United States Tax Court
T.C. Memo. 2024-2
TERENCE J. KEATING AND JANET D. KEATING, ET AL., 1
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket Nos. 15066-18, 15067-18, Filed January 4, 2024.
15068-18.
—————
Kacie N.C. Dillon, Jonathan A. Halmi, and Tim Alan Tarter, for
petitioners.
Andrea M. Faldermeyer, Estevan D. Fernandez, Marco Franco, John
Robert Gordon, Erin Kathleen Salel, and Emerald G. Smith, for
respondent.
TABLE OF CONTENTS
MEMORANDUM FINDINGS OF FACT AND OPINION ..................... 4
FINDINGS OF FACT .............................................................................. 6
I. RMS ................................................................................................... 6
A. Background ............................................................................... 6
B. Petitioners’ Roles at RMS ......................................................... 7
II. Commercial Insurance Coverage ..................................................... 8
1 Cases of the following petitioners are consolidated herewith: Cheryl L. Doss,
Docket No. 15067-18; and Arthur D. Candland and Michelle M. Candland, Docket No.
15068-18.
Served 01/04/24
2
[*2] A. Contractual Insurance Obligations .......................................... 8
B. Commercial Insurance Policies ................................................ 8
1. Background ........................................................................ 8
2. Workers’ Compensation Policies ....................................... 9
3. Mr. Hill’s Brokering Efforts .............................................. 9
4. Commercial Policies in Effect During the Years at
Issue ................................................................................. 10
III. Captive Insurance Program ........................................................... 13
A. Background ............................................................................. 13
B. Formation of Captive Insurance Program ............................. 14
C. Captive Owner Operations Manual ....................................... 15
D. Structure of Captive Insurance Program ............................... 17
E. Captive Policies ....................................................................... 19
1. Coverages, Policy Limits, and Premium Amounts......... 19
2. Coverage Selection and Policy Terms ............................. 26
F. Operations and Practices ........................................................ 27
1. Transaction Documentation Practices............................ 27
2. Underwriting Process, Premium Determination, and
Premium Payments ......................................................... 29
3. Claims Handling .............................................................. 32
4. Related-Party Loans and Payments ............................... 37
5. Risk Retention ................................................................. 41
6. Capitalization of Provincial and Provincial Pool............ 42
IV. Dividends ........................................................................................ 43
3
[*3]
V. Sale of RMS..................................................................................... 43
VI. Tax Reporting ................................................................................. 43
A. RMS ......................................................................................... 43
1. 2012 .................................................................................. 44
2. 2013 .................................................................................. 44
3. 2014 .................................................................................. 44
B. Risk Retention ......................................................................... 44
C. Petitioners ............................................................................... 45
OPINION ................................................................................................ 45
I. Evidentiary Matters ....................................................................... 45
II. Jurisdiction and Burden of Proof ................................................... 46
III. Credibility and Fact-Finding ......................................................... 48
IV. Microcaptive Arrangement ............................................................ 50
A. Whether the Arrangement Is Insurance ................................ 51
1. Commonly Accepted Notions of Insurance ..................... 53
2. Conclusion ........................................................................ 64
B. Effect on Petitioners................................................................ 64
1. Section 162 ....................................................................... 64
2. Section 165 ....................................................................... 66
3. Dividends ......................................................................... 70
V. Accuracy-Related Penalties............................................................ 73
4
[*4] MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge: During the years 2012–14 (years at issue),
petitioners Terence J. Keating, Cheryl L. Doss, and Arthur D.
Candland 2 were shareholders of Risk Management Strategies, Inc.
(RMS), an S corporation in the business of acting as a sole employer for
its clients, which were primarily banks administering special needs
trusts. 3 RMS assumed the employer liability resulting from the
employment of caregivers who worked for special needs trusts, handled
payroll, and generally carried out the responsibilities of being an
employer to caregivers and other employees that would have otherwise
fallen on its clients. For each year at issue RMS reported incurring
approximately $1.2 million of expenses for purported insurance
coverage provided through an arrangement among its affiliated captive
insurance company, Risk Retention, Ltd. (Risk Retention), and other
entities.
Respondent contends, among other things, that this arrangement
did not actually provide insurance and that petitioners cannot deduct
the amounts that RMS paid for the purported insurance and related fees
nor take advantage of a preferential rate for dividends paid by Risk
Retention. Respondent also contends that petitioners are liable for
accuracy-related penalties. Petitioners disagree, arguing that the
deductions and preferential dividend rate were proper because the
arrangement provided insurance. They also assert a reasonable-cause-
and-good-faith defense to the accuracy-related penalties. We agree with
respondent that the challenged deductions and preferential dividend
rate were improper and that accuracy-related penalties are appropriate.
On May 11, 2018, respondent determined deficiencies in
petitioners’ federal income tax and accuracy-related penalties under
section 6662(a) 4 as follows:
2 Petitioners Janet D. Keating and Michelle M. Candland had no involvement
in the transactions at issue in these cases, and we do not discuss them further.
3 In addition, some of its employees provided services to grantor trusts, family
offices, and other entities.
4 Unless otherwise indicated, statutory references are to the Internal Revenue
Code, Title 26 U.S.C. (Code), in effect at all relevant times, regulation references are
to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times,
and Rule references are to the Tax Court Rules of Practice and Procedure. Some
monetary amounts have been rounded to the nearest dollar.
5
[*5] Docket No. 15066-18—Terence J. Keating and Janet D. Keating
Year Deficiency § 6662(a) Penalty
2012 $274,039 $54,808
2013 244,578 48,916
2014 317,682 63,536
Docket No. 15067-18—Cheryl L. Doss
Year Deficiency § 6662(a) Penalty
2012 $18,039 $3,608
2013 21,299 4,260
2014 21,510 4,302
Docket No. 15068-18—Arthur D. Candland and Michelle M. Candland
Year Deficiency § 6662(a) Penalty
2012 $287,535 $57,507
2013 244,578 48,916
2014 312,275 62,455
Petitioners timely filed Petitions in these cases on August 2, 2018,
contesting respondent’s determinations. These cases were consolidated
pursuant to Rule 141 for purposes of trial, briefing, and opinion.
The issues for decision are (1) whether transactions conducted
through a purported microcaptive insurance arrangement among RMS,
Risk Retention, and other entities during the years at issue constitute
insurance for federal income tax purposes; (2) whether expenses RMS
incurred during the years at issue (a) through the purported
6
[*6] microcaptive insurance arrangement or (b) to Artex Risk Solutions,
Inc. (Artex), or PRS Insurance (PRS) for services rendered in connection
with the arrangement constitute ordinary and necessary business
expenses deductible under section 162; (3) if not, whether any of those
expenses are deductible as losses under section 165; (4) whether
dividends paid by Risk Retention to Mr. Keating and Mr. Candland in
their 2012 and 2014 taxable years are qualified dividends or ordinary
dividends; and (5) whether petitioners are liable for accuracy-related
penalties imposed under section 6662(a) for the years at issue. We also
address deferred evidentiary rulings.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The
First, Second, Third, and Fourth Stipulations of Facts and the
accompanying Exhibits are incorporated herein by this reference.
Petitioners resided in California when they filed their Petitions. 5 Use
of the terms “insurance,” “insurer,” “insured,” “policy,” “premium,”
“claim,” “reinsurance,” “reinsurer,” and other insurance-related terms in
this Opinion replicate the terminology used by the parties throughout
the litigation and do not imply that we have determined that any
financial arrangement constitutes insurance, or that any company is an
insurance company, as a matter of fact or law for federal income tax
purposes.
I. RMS
A. Background
Mr. Keating and Mr. Candland incorporated RMS, also known as
Trust Employee Administration & Management or TEAM, in 2003. At
the time of incorporation, they split RMS’s ownership evenly, with each
owning 50% of RMS’s stock.
RMS’s primary business was the employment, administration,
and management of service providers for the benefit of trusts.
Specifically, RMS acted as the sole employer for caregivers, guardians,
case managers, household staff, and others who provided services for
special needs trusts, grantor trusts, family offices, and other entities.
Most of RMS’s employees provided services to special needs trust
beneficiaries. RMS contracted its services primarily to national banks,
5 Unless otherwise agreed by the parties in writing, venue for an appeal is the
U.S. Court of Appeals for the Ninth Circuit. See § 7482(b)(1)(A).
