capstone performed any further risk analysis before settling

  on 18.5% as the price paid by all captive insureds in 2008 and 2009. 10 The premium for

  stop-loss coverage should depend on both the likelihood of losses covered by the Reserve

  policy and the likelihood that the losses during the year would satisfy the attachment-

  point and other conditions of the stop-loss coverage, which depends both on the amount

  of the loss and the frequency of losses. Not only does nothing in the record provide

  reason to believe that 18.5% of the total premium is the appropriate premium for the stop-

  loss coverage for any particular captive insured, but Reserve has also failed to explain

  why it should be the same percentage for every captive insured. Reserve has provided no

  reason to believe, for instance, that for every (properly priced) insurance policy with a $1

  million coverage limit, the probability of incurring two losses exceeding $100,000 in the

  same year is identical. And there is no indication in the record that the owners of Reserve


         10
            In 2010, in addition to the previously discussed changes in stop-loss coverage,
  Capstone changed the premium percentage received by PoolRe to 19.9%. Reserve
  submitted a letter from Glicksman Consulting, LLC in support of this number. But that
  letter did not assess any risk. Rather, it presented a range of options based on a number of
  (unsubstantiated) risk assumptions provided by PoolRe and said that it was beyond “the
  scope of th[e] review to recommend a specific change” to the stop-loss premium rate.
  Aplt. App., Vol. 12 at 3564.

                                                34
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022        Page: 35



  or anyone else on its behalf exercised any diligence or investigated the risks it was

  assuming from participation in the PoolRe pool. One would think that pool members

  would want to make sure that the premium prices, and therefore their quota-share

  percentages, accurately reflected the risks involved because if one of the captives’ stop-

  loss endorsements triggered a disproportionate number of claims, then that captive would

  receive a greater benefit than the rest of the pool members. 11

         In the absence of due diligence in assessing the risks of the other captives in the

  PoolRe pool, the willingness of the captives, including Reserve, to join the pool can

  perhaps be explained by the unusual, if not unique, fact that both PoolRe and all the

  captives were managed by Capstone. (One of Reserve’s experts testified that he had

  never seen a risk pool where all the participants and the pool were managed by the same



         11
             Say the amount of premiums paid by Peak for its insurance was identical to the
  amount paid by the insureds of captive insurer A in the pool, but Peak was only 1% as
  likely as the insureds of A to incur a loss covered by the stop-loss coverage provided by
  PoolRe. Reserve and A each would forgo the same amount in premiums (18.5% of the
  total premiums in 2009) to PoolRe and each would be paid that same amount from
  PoolRe for reinsurance premiums. So Reserve and A would each effectively receive all
  premiums paid by its insureds. The problem would arise from the discrepancy between
  the liability each insurer would incur for reinsuring PoolRe’s stop-loss liability and the
  benefit each would receive from that coverage. Since each had to forgo (at least in form)
  the same amount in premiums to PoolRe, each would be liable for the same percentage of
  losses incurred by PoolRe when it had to pay on claims under the stop-loss coverage to
  any of the captive insurers in the pool. This would be highly unfair to Reserve under our
  assumption that Reserve would expect to receive only 1% as much benefit as A would
  receive from the stop-loss coverage. Reserve would be shelling out a lot more to reinsure
  A’s losses than it would be getting in return from A. If the stop-loss risks to the other
  captive insurers in the pool were more like the risks to A than the risks to Reserve, it
  would be foolish for Reserve to join the PoolRe pool.

                                               35
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 36



  entity.) Zumbaum, for his part, testified that he completely relied on Capstone. Also, the

  captives may have determined, or been advised by consultants, that they would almost

  surely incur no liability under the stop-loss reinsurance policies, so the premiums for that

  coverage (which would come back to the captives via the reinsurance of PoolRe) was of

  no import.

                       2.     Credit-Coinsurance Arrangement

         The other way in which Reserve purportedly distributed risk was through a

  coinsurance arrangement between PoolRe and an insurer called CreditRe, which

  ostensibly accounted for about 15% of Reserve’s premiums receipts. CreditRe was not a

  Capstone-managed entity; rather, it was owned and operated by a man named Gary Fagg.

  Under the agreement between PoolRe and CreditRe, CreditRe ceded to PoolRe a portion

  of the risk that CreditRe assumed from vehicle-service contracts between consumers and

  another insurer, Lyndon Property Insurance Co. PoolRe then executed a separate

  agreement with Reserve—called the “Credit Insurance Coinsurance Contract”—under

  which Reserve reinsured about 1% of PoolRe’s liability from the coinsurance contract

  and, in return, PoolRe would pay a premium to Reserve. Aplt. App., Vol. 11 at 3261.

         The bona fides of the arrangement, however, could be questioned. Very little

  money changed hands between Reserve and PoolRe. The financial records do not show

  any premium payment actually transmitted to Reserve during the years in question. Nor is

  there any record of particular claims paid by PoolRe or Reserve. The sole payments in the

  relationship appear to be annual deposits of less than $200 each from PoolRe to Reserve

  purportedly equal to the amount by which the annual premiums exceeded the annual

                                               36
Appellate Case: 18-9011     Document: 010110683986            Date Filed: 05/13/2022    Page: 37



  reinsurance obligations incurred by Reserve. Reserve’s ledgers reflect actually receiving

  only three payments totaling $530 across three years under this agreement.

         Further, there is nothing in the record showing what liability Reserve was

  allegedly insuring. Reserve did not submit any underlying vehicle-service contracts. And

  when government counsel asked Fagg to “elaborate on what those claims [the vehicle-

  service claims] would generally entail,” he replied: “I’m familiar with them in the sense

  of I know them in terms of dollars. But I was not directly involved in the adjudication of

  those claims or any of that.” Aplt. App., Vol. 5 at 1285.

         Nor was there any evidence of how the premiums for the credit-coinsurance

  agreements were calculated. The agreement stated merely that the premium amounts

  would correspond to the share of risk that PoolRe assumed. Fagg testified that “in

  discussion with PoolRe,” he “basically asked them how much [risk] they would be

  willing to accept,” and then ceded that amount. Id.

                D.     Tax Dispute

         On its income-tax returns Peak deducted the premiums it paid Reserve. The Tax

  Code generally treats a business’s payment of insurance premiums as a tax deductible

  “ordinary and necessary expense[]” of doing business. I.R.C. § 162(a); see 4 Couch on

  Insurance, supra, § 63.5 (internal quotation marks omitted). But there was no

  corresponding taxable income reported by Reserve. Reserve paid no income tax on the

  premiums it received, claiming that it qualified under § 501(c)(15) as a tax-exempt

  insurance company receiving premiums under $600,000 per year.



                                              37
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 38



         The IRS sent Reserve a Notice of Deficiency challenging this claim, disputing that

  Reserve was tax exempt under § 501(c)(15). The notice said that Reserve’s “purported

  insurance and/or reinsurance transactions lack[ed] economic substance,” and that the

  money it had received was “not paid to an insurance company and . . . [was] not paid for

  insurance.” Aplt. App., Vol. 6 at 1592. As a result, the IRS assessed Reserve for taxes for

  2008, 2009, and 2010. It classified Reserve’s income as FDAP income, which is “[F]ixed

  or [D]eterminable [A]nnual or [P]eriodical gains, profits, and income” that is “received

  from sources within the United States,” but “not effectively connected with the conduct

  of a trade or business within the United States.” I.R.C. § 881(a). FDAP income is subject

  to a 30% tax rate. See id. Reserve contested the assessment, arguing that it was in fact an

  insurance company and that if it was not, the purported premiums it received were a

  nontaxable capital contribution to the company. The case was tried to the Tax Court,

  which affirmed the IRS. Reserve appeals.