7
[*7] and specifically to their wealth management and private banking
departments. RMS also provided payroll and human resources services,
benefits administration, and legal consultation.
RMS had contracts with its bank clients in their capacities as
trustees. Pursuant to these contracts, the parties agreed that it was
their “mutual intention” that “RMS shall do all acts necessary to employ
individuals who will be the employees of RMS . . . and that Trustee shall
not in any manner be deemed to be the employer of such persons,
whether in its corporate or fiduciary capacity.” The contracts also
obligated RMS to secure and maintain “workers’ compensation benefits,
unemployment insurance and the like,” as well as commercial general
liability insurance. An exhibit to the contracts disclosed applicable
service fees, including amounts for payroll taxes and insurance,
amounts for benefits chosen and paid for by the trustee, and a monthly
administrative fee.
After the enactment of the Affordable Care Act, RMS had to offer
health insurance coverage to its employees. RMS could not obtain a
guaranteed-cost group health plan because many of its employees were
parents of disabled trust beneficiaries. Instead, RMS formed a
voluntary employees’ beneficiary association (VEBA) to provide health
coverage to its employees and contracted with a stop-loss insurance
carrier and a claims administrator.
B. Petitioners’ Roles at RMS
In 2003 Mr. Candland and Mr. Keating recruited Ms. Doss to
work at RMS. In 2005 or 2006 Mr. Candland and Mr. Keating gave Ms.
Doss a 5% stake in RMS in the form of nonvoting stock in the
corporation. She eventually became director of client services for RMS,
a role she held during the years at issue.
During the years at issue RMS was a California corporation and
had a valid S corporation election in effect with the Internal Revenue
Service (IRS) pursuant to section 1362. RMS was owned 47.5% by Mr.
Keating, 47.5% by Mr. Candland, and 5% by Ms. Doss during the years
at issue. Mr. Keating was president of RMS and oversaw operations,
including managing payroll, human resources, and customer relations.
Mr. Candland was the chief financial officer of RMS. Ms. Doss served
as director of client services and assisted with onboarding new clients,
paperwork completion, and dealing with the state agencies that licensed
RMS.
8
[*8] RMS contracted with Charter Management Services, Inc.
(Charter), a California corporation formed in November 2003 and owned
by Mr. Keating, Mr. Candland, and Ms. Doss, during the years at issue
to provide administration and management services to RMS and to
serve as the employer of the staff handling the day-to-day operations of
RMS. Charter handled payroll, human resources, and benefits and
administration functions for RMS’s employees. Charter also had a legal
department. Ms. Doss oversaw Charter’s employees, who included
payroll specialists, human resources employees, and accountants.
II. Commercial Insurance Coverage
A. Contractual Insurance Obligations
In its service contracts with its clients during the years at issue,
RMS agreed that it would secure and maintain “workers’ compensation
benefits, unemployment insurance and the like” and “commercial
general liability insurance.” Specifically, RMS agreed that it would
maintain at least the following coverages (with specified minimum
policy limits): commercial general and professional liability, including
personal injury; nonowned automobile liability; workers’ compensation
and employer’s liability; employment practices liability insurance; and
third-party fidelity coverage. No other insurance coverage was
specifically required by the contracts.
B. Commercial Insurance Policies
1. Background
During the years at issue RMS worked with BB&T, an insurance
brokerage, to purchase insurance policies in the commercial
marketplace. Specifically, Mr. Keating and Mr. Candland worked with
John Hill and Geoff Shelton, insurance brokers at BB&T. Mr. Hill, a
commercial property and casualty insurance broker at BB&T, is a
certified insurance counselor and an accredited advisor of insurance. 6
Mr. Hill acts as an intermediary between policyholders and insurance
companies and assists with negotiating insurance coverages and
managing insurance programs.
Mr. Hill first met Mr. Candland and Mr. Keating when they asked
Mr. Shelton to help with their insurance program sometime in the
mid-2000s. Mr. Shelton then asked Mr. Hill to assist with RMS’s
6 Mr. Hill testified only as a fact witness, however, not as an expert witness.
9
[*9] account. When Mr. Hill first started brokering insurance for RMS,
it had a series of workers’ compensation policies through individual
state insurance funds. 7 Mr. Hill was able to find one workers’
compensation policy for RMS that replaced approximately 17
independent state fund policies.
2. Workers’ Compensation Policies
From at least July 1, 2006, to July 1, 2008, RMS had a workers’
compensation policy with the Employers Insurance Co. of Wausau
(Wausau). The Wausau workers’ compensation policy was a
retrospectively rated policy. 8 Beginning in July 2008 and continuing
through the years at issue, RMS had workers’ compensation insurance
with Crum & Forster through United States Fire Insurance Co.
Crum & Forster applied discounts to RMS’s workers’ compensation
premiums for large deductibles, schedule modifications, and loss
experience, among other items.
3. Mr. Hill’s Brokering Efforts
During the years at issue Mr. Hill sought insurance coverage for
RMS in both the retail market and the wholesale market. 9 Mr. Hill is a
retail broker. Retail brokers have a direct relationship with a
policyholder and standard insurance companies but must engage with
wholesale brokers to access the wholesale market. Mr. Hill provided
RMS with marketing summaries, which summarized each insurance
company approached for certain insurance coverages and the results of
those efforts, annually throughout the years at issue. We discuss RMS’s
commercial insurance policies immediately below.
7 State insurance funds are insurance carriers of last resort when the private
marketplace is unable or unwilling to provide the coverage.
8 With a retrospectively rated policy, the insurance company collects a deposit
premium, but at the end of the policy period it performs a calculation based on the
number and cost of claims that occurred during the policy period. If claims are lower
than anticipated, then the policyholder receives money back. If claims are higher than
anticipated, then the policyholder shares the cost of those claims by paying additional
sums to the insurance company. The deposit premium for the July 2006–July 2007
Wausau policy was $728,303, and the deposit premium for the July 2007–July 2008
Wausau policy was $729,307.
9 We sometimes refer to policies obtained in either of these markets as
commercial insurance policies.
10
[*10] 4. Commercial Policies in Effect During the Years at
Issue
RMS purchased the following commercial insurance policies that
were in effect during the years at issue:
Coverage Type Insurer Coverage Period Premiums
and Fees
Crime Chubb “2011-2012” 10 Unknown
Crime Chubb June 1, 2012, to $3,644
June 1, 2013
Crime Chubb “2013-2014” 3,910
Crime Chubb “2014-2015” 4,447
Cyber liability Chubb January 20, 2011, 39,308
to June 1, 2012
Cyber liability Lloyd’s of June 1, 2012, to 25,614
London June 1, 2013
Cyber liability Lloyd’s of June 1, 2013, to 18,628
London June 1, 2014
Cyber liability Lloyd’s of June 1, 2014, to 21,113
London June 1, 2015
Employment Lloyd’s of June 1, 2011, to 43,750
practices London through June 1, 2012
liability Beazley
Insurance Co.,
Inc.
10 Only one crime policy for the years at issue (with a coverage period of June 1,
2012, to June 1, 2013) is in the record. For the other three policies, the parties have
stipulated that they had coverage periods of “2011-2012”, “2013-2014”, and “2014-
2015”, respectively. The record does not provide any additional detail about what that
means.
11
[*11] Coverage Type Insurer Coverage Period Premiums
and Fees
Employment Lloyd’s of June 1, 2012, to 63,882
practices London through June 1, 2013
liability Beazley
Insurance Co.,
Inc.
Employment Lloyd’s of June 1, 2013, to 73,500
practices London through June 1, 2014
liability Beazley
Insurance Co.,
Inc.
Employment Lloyd’s of June 1, 2014, to 75,000
practices London through June 1, 2015
liability Beazley
Insurance Co.,
Inc.