         III. APPLICABLE LAW AND THE TAX COURT’S DECISION THAT
         RESERVE WAS NOT AN INSURANCE COMPANY

         Under § 501(c)(15) of the Tax Code, “[i]nsurance companies (as defined in

  section 816(a)) other than life” are tax exempt if “(I) the gross receipts for the taxable

  year do not exceed $600,000, and (II) more than 50 percent of such gross receipts consist

  of premiums.” I.R.C. § 501(c)(15)(A)(i). The core question before the Tax Court was

  whether Reserve was an insurance company. I.R.C. § 816(a) defines insurance company

  as “any company more than half of the business of which during the taxable year is the




                                                38
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 39



  issuing of insurance or annuity contracts or the reinsuring of risks underwritten by

  insurance companies.”

         But no part of the Code defines the term insurance. Unfortunately, this is not

  because the definition is obvious. Indeed, the meaning can depend on the context. See

  Robert E. Keeton & Alan I. Widiss, Insurance Law: A Guide to Fundamental Principles,

  Legal Doctrines and Commercial Practices § 1.1, at 5 (1988) (“There is no single

  conception of insurance that is universally applicable for use in disputes involving

  questions of law.”). At the core of the notion of insurance, however, are risk transfer and

  distribution. The insured transfers its risk of loss to the insurance company, and the

  insurer distributes that risk by charging premiums to many insureds. See id. at 4 (“[R]isk

  transference and risk distribution are among the basic characteristics of almost all

  insurance transactions.”); Grp. Life & Health Ins. Co. v. Royal Drug Co., 440 U.S. 205,

  211 (1979) (“The primary elements of an insurance contract are the spreading and

  underwriting of a policyholder’s risk.”); Beech Aircraft Corp. v. United States, 797 F.2d

  920, 922 (10th Cir. 1986) (“‘Risk-shifting’ means one party shifts [its] risk of loss to

  another, and ‘risk-distributing’ means that the party assuming the risk distributes [its]

  potential liability, in part, among others. An arrangement without the elements of risk-

  shifting and risk-distributing lacks the fundamentals inherent in a true contract of

  insurance.”); Stearns-Roger Corp. v. United States, 774 F.2d 414, 415 (10th Cir. 1985)

  (“[F]or there to be ‘insurance’ there must be a shifting of the risk of loss or a spreading of

  the risk.”).



                                               39
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022         Page: 40



         The Supreme Court decision in Helvering v. Le Gierse, 312 U.S. 531 (1941),

  illustrates that a transaction must display the basic attributes of insurance and that

  substance trumps form. A woman of 80 purchased a life-insurance policy and an annuity

  at the same time from the same life insurance company. The two contracts were formally

  treated as distinct transactions, but neither would have been purchased without the other.

  She paid $4,179 for an annuity that provided an annual payment of $589.80 throughout

  her life, and she paid $22,946 for a life-insurance contract that would pay $25,000 upon

  her demise. To obtain the policy she did not have to submit to a physical examination or

  answer the typical questions. She died a month later. The government claimed that the

  $25,000 payment under the contract could not be excluded from her taxable estate as life-

  insurance proceeds. The Court agreed. It observed that “Congress used the word

  ‘insurance’ in its commonly accepted sense,” and that “[h]istorically and commonly

  insurance involves risk-shifting and risk-distributing.” Id. at 539–40. In those respects the

  decedent had not acquired insurance. The Court said that the desirability of life insurance

  stems from its being “a device to shift and distribute risk of loss from premature death,”

  id. at 539, but the combination of the decedent’s two contracts “fail[ed] to spell out any

  element of insurance risk,” id. at 541. It noted that “annuity and insurance are

  opposites”—“[f]rom the company’s viewpoint, insurance looks to longevity, annuity to

  transiency.” Id. Through the combination of the two contracts, said the Court, “the one

  neutralizes the risk customarily inherent in the other.” Id. It concluded that the risk

  assumed by the insurance company “was an investment risk similar to the risk assumed

  by a bank; it was not an insurance risk.” Id. at 542.

                                                40
Appellate Case: 18-9011       Document: 010110683986          Date Filed: 05/13/2022       Page: 41



         We cannot anticipate every nuance that may arise and provide a comprehensive

  explication of what is required for a purported insurer to satisfy § 816(a), but this court

  has previously followed the approach of Le Gierse. See, e.g., Stearns-Roger Corp., 774

  F.2d at 415. Taking our lead then from that Supreme Court decision, we think that to be a

  “company more than half of the business of which . . . is the issuance of insurance . . .

  contracts,” I.R.C. § 816(a), the company must deal in the transference and distribution of

  risk and it must do so as a “business,” conducting itself through practices that one would

  expect from a reasonably ordered insurance enterprise.

         In our view, the Tax Court has captured the essence of the statutory requirement in

  the tests that it has employed to determine whether a taxpayer is an insurance company

  under § 816(a). In this case it stated that “[c]ourts 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.” Reserve, at 33 (citing Harper Grp. v. Comm’r, 96 T.C. 45, 57–58

  (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992), and AMERCO & Subs v. Comm’r, 96 TC

  18, 38 (1991), aff’d 979 F.2d 162 (9th Cir. 1992)); see also Caylor Land & Dev., Inc. v.

  Comm’r, 121 T.C.M. (CCH) 1205 (2021) at *31–32; Avrahami v. Comm’r, 149 T.C. 144,

  177 (2017). Neither party objects to this framework. The Tax Court held that Reserve’s

  policies failed to satisfy requirements (3) and (4). We begin with risk distribution.




                                                 41
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022        Page: 42



                A.     Risk Distribution

         Risk distribution is “essential” to insurance. Le Gierse, 312 U.S. at 539; see

  Comm’r v. Treganowan, 183 F.2d 288, 291 (2d Cir. 1950) (describing risk distribution as

  “the very essence of insurance” (internal quotation marks omitted)); Keeton & Widiss,

  supra, § 1.3, at 12 (“When insurance is considered from the viewpoint of an insurer or of

  society, it is appropriately viewed as a system for distribution[.]”). “Insuring many

  independent risks,” that is, independent in the sense that the likelihood of a loss under

  one policy is independent of the likelihood of a loss under a separate policy, “in return for

  numerous premiums serves to distribute risk.” Clougherty Packing Co. v. Comm’r, 811

  F.2d 1297, 1300 (9th Cir. 1987); see Beech Aircraft Corp., 797 F.2d at 922. The success

  of insurance derives from the “law of large numbers.” Clougherty Packing Co., 811 F.2d

  at 1300. When, as is assumed when writing insurance policies, the risk of an adverse

  event to each insured is random, with a chance of, say, X% per year, there is always the

  possibility that fate will strike a cruel blow and a number of adverse events will occur at

  the same time or in quick succession. The insurer may have to pay out much more in

  claims than it anticipated when it set the premiums on the policies, perhaps jeopardizing

  its financial solvency. The law of large numbers is no more than an expression of a

  simple computation using the mathematics of probability—when there are a sufficiently

  large number of independent risks each having an annual probability of occurrence of

  X%, there is an extraordinarily small likelihood that the percentage of insureds that suffer

  a loss during a year will deviate significantly from X%. (If a coin is tossed a million

  times, it is highly unlikely that the percentage of heads will differ appreciably from 50%.)