Excess Nautilus June 1, 2011, to 31,617
liability Insurance Co. June 1, 2012
Excess Nautilus June 1, 2012, to 36,824
liability Insurance Co. June 1, 2013
Excess Nautilus June 1, 2013, to 37,475
liability Insurance Co. June 1, 2014
Excess Nautilus June 1, 2014, to 37,611
liability Insurance Co. June 1, 2015
General Nautilus June 1, 2011, to 12,047
liability Insurance Co. June 1, 2012
General Nautilus June 1, 2012, to 14,217
liability Insurance Co. June 1, 2013
General Nautilus June 1, 2013, to 14,601
liability Insurance Co. June 1, 2014
General Nautilus June 1, 2014, to 14,641
liability Insurance Co. June 1, 2015
12
[*12] Coverage Type Insurer Coverage Period Premiums
and Fees
Professional Nautilus June 1, 2011, to 51,812
liability Insurance Co. June 1, 2012
Professional Nautilus June 1, 2012, to 60,143
liability Insurance Co. June 1, 2013
Professional Nautilus June 1, 2013, to 61,471
liability Insurance Co. June 1, 2014
Professional Nautilus June 1, 2014, to 61,635
liability Insurance Co. June 1, 2015
Property Greenwich June 1, 2011, to 2,577
Insurance Co. June 1, 2012
Property Greenwich June 1, 2012, to 3,387
Insurance Co. June 1, 2013
Property Greenwich June 1, 2013, to 3,451
Insurance Co. June 1, 2014
Property Greenwich June 1, 2014, to 3,435
Insurance Co. June 1, 2015.
Workers’ Crum & Forster July 1, 2011, to 536,590 11
compensation through United July 1, 2012
States Fire
Insurance Co.
Workers’ Crum & Forster July 1, 2012, to 424,242 12
compensation through United July 1, 2013
States Fire
Insurance Co.
11 This figure is after the policy’s annual audit. Before the annual audit, the
total cost for the policy was $487,216.
12 This figure is after the policy’s annual audit. Before the annual audit, the
estimated annual cost for the policy was $378,734.
13
[*13] Coverage Type Insurer Coverage Period Premiums
and Fees
Workers’ Crum & Forster July 1, 2013, to 500,615 13
compensation through United July 1, 2014
States Fire
Insurance Co.
Workers’ Crum & Forster July 1, 2014, to 563,334 14
compensation through United July 1, 2015
States Fire
Insurance Co.
III. Captive Insurance Program
A. Background
In addition to its commercial insurance, RMS was the insured on
several purported insurance policies maintained through a captive
insurance program 15 during the years at issue. RMS’s captive insurance
program began in 2008. In an email exchange with an external auditor
on June 18, 2012, Mr. Candland described the captive insurance
program as “RMS self-insur[ing]” (emphasis added) workers’
compensation claims although the scope of the captive program was not
limited to policies relating to workers’ compensation. In a later email
exchange with a potential buyer of RMS on October 24, 2012, Mr.
Candland also described the captive insurance program as a vehicle for
funding workers’ compensation and liability insurance deductibles and
for covering esoteric risks that either could not be covered commercially
or had such low risks that it made no sense to purchase them
13 This figure is before the policy’s annual audit, unlike the figures for the
2011–12 and 2012–13 policies. An October 16, 2014, email from a Crum & Forster
representative to Mr. Candland referencing an attached audit statement for this policy
is in the record, but the record does not disclose the results of the audit.
14 This figure represents the estimated annual cost for the policy before the
annual audit, unlike the figures for the 2011–12 and 2012–13 policies. The results of
the annual audit are not in the record.
15 We sometimes also refer to the captive insurance program interchangeably
as the captive program, the captive arrangement, the microcaptive arrangement, the
captive insurance arrangement, or the microcaptive insurance arrangement.
14
[*14] commercially. He explained that “[t]ypically we pay premium of
just under $1[,]200,000 per year.”
B. Formation of Captive Insurance Program
Mr. Candland had at least three discussions with Ken Kotch (Mr.
Kotch), a vice president at Tribeca Strategic Advisors, LLC (Tribeca),
from May to October 2008. Mr. Candland did not believe Mr. Kotch was
qualified to discuss or underwrite insurance risks. Mr. Candland’s
handwritten notes from these discussions focus on the topics of federal
income taxation, fees, and formation of the captive insurer (including
Anguillan 16 regulatory requirements), but none of the notes contain any
description of insurance needed by RMS. Mr. Candland wrote down that
“upon termination of the captive the funds return as capital gains” and
referred to “[section] 831(b) captives” (i.e., microcaptive insurers), as
well as to the fact that Mr. Kotch was “an . . . [attorney with] emphasis
in taxation[.]” The notes also refer to IRS Revenue Rulings 2002-89,
2002-90, and 2002-91 (concerning risk distribution for insurance
companies) and to an IRS “safe harbor” for risk distribution. In addition,
the notes reflect Mr. Candland’s understanding that $1.2 million was
“the max[imum] we can put into [the] captive” insurer each year and
that “of the funds deposited to the captive, 51% will go into [a risk pool]
for 366 days [and] then be transferred to [the] captive. 49% will stay in
[the] captive [and] we can invest [those funds].”
Contemporaneously with these discussions, Tribeca prepared a
feasibility study for RMS dated August 27, 2008. 17 According to the
feasibility study, RMS was motivated to create the captive in part
because it wanted “platinum-level coverage” and was willing to pay
“platinum-level premiums” for that coverage. However, the feasibility
study also stated that one of the advantages of forming a captive insurer
was the elimination or reduction of certain costs that commercial
insurers face and predicted that a captive insurer could generate
expense savings of up to 35% of the costs of conventional insurance. The
feasibility study contained financial forecast models for RMS that
assumed RMS would have no direct insured claim losses, nor any claims
against the risk pool (described below), for the first six years of
Anguilla is an island of the British West Indies.
16 See Monahan v.
Commissioner, 109 T.C. 235, 236 (1997).
17 Two different versions of the feasibility study are in the record although the
differences are immaterial for purposes of this discussion, and we refer to them as a
single study.
15
[*15] operations. Instead, the models assumed that RMS would have
annual pretax income of $2 million and pay annual captive insurance
premiums of $1.2 million each year for six years and that the captive
would provide RMS with a total net benefit of $3,279,823 over six years.
This net benefit was derived from (1) savings on the amount of income
taxes paid and (2) having greater assets available for investment in each
year beginning with the second year because of the decrease in income
taxes paid and a lack of claims. The models included no estimate of
savings from commercial insurance expenses despite the study’s
statement that such savings were potentially a significant advantage
from using a captive insurer. The feasibility study identified policies
that RMS never purchased, such as ones covering goodwill or identity
protection, as among “the most likely to be incorporated into a new
captive insurance program.” Conversely, the study omitted any mention
of policies relating to workers’ compensation, which RMS did purchase.
On October 31, 2008, Mr. Candland and Mr. Keating signed an
engagement letter on behalf of RMS agreeing to pay Tribeca $40,000 to
form a captive insurer, Risk Retention. 18 The feasibility study was
submitted to Anguilla regulators as part of Risk Retention’s license
application along with, inter alia, a business plan. The business plan
states that Risk Retention would “underwrite highly customized policies
carefully tailored to the specific needs of its insured,” but it also
repeatedly refers to Risk Retention’s intended insured erroneously as
“GTI” rather than RMS.
Risk Retention was formed in November 2008. 19 On
November 25, 2008, the Anguilla Financial Services Commission issued
Risk Retention a Class B Insurance License following an application by
Risk Retention. The Anguilla Financial Services Commission renewed
the license for each of the years at issue.
During the years at issue Risk Retention had no employees.
C. Captive Owner Operations Manual
Tribeca provided a Captive Owner Operations Manual (Owners’
Manual) to Mr. Candland and Mr. Keating on May 12, 2009. The
18 Risk Retention is not a party to these cases.
19 Risk Retention was initially capitalized with $100,000, and it maintained its
$100,000 paid-in capital during the years at issue. Risk Retention had signed bylaws
in effect as of November 24, 2008.
16
[*16] Owners’ Manual set out the responsibilities of the owner of a
captive insurer and noted that while Tribeca managed a captive insurer,
the owners of the captive insurer had ultimate decision-making
authority.
The Owners’ Manual stated that Tribeca could not properly
underwrite captive insurance policies without a completed underwriting
application for each insured. It also stated that captive owners should
determine the amount of coverage and premiums for the next policy year
before the end of the current policy year. Tribeca stated in the Owners’
Manual that it required owners of captive insurers to notify it of any
changes to the amount of premiums paid to the captive insurer for the
current policy year by November 15 and that it “strongly recommends
that premiums be paid during the policy period on a regular schedule,
and not after the end of the policy period.” In particular, Tribeca stated
that “[i]n traditional insurance companies, premiums are usually paid
in monthly, quarterly or annual payments. Premiums are usually
considered due either before the policy period begins or in equal
installments during the policy period.” Tribeca stated that any premium
payments due must be sent by December 31 of the coverage year and
received by January 8 of the following year.