                                               42
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022        Page: 43



  Thus, insuring a large number of independent risks protects the insurer against financial

  calamity. See Keeton & Widiss, supra, § 1.3 at 12–13 (“As the number of ventures

  included in a group or ‘pool’ is increased, there is a greater likelihood that the favorable

  and the harmful experiences will tend to be balanced – that is, grouping a large number of

  ventures in a pool increases the probability that the losses suffered by all the ventures will

  be spread over time.”). By writing policies for enough independent risks, an insurer can

  predict “the frequency and amount of loss within this larger group . . . [and] set the

  premium at a level that will cover the losses, cover the insurer’s overhead and expenses,

  and earn a profit.” 1 Daniel W. Gerber et al., New Appleman on Insurance Law Library

  Edition § 1.01 (2021).

         The Tax Court began by finding that Reserve’s direct written policies for Peak,

  RocQuest, and ZW did not themselves distribute risk. It said that because “most or all of

  the risk of loss was associated with the business operations of just one insured [Peak],”

  “the number of insureds and the total number of independent exposures were too few to

  distribute the risk that Reserve assumed under [those] policies.” Reserve, at 36. Reserve

  does not challenge this determination.

         The court therefore turned to Reserve’s contention that it distributed risk through

  the arrangements with PoolRe. It noted that Reserve relied on Harper, a Tax Court case

  holding that a particular captive insurer had “‘a sufficient pool of insureds to provide risk

  distribution’” when “approximately 30% of the captive’s business came from insuring

  unrelated parties.” Id. at 38 (quoting Harper Grp., 96 T.C. at 60). It pointed out that when

  it had previously held that risk distribution had been achieved through insuring unrelated

                                               43
Appellate Case: 18-9011       Document: 010110683986           Date Filed: 05/13/2022       Page: 44



  parties, it had “determined that the transactions with the unrelated parties were insurance

  transactions for Federal income tax purposes.” Id. Therefore, the court said, “[b]efore we

  can determine whether Reserve effectively distributed risk through these agreements, we

  must determine whether PoolRe was a bona fide insurance company.” Id. It set forth nine

  factors that the Tax Court had previously considered in making such a determination:

         (1) whether [the purported insurance company] was created for legitimate
         nontax reasons;
         (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. at 38–39 (quoting Avrahami, 149 T.C. at 185, with numbering added).

                        1.      Quota-Share Arrangement

         Beginning with the quota-share arrangement, the Tax Court addressed only the six

  factors that it found to be “the most relevant.” Id. at 39. 12 First, it determined that the

  “arrangement looks suspiciously like a circular flow of funds.” Id. at 41 (internal

  quotation marks omitted). It said that because Reserve never “had any losses or expenses

  in connection with its purported quota share liabilities[,] . . . the end result for each tax

  year . . . was that Reserve would receive payments from PoolRe in exactly the same


         12
           The Tax Court did not address three factors—comparable commercial coverage,
  adequate capitalization, and a separate account for claim payments. Neither party
  complains about the failure to address those factors.

                                                 44
Appellate Case: 18-9011       Document: 010110683986          Date Filed: 05/13/2022    Page: 45



  amount as the payments that PoolRe was entitled to receive from Peak . . . for the stop

  loss coverage.” Id.

         Second, the Tax Court concluded “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.” Id. at 42. It explained:

         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 the policies covering various unrelated lines of insurance.
         Reserve has not shown that the risks were comparable in scale.

  Id. at 41. The court noted that Reserve had not produced “evidence which shows

  the risks of other Capstone entities, . . . [such as] evidence regarding their

  industries, locations, operations, types of risk, and exposure to risk.” Id. at 42.

         Third, for similar reasons, the Tax Court concluded that the quota-share premiums

  were not actuarially determined. Not only was there “no evidence to support the

  calculation of the premiums,” but it was concerned that “all participants in the quota

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

  direct written premiums to PoolRe.” Id. at 42–43. Such a “one-size-fits-all” approach

  appeared inconsistent with actual actuarial determination. Id. at 43.

         As for whether the quota-share policies insured an actual and insurable risk, the

  Tax Court stated that “PoolRe was removed far from any actual risk associated with the

  business or operations of Reserve’s insureds.” Id. at 44. Before obtaining insurance from

                                                  45
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 46



  Reserve, Peak had “never suffered any losses that would even come close to triggering

  the stop loss coverage provided for in the stop loss endorsements.” Id.

         The fifth factor was whether PoolRe was licensed and regulated as an insurance

  company. The Tax Court observed that “Reserve executed both its 2008 and 2009

  reinsurance agreements with PoolRe before it obtained an insurance license in Anguilla,”

  and there was no evidence that PoolRe was a licensed insurer before then. Id. at 45.

         Sixth, the Tax Court found that “Reserve has not established that PoolRe was

  created or operated for legitimate nontax reasons.” Id. It said that “[a]ll 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.” Id. Instead, “[t]he only purpose

  PoolRe served through the quota share arrangement was to shift income from Peak to

  Reserve.” Id.

         The Tax Court concluded that “the facts surrounding Reserve’s quota share

  policies with PoolRe establish that those agreements were not bona fide insurance

  agreements.” Id. “PoolRe’s activities as they relate to [the Reserve] policies,” it said,

  “were not those of a bona fide insurance company.” Id. at 46.

         One aspect of the Tax Court’s analysis must be emphasized. Contrary to what is

  suggested in some briefs filed in this court, the Tax Court did not criticize risk pools as a

  general matter. Instead, its findings were specific to the PoolRe risk pool.

                       2.      Credit-Coinsurance Arrangement

         Turning to the credit-coinsurance contract, the Tax Court summarily rejected

  Reserve’s contention that it provided risk distribution. It said that Reserve had “failed to

                                                46
Appellate Case: 18-9011     Document: 010110683986         Date Filed: 05/13/2022         Page: 47



  provide evidence that the vehicle service contracts, which formed the basis for the

  reinsurance that PoolRe re-ceded in the coinsurance contracts, actually existed.” Id. at

  46–47. And it found that even if there were valid coinsurance contracts, PoolRe assumed

  a “de minimis” amount of risk from CreditRe and the amount ceded to Reserve was also

  de minimis. Id. at 47. Thus, “the coinsurance contracts were not bona fide reinsurance

  agreements.” Id.

                B.     Insurance in the Commonly Accepted Sense

         As an alternative basis for rejecting Reserve’s appeal, the Tax Court held that

  Reserve’s policies “did not constitute insurance in the commonly accepted sense.” Id. at

  48. The Tax Court considered the following factors: “[1] whether the company was

  organized, operated, and regulated as an insurance company; [2] whether it was

  adequately capitalized; [3] whether the policies were valid and binding; [4] whether the

  premiums were reasonable and the result of an arm’s-length transaction; and [5] whether

  claims were paid.” Id. at 48. These are all factors that the Tax Court had previously

  considered over the years. See, e.g., Avrahami, 149 T.C. at 191; R.V.I. Guar. Co., Ltd. v.

  Comm’r, 145 T.C. 209, 231 (2015); Harper, 96 T.C. at 60; Securitas Holdings, Inc. v.

  Comm’r, 108 T.C.M. (CCH) 490 (T.C. 2014) at *10; see also Caylor, 121 T.C.M. (CCH)

  1205 at *39–40. Reserve does not challenge that approach on appeal.

         First, the Tax Court said that although Reserve had observed the necessary

  formalities in incorporating under the law of Anguilla and complying with the insurance

  regulations of that country, it had not been operated as an insurance company. The court

  observed that “[o]ther than the feasibility study that Capstone produced, there is no

                                              47
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 48



  evidence that any due diligence was performed for the policies that Reserve issued.”

  Reserve, at 50. And it noted that the feasibility study was not complete until after Reserve

  issued its policies for 2008 and 2009, that many of the background documents attached to

  the study covered periods after Reserve had been incorporated and issued policies, and

  that the study said nothing about RocQuest and ZW even though those entities were

  covered under the policies. Also, Reserve’s operations (like its planning and

  incorporation) “were managed entirely by Capstone.” Id. Reserve had no employees of its

  own and Zumbaum—who was Reserve’s 50% owner, president, and chief executive

  officer—knew “virtually nothing about its operations,” and at trial showed “very little

  knowledge of provisions in the policies that Peak and his other entities held with

  Reserve.” Id. It further found that there was “no evidence that Reserve performed any due

  diligence with respect to the reinsurance agreements that it executed with PoolRe,” that

  “[n]othing in the record indicates that Reserve or anyone performing activities on

  Reserve’s behalf evaluated [the risks assumed by Reserve under the quota-share

  agreement] before executing the quota share policies,” and that no one with a financial

  interest in Reserve considered whether the quota-share or credit-coinsurance agreements

  would actually distribute risk. Id. at 51–52.

         The Tax Court also found that Reserve handled “in an irregular manner” its only

  claim—the one for loss of a major customer. Id. at 53. It said that “no supporting

  documentation accompanied the claim notice”; that Reserve never insisted on

  documentation of “the occurrence or the amount of the claimed loss”; that Reserve issued

  its first claim payment before Peak and Reserve executed their settlement agreement, and

                                                  48
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 49



  then issued another payment months after the settlement agreement without executing an

  addendum to the settlement agreement “reflecting this payment until years after the tax

  years in issue”; and that all the payments from Reserve to Peak were signed by a Peak

  employee. Id. at 52. The Tax Court concluded that “Reserve was not operated as an

  insurance company in the commonly accepted sense.” Id. at 53. It saw no virtue in

  Capstone’s management of Reserve, saying that “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.” Id. (emphasis

  added).

         As for the second factor—adequate capitalization—the Tax Court observed that

  “[g]enerally [its] caselaw holds that meeting the statutory requirements of the captive’s

  domicile jurisdiction is sufficient to show that the captive was adequately capitalized.” Id.

  And it concluded that because “Reserve met the minimum capitalization requirements of

  Anguilla,” this factor favored Reserve. Id. 13

         The Tax Court next found that “Reserve’s direct written policies contained the

  necessary terms to make them valid and binding insurance.” Id. at 54. But it noted that

  the policies were “cookie cutter”—“[t]he policies on their face indicate[d] that they were

  the copyrighted material of Capstone, and Capstone employees testified at trial that they


         13
           Reserve had plenty of capital if, as may well have been the case, the probability
  of a covered loss was extremely low. But, given the low probability that an attachment
  point would ever be satisfied, Reserve could not count on any reinsurance backup in case
  of a major loss that it could not pay out of its own funds, and it would take several years
  of accumulating premiums before Reserve could have sufficient capital to pay more than
  one policy-limits loss out of its own funds.
                                               49
Appellate Case: 18-9011      Document: 010110683986           Date Filed: 05/13/2022       Page: 50



  administered many of the same policies for all of their clients”—and “were not

  reasonably suited to the needs of the insureds, particularly Roc[Q]uest and ZW, both of

  which had extremely limited operations.” Id. at 54 (internal quotation marks omitted).

  The Tax Court also reiterated that Reserve’s only claim—the loss-of-a-major-customer

  claim—was paid in full without any “due diligence to determine whether the claim was

  actually covered by the relevant policy.” Id. at 55. The court concluded that the third

  factor—whether the policies were valid and binding—was a “neutral factor.” Id.

         The fourth factor considered by the Tax Court was whether Reserve’s premiums

  were reasonable and the result of arm’s-length transactions. The court acknowledged that

  “Capstone calculated Reserve’s premium using objective criteria and what appear to be

  actuarial methods,” id. at 61, and that to make his recommendations for premium pricing,

  McNeel used a spreadsheet showing the premiums charged by other Capstone entities for

  various lines of coverage and “pricing indications” from Mid-Continent, id. at 55.

         But the court said that “[d]espite [this] methodology . . . a number of factors

  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.” Id. at 56. It observed that

  Peak’s policies with Reserve caused a dramatic increase in Peak’s insurance expenses:

  Peak’s 2007 insurance expenses had been $95,828, but its Reserve premiums were more

  than “$412,089, and this was in addition to the premiums that Peak continued to pay for

  third-party commercial insurance.” Id. And it noted that despite this immense increase in

  cost, Reserve’s policies would be excess to any other policy that covered the same loss

  because of the other-insurance clauses in every Reserve policy.

                                                50
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022    Page: 51



         The Tax Court also noted apparent irregularities in the pricing of the policies. For

  example, the 2008 regulatory-changes policy (discussed earlier in this opinion) provided

  coverage for occurrences during only one month and charged a $64,899 premium for $1

  million in coverage, while the 2009 and 2010 versions of the policy charged a lower

  premium, $47,588, and offered $500,000 in coverage for a one-year coverage period.

  There was “no explanation” for this inconsistency. Id. at 57.

         In addition, the Tax Court questioned Peak’s assertion that it required unique

  pollution coverage from a captive insurer because one of its operations is located on a

  Superfund site. The court noted that “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.” Id. Moreover, Peak had operated at the same

  location “continuously for over 10 years,” and there was “no evidence that Peak had ever

  incurred costs during that time for excess pollution liability.” Id.

         Continuing this analysis, the Tax Court expressed doubts about Zumbaum’s

  testimony on the need to create Reserve. Zumbaum testified that one reason Peak wanted

  to create a captive was because it was unhappy with how its current commercial-liability

  insurer handled a claim for roof damage. But “no documentation was produced to

  substantiate” this point, id., and Peak continued to keep its policies with the commercial-

  liability insurers. Also, Zumbaum “did not know which of Peak’s policies with Reserve

  would have covered a loss like the one that was not covered by [its commercial insurer].”

  Id. at 58. And although Reserve contended that Peak risked substantial liability if one of

  its mining parts malfunctioned, “[t]here [was] no convincing evidence that legitimate

                                                51
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 52



  concerns about this kind of liability should have been greater in 2008 than in previous

  years.” Id. For example, the feasibility study “provided no information on the probability

  of a loss event that the direct written policies covered.” Id. at 59. The court added that

  Reserve “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.” Id. at 58.

         The Tax Court also pointed out that Zumbaum’s testimony about Peak’s business

  projections was inconsistent with the documentary evidence. Zumbaum testified that

  Peak was interested in obtaining additional insurance coverage because it expected that

  its business would “continue growing during the next few years.” Id. But “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,” and as it turned

  out, “Peak actually had fewer employees in 2010 than it did in 2008.” Id.

         After “conclu[ding] that any purported concerns about increased risks for the

  insureds were unfounded,” id. at 59, the court noted that in determining whether

  premiums charged by captive insurers were reasonable, it looked to whether “the

  amounts agreed upon by the parties were the result of arm’s-length negotiations,” id. at

  60. It said: “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.” Id. By that measure,

  Reserve failed to make its case. The Tax Court found that “the facts and circumstances of

                                               52
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022     Page: 53



  this case demonstrate that the direct written policies were not the result of arm’s-length

  negotiations.” Id. at 61. In its view, “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.” Id. It summarized: “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 policies were not reasonable and not negotiated at arm’s length.” Id.

         Turning to the fifth factor—the payment of claims—the Tax Court observed that

  Reserve did pay the single claim for loss of a major customer. And although it noted that

  “the circumstances surrounding the payment of [the loss-of-a-major-customer] claim

  were unusual,” it ultimately determined that this factor “weigh[ed] slightly in Reserve’s

  favor.” Id.

         The Tax Court said that on balance the evidence favored a conclusion “that

  Reserve’s transactions were not insurance transactions in the commonly accepted sense.”