Tribeca strongly discouraged owners of captive insurers from
using their captive insurers to make loans, especially loans from the
captive insurer to an insured or affiliated party. The Owners’ Manual
stated that loans to related parties could increase the likelihood that the
IRS would find that a captive insurer was a sham or that a circular flow
of cash existed. For captive insurers that decided to make loans despite
Tribeca’s advice, the Owners’ Manual advised that loans must be
evidenced by a promissory note or other written document; must be
enforceable; must contain commercially reasonable repayment terms
and interest rates; should be secured; and must be repaid timely.
Tribeca also stated that “it is critical that we receive full documentation
on all transactions involving the Captive and that you notify us in
advance regarding any proposed transaction . . . or movement of funds
involving the Captive.” It advised owners of captive insurers to “strictly
follow the policies of this manual” in view of legal authority taking into
account all of the facts and circumstances in determining what
constitutes insurance or an insurance company.
Regarding claims handling, the Owners’ Manual stated that if an
insured incurred a claim, it should notify Tribeca of the claim in writing.
The Owners’ Manual also stated that Tribeca would provide the insured
17
[*17] with a claim form, that the insured would need to submit
supporting documentation to substantiate the loss, and that the insured
“should make a claim for any loss covered by insurance.”
D. Structure of Captive Insurance Program
The purported captive insurance arrangement between Risk
Retention and RMS did not primarily involve Risk Retention simply
issuing insurance policies to RMS. Instead, two different general
structures were used, one from 2008 to 2010 and the other from 2011 to
2014. Both structures shared commonalities, including that Risk
Retention participated in a risk pool with other captive insurers
managed by Tribeca or, later, Artex. 20 However, the structures varied
in other respects. We describe the structure used from 2008 to 2010 first
because it forms the basis for our discussion of the structure later used
during the years at issue. Except as otherwise indicated, our findings of
fact in this subsection concern the structures set forth by the transaction
documentation and do not address other relevant practices by the
parties to the arrangement.
From 2008 to 2010 RMS and other insureds of Tribeca-managed
captive insurers participating in the risk pool purchased (1) a primary
(or direct) layer of purported insurance coverage for each insured risk
directly from their respective captive insurer and (2) an excess (or
quota-share) layer of purported insurance coverage for each same risk
from Procedant Insurance Co., Inc., a Nevada insurer that we do not
discuss further, or Provincial Insurance, PCC (Provincial), a fronting
insurer organized, licensed, and domiciled in Anguilla as of December
2009. 21 Tribeca allocated the total net premiums received from each
insured approximately 49% to the primary layer and approximately 51%
to the excess layer. An agent, PRS, collected payment from the insured,
20 Arthur J. Gallagher & Co., Inc. (Gallagher), an insurance brokerage and risk
management services firm based in Illinois, acquired the assets of Tribeca in 2010.
The acquisition was announced on December 21, 2010. While the record is unclear as
to whether the acquisition had also closed by December 21, 2010, we generally refer to
Artex rather than Tribeca with respect to events occurring after this date. After the
acquisition, the operations formerly conducted by Tribeca continued out of its Mesa,
Arizona, office under the direction of Gallagher’s wholly owned subsidiary, Artex.
21 The record discloses that Provincial was organized in the British Virgin
Islands as Provincial Insurance, Ltd, before its organization in Anguilla in
December 2009.
18
[*18] retained a 2.5% administrative fee, and transmitted to the captive
insurer and Provincial the net amounts owed to them.
Considering the primary and excess layers of coverage and their
policy limits together, the primary layer insured any covered loss up to
25% of the combined policy limits, and the excess layer insured the
portion of any loss exceeding the primary coverage, subject to a cap
equal to 75% of the combined policy limits (sometimes described as “75%
x/s 25%” or 75%-in-excess-of-25% coverage). Therefore, a smaller
covered loss might be completely covered by the primary layer, while the
excess layer applied to relatively larger covered losses and would pay
out the lesser of (1) the portion of a loss exceeding the policy limits of the
primary layer or (2) its own policy limit (which was triple the amount of
the primary layer’s policy limit and therefore constituted 75% of the
combined policy limits).
Regarding the excess layer, Provincial ceded the risks and
premiums from the excess layer (also known as quota-share risks and
quota-share premiums, respectively) to each of the captive insurers
participating in a risk pool. The risk pool was a purported reinsurance
arrangement conducted pursuant to Master Reinsurance Contracts or
Master Reinsurance Agreements (each also known as quota-share
agreements). The risk pool is known as the Provincial Pool.
Each captive insurer participating in the Provincial Pool,
including Risk Retention, bore a fixed quota-share percentage of any loss
covered by the excess coverage and was allotted the same quota-share
percentage of the premiums allocated to the Provincial Pool. 22 A captive
insurer later received from Provincial its quota share of the premiums
remaining after reduction by its quota share of any claims allowed
against the excess layer coverage. From at least 2009 to 2014 Risk
Retention’s quota share of pool premiums was equal to the net premiums
Provincial received from RMS for excess coverage. Therefore, if there
were no allowed claims or other withheld amounts, 23 Risk Retention
would receive the same amount from the Provincial Pool as RMS had
paid Provincial for excess coverage (net of the 2.5% administrative fee).
22 The quota-share percentage was calculated by computing the ratio of the
premiums paid by a captive insurer’s related insured (here, RMS) for excess coverage
to the total premiums received from all insureds by the Provincial Pool.
23 As discussed below, there were eventually some allowed claims and withheld
amounts.
19
[*19] The structure used from 2011 to 2014 retained this basic model
with some modifications. First, Artex replaced Tribeca as manager of
the captive insurers after the latter’s assets were acquired by the
former’s parent company in December 2010.
Second, insureds no longer purchased a primary layer of coverage
directly from their affiliated captive insurer but instead purchased a so-
called facultative layer of coverage from Provincial. Provincial then
ceded the associated risks and premiums (sometimes called facultative
risks and facultative premiums, respectively) to the affiliated captive
insurer under Reinsurance Contracts (also known as Facultative
Reinsurance Contracts or Facultative Reinsurance Agreements). Risk
Retention remained responsible for all of the losses allowed under the
facultative layer of coverage, albeit through a Facultative Reinsurance
Contract or Agreement rather than by directly issuing insurance policies
to RMS. Artex still allocated approximately 49% of total net premiums
to Risk Retention for this coverage, and Provincial wired these
premiums to Risk Retention within two weeks of receipt. Approximately
51% of total net premiums remained allocable to the Provincial Pool.
Finally, Artex made changes in its practices that we discuss further
below.
E. Captive Policies
1. Coverages, Policy Limits, and Premium Amounts
We summarize RMS’s captive coverages, policy limits, and
premium amounts for the years at issue here. The captive insurance
policies for the years at issue were all claims-made policies, meaning
that they applied only to claims reported during the coverage period or
extended reporting period. The general terms and conditions common
to all Provincial policies during the years at issue included a 45-day
extended reporting period, among other terms. The policies in effect
during the years at issue all had coverage periods running from
January 1 to the following January 1.