  Id. at 62. It placed particular emphasis on (1) Reserve’s not being operated as a bona fide

  insurance company, (2) the lack of a legitimate business purpose for the policies, and

  (3) the large increase in payments for new insurance while still maintaining prior

  coverages. See id.

         IV. THE TAX COURT DID NOT ERR IN RULING THAT RESERVE
         WAS NOT AN INSURANCE COMPANY

         “We review decisions of the Tax Court in the same manner as civil actions tried

  without a jury.” Hamilton v. Comm’r, 955 F.3d 1169, 1171 (10th Cir. 2020). That is, we


                                               53
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022        Page: 54



  “review legal conclusions de novo and factual determinations only for clear error.” Id. at

  1172 (emphasis omitted). And we review the evidence in the light most favorable to the

  Tax Court’s ruling. See Exxon Corp. v. Gann, 21 F.3d 1002, 1005 (10th Cir. 1994) (“On

  appeal, we view the evidence in the light most favorable to the district court’s ruling and

  must uphold any district court finding that is permissible in light of the evidence.”

  (citation omitted)).

         The essence of the Tax Court’s ruling was that Reserve’s insurance policies issued

  to Peak did not provide true insurance even though Reserve complied with some (but by

  no means all) of the customary formalities for insurance companies and went through

  some of the motions associated with pricing insurance premiums.

         Perhaps we would have emphasized different evidence than did the Tax Court. But

  that court’s findings and conclusions were supported by overwhelming evidence in the

  record. No experience, expertise, or studies supported the need for Peak to obtain the

  policies. And the premiums for that additional insurance were not supported by any study

  of similar commercially available policies or careful analysis of Peak’s risks of loss. Nor

  has Reserve raised any persuasive challenges to the Tax Court’s conclusions. We now

  address those challenges in turn.

                A.       Risk Distribution—the Quota-Share Arrangement

         To qualify as an insurance company, Reserve needed to distribute risk. Reserve

  acknowledges that issuing a dozen-odd policies to essentially one insured (Peak) did not

  fill the bill. Rather, it relies on the reinsurance arrangements it had with PoolRe to

  establish risk distribution. The Tax Court rejected that reliance. Reserve challenges that

                                               54
Appellate Case: 18-9011        Document: 010110683986       Date Filed: 05/13/2022      Page: 55



  rejection, arguing that the court improperly held that risk could not be distributed via

  PoolRe simply because PoolRe was not a bona fide insurer.

         Reserve does not challenge the Tax Court’s conclusion that PoolRe was not a bona

  fide insurer with respect to the quota-share agreement. Instead, it argues that “the tax

  court misapplied the legal test for analyzing risk distribution” by considering whether

  PoolRe—rather than Reserve—was a bona fide insurance company. Aplt. Br. at 37. It

  contends that “the existence of a bona fide insurance company is not necessary for risk

  distribution to exist.” Id. at 38.

         As an abstract legal proposition, Reserve’s point has some merit. The courts have

  recognized, and the Commissioner concedes, that certain arrangements distributing risk

  provide insurance even though there is no insurance company involved. See Ross v.

  Odom, 401 F.2d 464, 466–67 (5th Cir. 1968) (Although “[t]he amounts payable to

  beneficiaries under the system were not funded or reinsured by any independent

  insurance company [,] . . . we fully approve the Trial Court’s holding that the [payment]

  constituted amounts received under a life insurance contract.”); Treganowan, 183 F.2d at

  290–91 (plan under which all members of an organization pledged to pay a set sum to a

  deceased member’s beneficiary constituted insurance). Reserve argues that an insurance

  company could reinsure such risks without jeopardizing its status as an insurance

  company. Perhaps. 14 But that proposition does not help Reserve here.


         14
           We note that the definition of insurance company cited by Reserve is “any
  company more than half of the business of which during the taxable year is the issuing of
  insurance or annuity contracts or the reinsuring of risks underwritten by insurance
  companies.” I.R.C. § 816(a) (emphasis added). It is not clear whether reinsurance of risks
                                               55
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 56



         To begin with, the Tax Court’s conclusion that PoolRe was not a bona fide

  insurance company was not based on the absence of formalities. True, one of the six

  factors discussed by the court was whether PoolRe was licensed and regulated as an

  insurance company; and the court noted that there was no evidence that it was so licensed

  when the first two sets of policies were issued to Peak (in December 2008 and January

  2009). But that factor apparently had little or no effect on the court’s conclusion, since it

  reached the same conclusion about PoolRe for the policies issued in 2010 as well, and the

  “Conclusion” section of this part of the court’s opinion makes no mention of the licensing

  issue when it summarizes why it finds that “PoolRe’s activities as they relate to [the

  quota-share] policies were not those of a bona fide insurance company.” Reserve, at 46.

         Elsewhere in that Conclusion the Tax Court used language that fairly encompasses

  a determination that the quota-share arrangement did not distribute risk for Reserve. The

  heart of the problem was not that PoolRe was not an insurance company but that its

  product was not actual insurance. The court concluded that “the facts surrounding

  Reserve’s quota share policies with PoolRe establish that those agreements were not bona

  fide insurance agreements.” Id. at 45. We agree with the Commissioner’s characterization

  of the Tax Court’s analysis: “[T]he Tax Court did not invalidate the quota share

  arrangement on the ground that PoolRe failed to meet the formal definition of an

  insurance company. Rather, it invalidated the quota share arrangement on the ground




  that have not been underwritten by an insurance company would qualify in the way
  Reserve hopes.

                                               56
Appellate Case: 18-9011       Document: 010110683986        Date Filed: 05/13/2022       Page: 57



  that, as a matter of substance, PoolRe did not perform the functions of an insurance

  company—regardless of label—vis-à-vis the quota share arrangement.” Aplee. Br. at 40.

  In short, what the Tax Court determined is what Reserve contends should have been

  determined—whether the quota-share arrangement was a true insurance arrangement for

  the distribution of risk.

         The Tax Court did not err when it assessed PoolRe’s bona fides. Reserve’s

  opening brief does not point to, and we do not see, any significant flaw in the analysis by

  the Tax Court in reaching its conclusions that “Reserve’s quota share policies with

  PoolRe . . . were not bona fide insurance agreements” and that “Reserve did not enter into

  the quota share arrangement with the intention of distributing its risk.” Reserve, at 45. On

  the contrary, the Tax Court opinion, if anything, understates the compelling evidence that

  the quota-share arrangement was a sham.

         Because Reserve’s reinsurance of PoolRe’s quota-share arrangement did not

  create any meaningful risk for Reserve, Reserve did not satisfy even the distribution

  threshold that Capstone set for it—obtaining 30% of its insurance premiums by insuring

  unaffiliated risks. Reserve has not argued that it could reach the 30% figure based only on

  the reinsurance of the credit-coinsurance agreements. The Tax Court’s ruling must

  therefore stand. But we briefly discuss the credit-coinsurance arrangement because the

  Tax Court’s ruling on that arrangement is an alternative basis for affirmance.

                 B.     Risk Distribution—The Credit-Coinsurance Arrangement

         The Tax Court determined that the credit-coinsurance agreements were not bona

  fide reinsurance agreements for two reasons: (1) there was no evidence that the

                                              57
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 58



  underlying risk existed because Reserve never produced the vehicle-service contracts and

  (2) even if the agreements insured an actual risk, both the amount of risk PoolRe assumed

  and the amount ceded to Reserve were too “de minimis” to constitute “actual risk.” Id. at

  47.

         Reserve challenges the first of the Tax Court’s reasons, contending that the court

  should not have faulted it for failing to produce the vehicle-service contracts. It argues

  that because the reinsurance arrangements were what are called “treaty” arrangements

  (under which the reinsurer is “bound to automatically accept all the policies and losses

  covered thereby”), Reserve “would not have examined risks, investigated claims, or even

  received notices of losses from the original insureds.” Aplt. Br. at 44. Therefore, it says,

  the Tax Court’s criticism for not providing documentary evidence of the vehicle-service

  contracts is “misplaced and ignores not only the evidence in the record but also the

  rationale behind treaty reinsurance. Indeed, if a reinsurer were required to duplicate the

  costly but necessary efforts of a primary insurer in evaluating risks and handling claims,

  reinsurance simply would not work because it would not be economical to place and

  administer.” Id. at 44–45 (citations omitted). This argument ignores, however, (1) the

  need for the information sought by the court in checking the bona fides of the

  “reinsurance” arrangement, (2) the documents that apparently gave PoolRe the right of

  access to the information sought, and (3) the need for a prospective treaty insurer to

  examine such information in some fashion when deciding whether or not to enter into a

  treaty-insurance relationship in the first place. But we need not resolve the merits of



                                               58
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022      Page: 59



  Reserve’s arguments on this point, because we must affirm on the other ground (de

  minimis risk) for the Tax Court’s decision.

         There is certainly substantial evidence suggesting that Reserve incurred very little

  risk from the agreements. Over the course of 2008–10, Reserve received no payment of

  annual premiums and made no payment on claims. It instead received only one deposit

  each year, purportedly equal to the net of premiums less claims for that year, for a total of

  $530 over three years. Perhaps there are factual or legal flaws in the Tax Court’s analysis

  of the extent of risk assumed by Reserve through the credit-coinsurance arrangement, but

  Reserve’s opening brief raised no factual or legal challenge to the analysis. It completely

  failed to address the court’s determination that the risk from the vehicle-service contracts

  did not constitute actual risk. The issue is therefore waived, and we must affirm the Tax

  Court’s determination that the credit-coinsurance arrangements did not distribute risk.

  See Lebahn v. Nat’l Farmers Union Unif. Pension Plan, 828 F.3d 1180, 1188 (10th Cir.

  2016) (“When a district court dismisses a claim on two or more independent grounds, the

  appellant must challenge each of those grounds.”).

                C.     Insurance in the Commonly Accepted Sense

         As a third alternative ground for rejecting Reserve’s appeal, the Tax Court ruled

  that the Reserve policies did not satisfy the requirement that they be insurance in the

  commonly accepted sense. We also affirm this ruling.

         We have already discussed at some length the evidence supporting the Tax Court’s

  determination that Reserve did not act like a company in the business of writing

  legitimate insurance policies. Its only true insured was Peak. The arrangements with

                                                59
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 60



  PoolRe lacked substance. There was no apparent business reason for the credit-

  coinsurance contracts. And the Tax Court was fully justified in determining that the

  quota-share reinsurance arrangement was a sham. The attachment points that had to be

  met before PoolRe had any liability to the Capstone captive insureds defied explanation.

  Reserve provided no evidence to overcome the logical inference that the reason to set

  such intricate limitations on liability was to ensure that PoolRe would never have to make

  a payment (particularly when the risk of loss under any of the underlying policies issued

  by the captive insurers was apparently low to start with), so there was really nothing for

  Reserve or the other captive insurers to reinsure.

         Moreover, there was no evidence of any reasonable risk assessments to determine

  whether Peak needed any of the additional policies. Nor was there any evidence of due

  diligence to determine whether the premiums charged on the policies were worth it to

  Peak. And Reserve was hardly run like a business. The preparation of the original one-

  month policies in an apparent rush to obtain a large business deduction for Peak in 2008

  was laughable. It suffices to note that on two of the policies the listed insureds, rather

  than Peak, RocQuest, and ZW, were “Pacific Arts Entertainment, LLC” and “Pacific Arts

  Presents, LLC.” Nor did Reserve operate in a more businesslike fashion thereafter. No

  self-respecting insurance company would have paid $340,000 on the loss-of-customer

  claim without any investigation or supporting documentation. And it was clear from his

  testimony that Zumbaum, the Chief Executive Officer of Reserve, knew zero about its

  business. The Tax Court was fully warranted in its finding that “Reserve’s transactions

  were not insurance transactions in the commonly accepted sense.” Reserve, at 62.

                                                60
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022         Page: 61



         Nevertheless, Reserve raises three challenges to the Tax Court’s analysis of this

  issue: (1) the court mischaracterized Reserve’s policies as providing only excess

  coverage; (2) the court erroneously determined that the premiums were unreasonable and

  not negotiated at arm’s length; and (3) the court erroneously determined that Reserve was

  not operated like an insurance company because it was managed by hired professionals.

  We address these challenges in turn.

                       1.      Alleged Mischaracterization of Reserve’s Policies

         Reserve contends that the Tax Court misinterpreted the other-insurance clauses in

  Reserve’s policies to mean that they provided only excess coverage. But those clauses

  stated: “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.” Reserve, at 14 (capitalization and ellipsis omitted).

  In other words, if Reserve’s policies covered the same loss as another policy, then

  Reserve’s liability would not arise until that other insurance was exhausted. See 15 Couch

  on Insurance, supra, § 219:1–2 (discussing purpose of other-insurance clauses). The Tax

  Court quoted this language in its recitation of the facts, and later observed that “the

  polic[ies] would be valid only after insurance coverage from other insurers was

  exhausted.” Reserve, at 60. This observation is not clearly erroneous. To be sure, it

  appears that at least some of the policies issued by Reserve covered risks that were not

  covered by Peak’s commercial policies; consequently, there would often be no coverage

  from other policies that Peak would have to exhaust. But Reserve has not pointed to any

                                               61
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 62



  language by the Tax Court to the contrary. There was no mischaracterization of the

  policies.

                       2.      Unreasonableness of Premiums

         Reserve’s second challenge is that the basis for the Tax Court’s determination that

  the premiums were unreasonable and not negotiated at arm’s length “flowed directly

  from its misreading of Reserve’s policies” as providing only excess insurance. Aplt. Br.

  at 53. We beg to differ. First, as just stated, the Tax Court did not misread the policies.

  And there were multiple reasons supporting the Tax Court’s determination. The

  observation that the policies provided only excess insurance was only a small component

  of the total analysis. We have repeatedly set forth a number of the questionable features

  of the policies issued by Reserve. Most important, however, was Reserve’s utter failure to

  provide a reasonable explanation of how it calculated the risks covered by those policies.

  The best it could do at the hearing before the Tax Court was to suggest, through the

  testimony of experts who were not familiar with Peak, that the premiums were in line

  with the premiums charged for similar insurance by other captive insurers managed by

  Capstone. But there was no evidence that those other captive insurers faced risks similar

  to those of Peak, nor was there any evidence that the premiums charged by those other

  captive insurers were themselves reasonable. The Tax Court was fully justified when it

  said that “[t]aking into consideration all the surrounding facts and circumstances, . . . 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,” and then



                                                62
Appellate Case: 18-9011      Document: 010110683986           Date Filed: 05/13/2022      Page: 63



  found that “the polic[i]es were not reasonable and not negotiated at arm’s length.”

  Reserve, at 61.