RMS paid premiums approximating $1.2 million for each year at
issue. Below, we set forth charts outlining (1) RMS’s captive coverages
and policy limits for the years at issue and (2) the premium amounts
applicable to each coverage for the years at issue. Both in these charts
and throughout the rest of this Opinion, we refer to the concept of a
self-insured retention (SIR), which is a dollar amount specified in an
insurance policy that must be paid by the insured before the insurance
20
[*20] policy will respond to a loss. SIRs generally operate slightly
differently from deductibles, such as with respect to how they erode the
policy limit or whether the insurer has an obligation for indemnity and
defense costs before the deductible or SIR is paid, but they serve a
similar overall function and purpose.
a. 2012
The following chart shows the coverages and policy limits in the
Risk Retention captive insurance program for 2012:
Coverage Self-Insured Total Policy Facultative Pool Limit
Retention Limit Policy Limit
Administrative $250,000 $750,000 — $750,000
actions
Employment — 100,000 $100,000 —
practices
deductible / SIR
reimbursement
Legal expense — 1,000,000 250,000 750,000
Loss of key 250,000 750,000 — 750,000
contract
Loss of key — 1,000,000 250,000 750,000
customer
Professional — 1,000,000 250,000 750,000
liability
difference in
conditions
Worker’s [sic] — 100,000 100,000 —
compensation
deductible / SIR
reimbursement
Total $500,000 $4,700,000 $950,000 $3,750,000
21
[*21] The following chart shows the premium amounts applicable to
these coverages for 2012:
Coverage Gross Administrative Net Facultative Pool
Premium Fee Premium Premium Premium
Administrative $157,281 $3,932 $153,349 — $153,349
actions
Employment 145,500 3,638 141,862 $141,862 —
practices
deductible / SIR
reimbursement
Legal expense 175,051 4,376 170,675 83,631 87,044
Loss of key 167,340 4,184 163,156 — 163,156
contract
Loss of key 194,294 4,857 189,437 92,824 96,613
customer
Professional 183,723 4,593 179,130 87,774 91,356
liability
difference in
conditions
Worker’s 167,500 4,188 163,312 163,312 —
compensation
deductible / SIR
reimbursement
Total $1,190,689 $29,768 $1,160,921 $569,403 $591,518
22
[*22] b. 2013
The following chart shows the coverages and policy limits in the
Risk Retention captive insurance program for 2013:
Coverage Self-Insured Total Policy Facultative Pool Limit
Retention Limit Policy Limit
Administrative $250,000 $750,000 — $750,000
actions
Employment — 100,000 $100,000 —
practices
deductible / SIR
reimbursement
General liability — 50,000 50,000 —
deductible / SIR
reimbursement
Legal expense — 1,000,000 250,000 750,000
Loss of key 250,000 750,000 — 750,000
contract
Loss of key 250,000 750,000 — 750,000
customer
Professional — 1,000,000 250,000 750,000
liability
difference in
conditions
Worker’s — 100,000 100,000 —
compensation
deductible / SIR
reimbursement
Total $750,000 $4,500,000 $750,000 $3,750,000
23
[*23] The following chart shows the premium amounts applicable to
these coverages for 2013:
Coverage Gross Administrative Net Facultative Pool
Premium Fee Premium Premium Premium
Administrative $137,699 $3,442 $134,257 — $134,257
actions
Employment 159,500 3,988 155,512 $155,512 —
practices
deductible / SIR
reimbursement
General liability 89,000 2,225 86,775 86,775 —
deductible / SIR
reimbursement
Legal expense 171,287 4,282 167,005 81,832 85,173
Loss of key 146,506 3,663 142,843 — 142,843
contract
Loss of key 158,715 3,968 154,747 — 154,747
customer
Professional 179,773 4,494 175,279 85,887 89,392
liability
difference in
conditions
Worker’s 181,500 4,538 176,962 176,962 —
compensation
deductible / SIR
reimbursement
Total $1,223,980 $30,600 $1,193,380 $586,968 $606,412
24
[*24] c. 2014
The following chart shows the coverages and policy limits in the
Risk Retention captive insurance program for 2014:
Coverage Self-Insured Total Policy Facultative Pool Limit
Retention Limit Policy Limit
Administrative $250,000 $750,000 — $750,000
actions
Employment — 400,000 400,000 —
practices
deductible / SIR
reimbursement
General liability — 100,000 100,000 —
deductible / SIR
reimbursement
Legal expense 250,000 750,000 — 750,000
Loss of key 250,000 750,000 — 750,000
contract
Professional — 1,000,000 250,000 750,000
liability
difference in
conditions
Regulatory 250,000 750,000 — 750,000
change
Worker’s 100,000 1,000,000 1,000,000 —
compensation
deductible / SIR
reimbursement
Total $1,100,000 $5,500,000 $1,750,000 $3,750,000
25
[*25] The following chart shows the premium amounts applicable to
these coverages for 2014:
Coverage Gross Administrative Net Facultative Pool
Premium Fee Premium Premium Premium
Administrative $118,923 $2,973 $115,950 — $115,950
actions
Employment 159,500 3,988 155,512 155,512 —
practices
deductible / SIR
reimbursement
General liability 89,000 2,225 86,775 86,775 —
deductible / SIR
reimbursement
Legal expense 134,851 3,371 131,480 — 131,480
Loss of key 140,329 3,508 136,821 — 136,821
contract
Professional 157,290 3,932 153,358 75,145 78,213
liability
difference in
conditions
Regulatory 135,275 3,382 131,893 — 131,893
change
Worker’s 255,543 6,389 249,154 249,154 —
compensation
deductible / SIR
reimbursement
Total $1,190,711 $29,768 $1,160,943 $566,586 $594,357
As shown in the tables above, throughout the years at issue Artex
increasingly allocated risks and premiums from individual RMS policies
solely either (1) to the Provincial Pool (i.e., to pool premium and the pool
26
[*26] limit) or (2) to Risk Retention (i.e., to facultative premium and the
facultative policy limit), and it increasingly used SIRs. 24
2. Coverage Selection and Policy Terms
Mr. Hill, RMS’s commercial insurance broker, did not shop for
insurance policies covering administrative actions, loss of a key
customer, or regulatory change because Mr. Candland never asked him
to shop for these policies in the commercial marketplace. Mr. Hill did
not know what administrative action or loss of key customer policies
were. Mr. Candland did not direct Mr. Hill to seek out a zero-dollar
deductible workers’ compensation policy in the commercial
marketplace. 25
During the years at issue the general terms and conditions
common to all Provincial policies contained a number of coverage
exclusions, including for claims that were the subject of any notice given
under other insurance before the inception date of the policies; for claims
based upon circumstances or events that any insured knew about before
the policy period; for criminal, dishonest, or deliberately fraudulent acts,
including sexual abuse or molestation or fraud of any insured; and for
personal profit, remuneration, or advantage gained by any insured to
which it was not legally entitled.
We pause to discuss some terms and context regarding RMS’s
Worker’s Compensation Deductible / SIR Reimbursement policy given
24 In an email dated August 2, 2011, an Artex underwriter explained that
deductible reimbursement policies were “no longer being insured through the pool.”
However, without adjustment, reinsuring deductible reimbursement policies entirely
with Risk Retention would have caused over 49% of Risk Retention’s premium volume
to come from RMS and under 51% to come from reinsuring its quota-share percentage
of the Provincial Pool. To address this perceived problem, Artex “needed to put 2 other
policies 100% in the pool to achieve [the] 49%/51% split that the IRS likes to see for
risk distribution.” For 2011 and 2012 the policies whose risks and premiums were
allocated completely to the Provincial Pool were the Administrative Actions and Loss
of Key Contract policies. This, however, could have exposed the Provincial Pool to
small claims on those policies that previously would have been retained in the primary
coverage layer. Therefore, in order “[t]o protect the pool in these instances,” Artex
added a $250,000 SIR to each policy that “mimics the 25%/75% limit split the standard
structure would have between the captive and the pool.”
25 In fact, Mr. Candland emailed an Artex employee during the years at issue
to inform him that RMS had raised its deductible from $100,000 to $250,000 on the
Crum & Forster policy and stated: “This should make it easier to justify our $1,200,000
captive contribution.”
27
[*27] its importance to the issues in these cases. This policy covered
losses within the deductible or SIR of RMS’s commercial workers’
compensation policy.
Artex did not separately adjust underlying workers’
compensation claims because RMS’s commercial carrier was responsible
for the settlement of claims and then billed RMS for amounts within the
deductible. Instead, RMS filed claims under its workers’ compensation
policy with Crum & Forster, its commercial workers’ compensation
insurance carrier. Crum & Forster adjusted each claim and invoiced
RMS monthly for the deductible portion of any approved claims. When
RMS received a monthly deductible billing invoice from
Crum & Forster, Risk Retention paid it on RMS’s behalf by issuing a
check to United States Fire Insurance Co., which received it on behalf of
Crum & Forster. On one occasion during the years at issue, Mr.
Candland raised the deductible on RMS’s commercial workers’
compensation policies to “make it easier to justify our $1,200,000 captive
contribution.”
F. Operations and Practices
The operations and practices of RMS, Risk Retention, Provincial,
Artex, and petitioners provide additional context to the transactions
among them beyond what is evident from the transaction structure or
captive policies alone. We describe those operations and practices that
are relevant in this subsection.