         Reserve argues that the Tax Court should not have faulted Reserve for issuing

  policies in “the absence of a significant history of losses for Peak.” Aplt. Br. at 54. It

  likens the Tax Court’s analysis to “saying that automobile insurance is unnecessary for

  drivers who have not yet had an accident.” Id. But the Tax Court did not conclude that

  Reserve’s policies were per se unreasonable just because Peak did not have a history of

  losses that would be covered by the policies. Instead, it observed that the lack of loss

  history was suspicious given that (1) the Reserve policies increased Peak’s insurance

  expenses by roughly 400%, (2) the policies’ other-insurance clauses meant that Reserve’s

  policies would provide only excess coverage if Peak’s other policies covered the same

  loss, (3) “Peak had never come close to exhausting the policy limits of its third-party

  commercial insurance coverage,” Reserve, at 60, and (4) Reserve provided no risk

  assessment to support the high premiums.

         The Tax Court did not clearly err when it concluded that Reserve’s premiums

  were unreasonable and not negotiated at arm’s-length.

                        3.     Irregularities of Reserve’s Operation

         Reserve also argues that the Tax Court should not have considered the fact that

  Reserve was managed by the hired professionals at Capstone and should not have faulted

  Zumbaum for being unable to discuss Reserve’s policies in any detail. It says that

  “existing caselaw recogniz[es] that most captive insurance companies operate without

  any employees and routinely delegate operational functions, financial reporting,

                                                63
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022       Page: 64



  regulatory compliance and day-to-day tasks to captive managers.” Aplt. Br. at 58. It says

  that it is “meaningless that [Zumbaum] could not recall details about the very subjects

  that he had hired professionals to handle,” and likewise of no importance that Reserve

  was managed by Capstone. Id. at 60.

         But the Tax Court did not criticize Reserve simply because it was managed by

  Capstone. Instead, the Tax Court observed that Reserve’s operations were irregular

  because it had no employees, it maintained an address in Anguilla without ever doing

  business there, and Zumbaum—the co-owner, president, and CEO—“knew virtually

  nothing about its operations.” Reserve, at 50. Even if we credit Reserve’s position that

  captives are frequently managed by third parties, Reserve does not explain why

  Zumbaum—the responsible officer of both Reserve and Peak—could not testify about the

  specifics of any of the policies or their pricing even though McNeel testified that

  Zumbaum and Weikel were “the most significant” people in determining premium prices,

  Aplt. App., Vol. 5 at 1247, and Feldman testified that Zumbaum had the final say on

  “[p]olicies, pricing, which coverages, everything.” Aplt. App., Vol. 5 at 1430. Moreover,

  Zumbaum’s lack of knowledge about Reserve and Capstone’s management of Reserve

  contradicts Capstone’s feasibility study, which emphasized that a prerequisite to forming

  a captive was “wholehearted top management support” and “strong internal oversight.”

  Aplt. App., Vol. 7 at 2039–40 (capitalization omitted). It is one thing to seek technical

  and administrative assistance from professionals; it is quite another to abandon all

  responsibility for how your company is handling $400,000 of insurance and simply

  believe everything Capstone says.

                                               64
Appellate Case: 18-9011     Document: 010110683986         Date Filed: 05/13/2022     Page: 65



         Further, the Tax Court also observed that Reserve’s highly unprofessional

  handling of its only claim suggested that it was not operating as an insurer. The Tax

  Court observed that “no supporting documentation accompanied the claim notice,” that

  “Peak did not submit and Reserve did not insist on obtaining any documents to

  substantiate the occurrence or the amount of the claimed loss,” that the first payment was

  made to Peak “more than a month before” the settlement agreement, that the final

  payment—which increased the total payments from $165,820 to $339,820—was made

  several months after the settlement agreement, that Peak and Reserve did not prepare an

  addendum to the settlement agreement reflecting the increase in payments until years

  later, and finally, that all Reserve’s payments were issued via checks signed by a Peak

  employee. Reserve, at 52. (As shown by our description earlier in the opinion of how the

  claim was handled, these irregularities do not exhaust the improprieties in the

  processing.) Reserve does not dispute on appeal any of these findings regarding its claim

  handling, or even the Tax Court’s conclusions from these findings.

         The Tax Court did not clearly err in concluding that Reserve did not operate as an

  insurance company in the commonly accepted sense.

         V.  THE TAX COURT DID NOT ERR IN REFUSING TO
         RECHARACTERIZE PEAK’S “PREMIUMS” AS CAPITAL
         CONTRIBUTIONS

         Having concluded that the premiums Reserve received from Peak and PoolRe

  were not payments for insurance, the IRS determined that the receipts instead constituted

  FDAP income, which is “fixed or determinable annual or periodical gains, profits, and

  income” that is “received from sources within the United States” but “not effectively

                                              65
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 66



  connected with the conduct of a trade or business within the United States.” I.R.C.

  § 881(a). Such income is taxed at a rate of 30%.

         Reserve challenges this characterization. It argues that if it does not qualify for

  treatment as an insurance company under the Internal Revenue Code, the IRS should

  have treated its receipts as contributions to capital, which are not taxable income for the

  recipient. The Tax Court rejected this argument below, correctly noting that whether a

  payment constitutes a capital contribution turns on the motive of the payor. See United

  States v. Chi., Burlington & Quincy R.R. Co., 412 U.S. 401, 411 (1973) (identifying “the

  intent or motive of the transferor” as “determin[ing] the tax character of the transaction”

  when deciding whether payment by nonshareholder was a contribution to capital); Wash.

  Athletic Club v. United States, 614 F.2d 670, 674 (9th Cir. 1980) (“[T]he motive or

  purpose and intent [of a club member] in making the contributions is a dominant factor in

  determining whether [the payments were] a capital contribution or payment for goods and

  services.” (internal quotation marks omitted)); Bd. of Trade v. Comm’r, 106 T.C. 369,

  381 (1996) (for both shareholders and nonshareholders, payor’s intent controls whether a

  payment is a contribution to capital); cf. Sammons v. Comm’r, 472 F.2d 449, 451–53 (5th

  Cir. 1972) (applying both objective test and subjective-purpose test to determine whether

  to characterize the transfer of property from one corporation to another corporation as a

  dividend to an individual who has an ownership interest in both corporations followed by

  a capital contribution to the transferee corporation). The court pointed out that Reserve

  had the burden to show that the payments it received were not FDAP income but “did not

  produce evidence” supporting that position. Reserve, at 64. It said that “[t]he record does

                                               66
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 67



  not reflect that the parties to the purported insurance transactions treated or intended the

  amounts paid to Reserve as additional capital contributions.” Id. at 65. The absence of

  evidence is particularly striking since Zumbaum was a witness at the hearing and could

  have testified to a capital-contribution intent (although such testimony would, of course,

  have undermined the argument that the premiums were for insurance coverage).

         We review for clear error a Tax Court finding that a taxpayer has not satisfied its

  burden of persuasion on a factual element of its claim. See Hamilton, 955 F.3d at 1172;

  Wash. Mut., Inc. v. United States, 856 F.3d 711, 721 (9th Cir. 2017) (reviewing failure of

  proof in tax-refund case for clear error).

         On appeal Reserve does not dispute that it had the burden of proving its receipts

  were not FDAP income. Nor does it dispute that if its receipts were not capital

  contributions, they meet the criteria for FDAP income. It also does not dispute that it

  listed these payments as income on its tax returns and Peak reported them as deductible

  expenses; and it does not dispute that the payor’s intent is a crucial element when

  determining whether a payment constitutes a capital contribution. It does not even dispute

  that it provided no direct or indirect evidence that its receipts were intended as capital

  contributions rather than business income. On the contrary, Reserve asserts that Peak did

  not intend to contribute to capital, stating, “Both the payors (the Direct Insureds) and the

  payee (Reserve) undeniably intended the payments to be insurance premiums.” Reply Br.

  at 31. On this record alone, we can conclude that the Tax Court did not clearly err by

  finding Reserve failed to satisfy its burden.



                                                  67
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022       Page: 68



         Reserve nevertheless argues that because the Tax Court found no legitimate

  business purpose or non-tax reason for the issuance of the insurance policies, the only

  logical conclusion that the Tax Court could draw is that the payments from Peak to

  Reserve—the purported policy premiums—were capital contributions. See, e.g., Aplt. Br.

  at 63 (“The tax court’s determination that there was no legitimate non-tax reason for

  Reserve’s receipt of the payments is dispositive of the issue of the characterization of the

  amounts received from the perspective of Reserve.”). It points to IRS Revenue Ruling

  2005-40, 2005-2 C.B. 4, 2005 WL 1415557 (2005), which states that “an arrangement

  that purports to be an insurance contract but lacks the requisite risk distribution may

  instead be characterized as a deposit arrangement, a loan, a contribution to capital . . . , an

  indemnity arrangement that is not an insurance contract, or otherwise.” Id. at *1. Reserve

  claims that among these options, the only possible characterization for a transaction

  without a business purpose or nontax reason is as a contribution to capital. Reserve relies

  on Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff’d, 640 F.2d 1010 (9th Cir.

  1981), where the Tax Court determined that a corporation’s payment to a subsidiary

  insurance company was not an insurance premium and recharacterized that payment as a

  capital contribution, see 71 T.C. at 415.

         We disagree. To begin with, Carnation is not persuasive authority that whenever

  an affiliate of a captive insurer deducts a purported “premium” paid to the insurer and the

  insurer is found not to be an insurance company, then the premium should be

  recharacterized as a capital contribution to the insurer. In Carnation there was no dispute

  between the parties regarding how the payments should be recharacterized, see id.; and

                                                68
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022      Page: 69



  there was compelling evidence of intent in any event, since the parent had entered into an

  agreement with a third-party insurance company to provide an additional $3 million of

  capitalization to the subsidiary insurance company, see id. at 403–04. Nor is the situation

  here like that where a portion of a purported deductible business expense paid by one

  subsidiary to another is properly recharacterized as a dividend from the paying subsidiary

  to the parent company followed by a capital contribution from the parent to the other

  subsidiary. This may occur when the paying subsidiary pays an excessive amount (well

  above what would have been paid in an arm’s-length transaction) for goods or services

  from a second subsidiary. In that circumstance, the Commissioner can consider the larger

  picture and infer that the purpose of the transaction was to increase the capital of the

  second subsidiary by, in essence, making a distribution (a taxable dividend) of the excess

  price from the first subsidiary to the parent, which then transfers that excess to the second

  subsidiary as an infusion of capital. See IRS Revenue Ruling 78-83, 1978-1 C.B. 79,

  1978 WL 42300 (1978) (engaging in such reallocation under authority of IRC § 482,

  which permits Commissioner to reallocate gross income, deductions, etc., between two

  organizations controlled by the same interests if Commissioner “determines that such

  distribution, apportionment, or allocation is necessary in order to prevent an evasion of

  taxes or clearly to reflect the income of any of such organizations”); Sammons, 472 F.2d

  at 452–53 (“The concept that a transfer of property between corporations with common

  ownership may constitute a dividend to the common owner, even when the stockholder

  has not received funds or property from either corporation, has been well established . . . .

  In [this] situation . . . the theory is that the funds pass from the transferor to the common

                                                69
Appellate Case: 18-9011      Document: 010110683986           Date Filed: 05/13/2022      Page: 70



  stockholder as a dividend and then to the transferee as a capital contribution.” (emphasis

  added)). But Reserve can point to no evidence, and has conceded there is none, that

  would support such an inference regarding Peak’s purpose here. In particular, it has

  proffered no reason why Peak would want to make a capital contribution to Reserve.

         Revenue Ruling 2005–40 does not declare that when an ostensible insurance

  arrangement fails to adequately distribute risk it must be recharacterized as a contribution

  to capital. The Revenue Ruling mentions some alternatives but those are not exclusive.

  Whether an alternative characterization is appropriate depends upon both the objective

  facts of the transaction and the subjective intent of the parties. Here, the objective reality

  is that Peak and Reserve entered into contracts that required Reserve to pay Peak if Peak

  suffered losses covered by the contracts. Although the Tax Court held that those contracts

  were not insurance contracts and that the policies, with their unreasonable premiums, had

  no legitimate business purpose, that does not mean that the transfer of funds from Peak to

  Reserve could not serve a legitimate business purpose. The court’s findings are consistent

  with the characterization of the transaction proffered by the Commissioner—namely, that

  the transaction was just a movement of funds offshore “to self-insure against business

  losses.” Aplee. Br. at 66. Reserve does not challenge the Commissioner’s assertion that

  the receipt of money by Reserve in such a transaction would be taxable under IRC

  § 881(a), by analogy to the taxation of the receipt of payments for underwriting or for

  providing a guarantee. Cf. Gulf Oil Corp. v. Comm’r, 914 F.2d 396, 411–13 (3d Cir.

  1990) (although premiums paid to an insurance subsidiary were not deductible as

  payments for insurance because the risk was not truly distributed, court refused to

                                                70
Appellate Case: 18-9011      Document: 010110683986          Date Filed: 05/13/2022       Page: 71



  characterize the premium payments by subsidiaries as dividends to the parent corporation

  followed by a capital contribution from the parent to the purported insurance company

  because the insurance subsidiary did provide a benefit—risk coverage—to its affiliates).

         In any event, what is totally absent here is proof of the essential element of

  motive, purpose, or intent—evidence from which one can infer that Peak intended to

  make a capital contribution. The Tax Court’s finding that the policies issued by Reserve

  were not true insurance policies said nothing about Peak’s intent. The finding was based

  on objective facts regarding risk distribution and conducting affairs as an insurance

  business. Reserve has not suggested any reason why Peak or its owners would want to

  make a capital contribution to Reserve. Nor has it presented any argument why a

  factfinder could not infer that Peak’s intent was simply the intent to create a plausible

  insurance company through which Peak could obtain a substantial tax deduction without

  reducing the funds available to its two owners. The intent behind the act does not change

  just because the act failed to achieve its purpose. (In fact, the arrangement did accomplish

  Peak’s purpose. Counsel for the Commissioner reported at oral argument that it was too

  late to challenge Peak’s business deductions for insurance premiums paid to Reserve for

  2008–10.) By the same token, Reserve earned income by creating the appearance of

  issuing insurance policies to Peak, even if it ultimately failed to convince the

  Commissioner that the policies were bona fide. Reserve could have reported the

  transactions with Peak on its tax returns as the receipt of capital contributions, but it did

  not do so. “[W]hile a taxpayer is free to organize his affairs as he chooses, nevertheless,

  once having done so, he must accept the tax consequences of his choice, whether

                                                71
Appellate Case: 18-9011      Document: 010110683986         Date Filed: 05/13/2022         Page: 72



  contemplated or not, and may not enjoy the benefit of some other route he might have

  chosen to follow but did not.” Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417

  U.S. 134, 149 (1974) (citations omitted). We have been pointed to nothing in the Tax

  Code that required the Commissioner to recharacterize the obvious intent of the parties to

  enable Reserve to escape taxation.

         We must emphasize, however, that the Commissioner did not need to prove that

  the transfer of funds from Peak to Reserve was not a capital contribution. Reserve bears

  the burden of persuasion. In particular, Reserve had to prove Peak’s intent to make a

  capital contribution. To rule against Reserve, it sufficed for the Tax Court to not be

  persuaded that this was Peak’s intent. That court did not commit clear error in failing to

  be persuaded.

         VI.      CONCLUSION

         We AFFIRM the judgment of the Tax Court.




                                               72