1. Transaction Documentation Practices
The Master Reinsurance Contracts or Agreements, under which
Provincial ceded risks and premiums to the captive insurers
participating in the Provincial Pool, were not executed by the captive
insurers participating in the Provincial Pool. Instead, Artex employees
executed these contracts. In some cases, Karl Huish, a co-founder of
Tribeca who remained involved with the business after the sale of
Tribeca’s assets to Artex’s parent company, executed both sides of the
same contract, including during the years at issue. In addition, both
before and during the years at issue, policy documents were sometimes
irregularly dated, and policy or coverage periods often began
retroactively relative to policy issuance. We describe some of these
occurrences during the years at issue below.
28
[*28] a. 2012
RMS’s 2012 policy documents were not actually issued until
May 24, 2012, 26 more than four months into the 2012 coverage period. 27
Furthermore, on January 28, 2013, Artex prepared a Change
Endorsement for RMS’s 2012 Worker’s Compensation Deductible / SIR
Reimbursement policy with an effective date of January 1, 2013.
The Change Endorsement stated that losses under the Worker’s
Compensation Deductible / SIR Reimbursement policy would be paid
either directly to RMS’s commercial insurer or to a collateral account
held by the insurer unless otherwise directed by RMS. Nonetheless,
Risk Retention had already begun paying RMS’s commercial insurer
directly (rather than paying Provincial) in 2011. The Change
Endorsement is thus anomalous not only in its effectiveness on
January 1, 2013, a date both before its execution and coinciding with the
end of the applicable coverage period, but also in its late documentation
of a payment practice that had already begun much earlier. 28
b. 2013 and 2014
Beginning in 2013, Artex’s practice was to have Provincial issue
policy documents only once a captive had paid at least 10% of its annual
premiums. Artex finalized RMS’s 2013 and 2014 captive insurance
policies only on June 19, 2013, and July 3, 2014, respectively, well into
the applicable coverage periods. Even the essential terms of the policies
were not always agreed upon before the beginning of each applicable
coverage period. For example, Artex prepared a renewal policy
summary for RMS’s 2013 captive insurance policies dated
26 On February 1, 2012, Artex provided RMS with a renewal policy summary,
describing the coverage period, coverage type, limits, SIR, premium, and policy
number. Although an Artex underwriter testified that a policy summary is “like a
binder,” we find that the renewal policy summary was on its face simply a summary of
the intended policy issuance; that the record contains no credible contemporaneous
evidence that it was intended to have any binding effect; and that the renewal of the
policies was actually completed no earlier than May 24, 2012.
27 RMS’s renewal endorsements during the years at issue refer to a renewal
period rather than a coverage period. We refer to renewal periods as coverage periods
throughout in order to avoid undue confusion.
28 An Artex employee raised the issue that RMS’s Worker’s Compensation
Deductible / SIR Reimbursement policy did not permit Risk Retention to pay RMS’s
commercial insurer directly on January 17, 2013, 11 days before the Change
Endorsement was executed on January 28, 2013.
29
[*29] January 23, 2013, and a revised renewal policy summary dated
March 19, 2013, both after the 2013 coverage period was underway.
Comparing the revised renewal policy summary to the original one,
Artex (1) increased RMS’s 2013 gross premiums from $1,217,018
to $1,223,980, (2) added a General Liability Deductible / SIR
Reimbursement policy, and (3) either increased or decreased the
premium amounts applicable to each of RMS’s other 2013 policies.
2. Underwriting Process, Premium Determination, and
Premium Payments
Mr. Candland provided Tribeca or Artex with the amount that he
was willing to pay, and provided a target premium for all policies
purchased by RMS, both before and during the years at issue. 29
Regarding premium payments, Artex required only that RMS (1) pay its
pool premiums and 2.5% administrative fee by December 31 of the
applicable policy year and (2) pay its facultative premiums by the end of
the first quarter of the following year.
We now describe some additional practices of petitioners, RMS,
Provincial, and Artex pertaining to the underwriting process, premium
determination, and premium payments during the years at issue. We
discuss these topics together because RMS generally decided how and
when to pay its premiums, and Artex adapted its purported
underwriting after the fact to accommodate its preferred payment
amounts and schedule. We specifically find that petitioners, RMS,
Provincial, or Artex (as applicable) engaged in the following practices
related to underwriting, premium determination, and premium
payments during the years at issue:
• The Provincial policies were not objectively rated by evaluating
the risk and magnitude of loss on a prospective basis informed by
detailed underwriting. The premiums that RMS paid for its
captive coverages were inappropriately inflated by subjective,
judgment-driven factors that made little sense under the
circumstances here. The premiums were not supported by
29 Mr. Candland claimed the opposite in a sworn interview with respondent in
September 2015, stating that he told Tribeca he was interested in particular types of
coverage rather than in paying a certain dollar amount of premiums. Mr. Candland
changed his answers in this regard at trial.
30
[*30] actuarial analysis, 30 nor was Artex’s allocation of 49% of
premiums to individual captives and 51% of premiums to the
Provincial Pool.
• Insurance transactions, including premium pricing and premium
payments, were completed after the fact even though in a typical
insurance program they would be completed prospectively. Artex
backdated policy changes and permitted the late issuance of
insurance contracts and late premium payments.
• Artex did not obtain sufficient information from RMS to support
the underwriting process.
• Artex placed undue weight in its purported underwriting on
target premium figures provided by RMS without regard to
whether the target premiums were supported by objective
exposure information.
• Artex permitted its clients, including RMS, to alter their
coverages or total premiums well into coverage periods in a
manner that rendered clients’ decisions of whether to fund the
policies and in what amount as essentially optional and
retrospective, not binding and prospective.
• RMS and Mr. Candland sometimes requested premium increases
to $1.2 million. 31
30 The primary actuarial report Provincial relied on for pricing was prepared
by James Rech (Mr. Rech), an actuary, in 2008. In it, Mr. Rech stated it was his opinion
that “the rating methodology, pricing models, rating factors and rate parameters are
reasonable.” Nonetheless, Mr. Rech did not opine on the ratings for any individual
policies, and his report therefore does not constitute an actuarial endorsement of those
premiums. Mr. Rech did not testify at trial, and Artex’s underwriters never
documented how they derived rating factors.
Mr. Rech’s analysis attempted to provide support for a “Captive Risk Factor,”
which is not a typical rating factor used in the insurance industry. In his definition of
this factor Mr. Rech implied that the adjustment was necessary because an additional
premium is necessary for the first five or more years of a captive’s existence to be viable
in the event of unusual losses. This is not a typical or industry standard adjustment
made by actuaries and would not be a viable business methodology in the commercial
market due to the competitive disadvantage created by excessive premiums.
31 Mr. Candland also requested a premium decrease on one occasion if Artex
did not permit RMS to pay a portion of its premiums after the coverage period. Artex
ultimately relented and permitted the late payment, however.
31
[*31] • RMS paid a disproportionate share of its captive premiums
during the years at issue toward the end of, or after, each
coverage period, and Artex acquiesced in this practice.
• The premiums RMS paid for coverage from Provincial were not
reasonable compared to typical industry pricing. 32 RMS’s total
premiums were always remarkably close to the $1.2 million limit
for nontaxable premium income under section 831(b), regardless
of any variation in coverage.
• Artex generally relied on existing information in its purported
underwriting of RMS’s policies instead of requesting up-to-date
information. Artex’s relatively small underwriting staff was
ill-prepared to underwrite the many different types of policies
that Artex provided.
• Artex caused Provincial to issue RMS’s policy documents well into
the coverage periods that the policies purported to cover without
binders in place.
• Provincial wired facultative premiums to Risk Retention within
about two weeks of receipt.
• Provincial often released pool premiums to Risk Retention within
a few weeks after RMS paid them.
• RMS and Artex did not consistently recognize RMS’s premium
payments for the insurance written by Provincial as constituting
separate amounts from the amounts that Provincial ostensibly
paid to Risk Retention for (1) providing reinsurance to unrelated
members of the Provincial Pool pursuant to Master Reinsurance
32 For example, the average rate-on-line for RMS’s captive policies during the
years at issue was more than ten times greater than the average rate-on-line for
comparable commercial insurance policies, even though RMS did not have major issues
with its existing commercial insurance coverage, or in obtaining the insurance
required by its client contracts. A higher rate-on-line means that insurance coverage
is more expensive per dollar of coverage and could therefore lead to a greater deduction
for premiums. See Syzygy Ins. Co. v. Commissioner, T.C. Memo. 2019-34, at *31.
The pricing for some individual policies did not make sense on its face. For
example, the Employment Practices Deductible / SIR Reimbursement policy had
premiums of $145,500 for 2011 and 2012 and $159,500 for 2013 but had a per-
occurrence limit of $100,000. This cost does not make sense unless RMS anticipated
multiple high-dollar claims per year (or a very large volume of small-dollar claims). In
fact, however, RMS filed only one claim against the policy, for $3,452.
32
[*32] Contracts or Agreements or (2) providing reinsurance to
Provincial pursuant to Facultative Reinsurance Contracts or
Agreements. 33
3. Claims Handling
Artex’s director of underwriting, Deborah Inman, was involved
with the claims process at Artex during the years at issue. Ms. Inman
supervised the claims function at Artex until 2018. In March 2014 Artex
hired a licensed claims adjuster. 34
The general terms and conditions for all Provincial policies during
the years at issue provided that if an insured incurred a claim, it was
required to give Artex prompt notice of the claim. The general terms
and conditions further stated that an insured was required to give Artex
a description of the events and circumstances that led to the claim as
soon as possible.
33 For example, on November 4, 2013, Mr. Candland asked an Artex employee:
“If I wire a captive premium, how long before you can turn the funds around and
deposit [them] in [Risk Retention’s] bank account?” The employee told Mr. Candland
that direct premiums were “returned” three to five business days after payment and
that pool premiums were “returned” within ten business days. On December 3, 2013,
Mr. Candland told that Artex employee that he would be wiring $300,000 for a captive
insurance premium and instructed him to deposit the funds “back into” Risk
Retention’s bank account. The employee responded that he would “make sure” that
those funds ended up “back at” Risk Retention’s bank. On January 7, 2014, Mr.
Candland asked the same employee for help in getting other premium payments
“moved through the system and back” because “[t]he previous premium took one week
to turn around and I had anticipated the same for this last payment.” Provincial
transferred the direct premiums to Risk Retention that day.
34 Before the hiring of a licensed claims adjuster, an underwriting assistant
and Artex’s risk pool administrator assisted Ms. Inman with handling claims.
33
[*33] a. RMS’s Claims
Risk Retention paid claims filed by RMS in the following
amounts:
Year Amount
2008 —
2009 $2,450
2010 34,354
2011 323,379
2012 231,455
2013 400,868
2014 81,094
All paid claims filed by RMS under its 2012–14 captive policies
were filed against its Worker’s Compensation Deductible / SIR
Reimbursement policy. We make the following findings regarding the
handling of RMS’s claims during the years at issue:
• RMS generally did not submit the deductible billing invoices or
other claim documents it received from Crum & Forster to Artex
before Risk Retention paid the deductibles billed, and it did not
otherwise await approval from Artex. 35 Artex performed little
35 Petitioners’ expert witness Michael Angelina opined that “since the
[Worker’s Compensation Deductible / SIR Reimbursement] policy is a deductible
reimbursement policy, there is no real need for Artex to ‘re-adjust’ a claim that has
already been handled by the claims team of the commercial insurer (Crum & Forster).
. . . While the approach to pay the claims in a ‘batch mode’ . . . was ‘not the norm’ for
Artex, it was an approved process by Artex for these claims.” We reject as unsupported
by the record any suggestion that Artex had no obligation to adjust claims for
deductible or SIR amounts under RMS’s Worker’s Compensation Deductible / SIR
Reimbursement policy simply because Crum & Forster had adjusted the underlying
34
[*34] timely review of these claims. It is not a typical practice in the
insurance industry to approve a claim after it has already been
paid.
• An objective coverage assessment could have resulted in a denial
of most of RMS’s workers’ compensation deductible claims
because the underlying losses had been previously reported
before the inception of the applicable captive insurance policies.
• RMS sometimes notified Artex of claims after both the coverage
period and the extended reporting period for a policy had lapsed.
Risk Retention nonetheless issued payments for such claims.
• RMS used, and Artex acquiesced in the use of, board resolutions
to authorize the payment of claims that should have been denied.
RMS’s use of a board resolution to permit a settlement payment
to Wausau, RMS’s former workers’ compensation carrier, under
the Worker’s Compensation Deductible / SIR Reimbursement
policy was intentionally misleading. 36
workers’ compensation claims under RMS’s separate commercial workers’
compensation policy.
Even if Risk Retention had been permitted to pay RMS’s workers’
compensation deductibles directly without any approval from Artex, this would be a
major process deficiency because it allowed Risk Retention to pay claims that should
not have been covered and to escape independent claims adjustment. There was a
need for such claims adjustment to determine whether the deductibles charged by
Crum & Forster were covered under the terms of each captive policy during the years
at issue. For example, an objective coverage assessment could have resulted in a denial
of most of RMS’s workers’ compensation deductible claims because the underlying
losses had been previously reported before the inception of the applicable captive
insurance policies.
36 On May 10, 2012, Mr. Candland notified Artex that RMS had settled a
dispute regarding 2007 workers’ compensation claims with its former workers’
compensation carrier, Wausau. The Wausau claim arose from RMS’s nonpayment of
disputed retrospective premium adjustments on its 2007–08 policy with Wausau; the
retrospective adjustments were calculated on February 9, 2010, and January 31, 2011.
Ms. Inman accurately enumerated several issues with the claim on
May 11, 2012. First, according to Ms. Inman, Mr. Candland “wants to make payment
from the captive for claims that occurred in 2006 & 2007 which is before the captive
was formed so the captive didn’t have any policies in force during that time.” Second,
he “had knowledge of these claims when he started his captive and any . . . [workers’
compensation] policies that were written for him when the captive started. Claims of
which the insured has prior knowledge are excluded.” Third, “[t]he claims would be
35
[*35] • Risk Retention, a purported reinsurer, inappropriately paid
certain workers’ compensation deductible claims directly to the
commercial carrier instead of paying Provincial. The January
28, 2013, Change Endorsement that Artex prepared for RMS’s
2012 Worker’s Compensation Deductible / SIR Reimbursement
policy provided belated approval at best for this practice.
b. Provincial Pool Claims
The Provincial Pool paid a single claim in 2011 of $8,274,
representing about 0.016% of the $51,702,549 in pool premiums for that
year. The Provincial Pool paid $210,615 on account of three claims in
2012, which amounts to 0.324% of total pool premiums for 2012. In 2013
the Provincial Pool paid $2,631,536 on account of nine claims, which
amounts to 3.322% of total pool premiums for 2013. The Provincial Pool
had paid $2,507,682 in pool claims for the 2014 policy year as of
February 17, 2021. This amounts to 3.019% of total pool premiums
for 2014.
Risk Retention’s quota share of pool claims and loss adjustment
expenses from 2012 to 2014, in dollars and as a percentage of pool
premiums paid by RMS, was as follows:
Year Quota Share Quota Share as
Approximate Percentage
of Pool Premiums Paid by
RMS
2012 $1,921 0.325%
2013 20,209 3.333%
2014 18,732 3.152%
considered as late reported even if they were covered by the 2008 policy.” Fourth,
“[b]ecause Risk Retention is now and was in 2011 a reinsurer of Provincial instead of
a direct insurer, claims should be authorized by and paid through Provincial instead
of directly from the captive.”
Nonetheless, Artex informed RMS that Risk Retention could pay Wausau if
Risk Retention executed a board resolution authorizing the payment. On May 15,
2012, Risk Retention passed a board resolution authorizing Risk Retention to pay
Wausau (and a related insurer, Liberty Mutual) $235,000. On the same day, Ms.
Inman signed a proof of claim form approving the claim, and Risk Retention wired
$235,000 to Wausau.
36
[*36] We make the following findings regarding Artex and Provincial’s
handling of claims in the Provincial Pool:
• The low ratio of losses to premiums in the Provincial Pool
compared to the insurance industry as a whole contributed to
nearly a full round trip of pool premiums paid by RMS to Risk
Retention, through various entities managed by Artex.
• Artex added or altered policies for its clients retroactively in order
to permit them to file claims against the Provincial Pool or to
reduce their premiums if they were unable to pay in full.
• Artex did not consistently enforce the prior-knowledge
limitation 37 when adjusting claims, or treat claims as uncovered
because no coverage was in effect at the time of a loss, even
though it should have. It also did not consistently enforce the
requirement that a claim be promptly submitted after an insured
learned about it.
• There was inappropriate overlap between the claims and
underwriting functions at Artex. On one occasion, Ms. Inman
backdated a policy document to a date that preceded her
employment at Artex in order to facilitate a client’s filing of claims
under a retroactively added policy. 38 The claims were ultimately
paid.
• Artex permitted its clients to use board resolutions to obtain
claims payment for claims that should have been denied.
• Artex encouraged the submission of pool claims during the years
at issue in order to improve the public perception of the legitimacy
of the Provincial Pool, regardless of whether those claims should
have been denied.
• Artex required only slight documentation in support of some pool
claims.
37 The general terms and conditions to the captive policies excluded claims for
which an insured had knowledge of a covered cause of loss before the coverage period.
38 The client was Lanter Delivery Systems, Inc.
37
[*37] 4. Related-Party Loans and Payments
Before and during the years at issue, Risk Retention made loans
to RMS to fund various business expenses of RMS and made other
related-party payments. We describe those loans and payments here.
a. Premium Finance Agreements
Beginning in 2009 and continuing through the years at issue RMS
executed eight premium finance agreements (PFAs) with Risk Retention
in order to finance premiums on certain of RMS’s commercial insurance
policies. 39 On August 19, 2009, Mr. Candland sent an email to an Artex
employee explaining that “[i]n the past we have chosen to finance these
premiums in an effort to cash flow the payment, rather than take an
annual hit to our cash. Is there any legal reason why we can’t use some
of our captive money and run the financing through our captive?” Mr.
Candland also stated that “we would feel comfortable paying to Risk
Retention” an interest rate for premium financing that “is much higher
than we have paid in the past.” Mr. Candland prepared the PFAs on
behalf of Risk Retention and signed each one on behalf of RMS.
Under the terms of the PFAs, Risk Retention paid commercial
insurers directly for the full amount of certain of RMS’s annual
commercial insurance policy premiums. RMS was then required to
repay the total premiums plus an interest or finance charge to Risk
Retention over the course of 12 months, except that the term for the
fourth PFA, which was executed on January 24, 2011, was 16 months.
All of the PFAs carried an annual interest rate of 10% with 12 or 16
equal monthly payments, as applicable. RMS sometimes notified Artex
of the execution of PFAs only after the fact. 40
39 The parties stipulated that RMS and Risk Retention executed seven PFAs
during these years, but we note that eight PFAs for these years have been received
into the record. We find that RMS and Risk Retention executed eight PFAs during
these years. See Cal-Maine Foods, Inc. v. Commissioner, 93 T.C. 181, 195 (1989)
(holding that we are not obliged to accept a stipulation between the parties when it is
clearly contrary to facts disclosed by the record).
40 For example, Mr. Candland notified an Artex employee on June 15, 2011, of
the June 1, 2011, execution of the fifth PFA. Likewise, he informed Artex of the
execution of the fourth PFA only on the same day that he executed it, which was
January 24, 2011.
38
[*38] We do not discuss the first three PFAs further. RMS executed the
fourth through eighth PFAs as follows:
PFA Execution Date Amount of Type of Premiums
Premiums Financed
Financed
Fourth January 24, 2011 $39,308 Cyber liability policy
Fifth June 1, 2011 144,642 Crime, general liability,
professional liability,
excess liability, and
employment practices
liability policies
Sixth June 19, 2012 210,162 Crime, employment
practices liability,
commercial property,
general liability,
professional liability,
excess liability, and
cyber liability policies
Seventh June 6, 2013 217,763 Crime, employment
practices liability,
property, general
liability, professional
liability, excess liability,
and cyber liability
policies
Eighth June 14, 2014 224,033 Crime, employment
practices liability,
property, general
liability, professional
liability, excess liability,
and cyber liability
policies
RMS timely repaid the principal and interest on each PFA in accordance
with its terms.
b. Life Insurance Policy Payments
During the years at issue, RMS also purchased various life
insurance policies for Mr. Keating, Mr. Candland, and Ms. Doss. Risk
39
[*39] Retention financed the premiums on these life insurance policies
by paying the commercial life insurance carriers directly and in full.
Artex and RMS considered this arrangement a loan. Risk Retention
accounted for the payments to commercial insurance carriers for life
insurance as notes receivable in its books and records. RMS repaid Risk
Retention periodically for the life insurance premiums with interest.
Nonetheless, petitioners have not produced a promissory note or any
other writing evidencing a loan or another financing arrangement
permitting Risk Retention to finance petitioners’ personal life insurance
premiums nor one permitting RMS to repay Risk Retention with
interest.
Artex characterized amounts paid in excess of principal
repayment as captive insurance premiums rather than solely as
interest. 41 Furthermore, in an email dated August 26, 2011, an Artex
employee also described the “extra” money as being “circled back out
pretty quickly” because it was used for RMS to pay further life insurance
premiums. In 2012 Risk Retention financed life insurance premiums on
behalf of Mr. Keating, Mr. Candland, and Ms. Doss of approximately
$72,000.
Throughout most of 2012 Artex recorded the life insurance
policies themselves as “Other Assets” in Risk Retention’s books and
records. However, on December 1, 2012, Mr. Candland informed Artex
that the policies were not owned by Risk Retention; instead they were
used to fund a buy-sell agreement between Mr. Keating and himself, and
each personally owned the policy taken out on the other. He further
stated: “We have never intended for the life insurance policies to be
owned by the captive, unless there is a significant tax advantage.”
41 In an email dated August 3, 2011, an Artex employee described the process
used by Risk Retention to finance the life insurance premiums by stating that RMS
“make[s] monthly payments directly to the captive each month for loans that they took.
When they make these payments, they pay ‘extra money’ directly into the captive that
the captive then turns around and pays to buy life insurance policies. This extra money
is considered premiums paid so at the end of the year when I calculate what they still
owe(direct premiums, risk pool premiums, and 2.5% fee) everything worked out right
to the very last zero.” (Emphasis added.)
40
[*40] c. Miscellaneous Loans
Risk Retention also made loans to RMS to finance software,
hardware, and excess self-funded group health plan claims. We describe
those loans here.
i. Software Note
On July 16, 2012, Risk Retention lent $126,000 to RMS to finance
new computer software. The loan was evidenced by a promissory note
although the promissory note stated that RMS’s obligation to make
24 monthly payments began on August 1, 2012, and ended on a maturity
date of July 31, 2012, a patent error. The loan carried an annual interest
rate of 10% and was secured through a security agreement. RMS made
monthly payments of principal and interest to Risk Retention and
repaid the loan in full on July 21, 2014.
ii. Hardware Note
On August 20, 2012, Risk Retention lent $71,000 to RMS for the
purchase of computer hardware. The loan was evidenced by a
promissory note and required 24 monthly payments. The loan carried
an interest rate of 10% and was secured through a security agreement.
RMS made monthly payments of principal and interest to Risk
Retention and repaid the loan in full on August 21, 2014.
iii. Group Health Plan Notes
On November 1, 2013, Risk Retention lent $300,000 to RMS to
finance the portion of RMS’s self-funded group health plan claims that
exceeded premiums received in 2013. The November 1, 2013, loan was
evidenced by a promissory note (First Stop Loss Bridge Note), and a
security agreement was also executed on the same date. The loan
carried an interest rate of 10%. Mr. Candland informed Artex of this
loan through an email dated December 18, 2013. The First Stop Loss
Bridge Note required repayment of all outstanding principal, interest,
and other amounts on its maturity date, April 1, 2014, but RMS had not
made any payments toward it as of that date.
Risk Retention made a second $300,000 loan to RMS in respect of
its excess self-funded group health plan claims on January 8, 2014,
which was also evidenced by a promissory note (Second Stop Loss Bridge
Note). The loan carried an annual interest rate of 10%. Although the
Second Stop Loss Bridge Note states that it was secured by a
41
[*41] contemporaneous security agreement, petitioners did not produce
a copy of the security agreement. The Second Stop Loss Bridge Note
required repayment of all outstanding principal, interest, and other
amounts on its maturity date, May 1, 2014, but RMS had not made any
payments toward it as of that date. Risk Retention did not take any
action to enforce repayment of either the First or Second Stop Loss
Bridge Note following default. On June 10 and September 29, 2014,
RMS made payments to Risk Retention of $500,000 and $132,822,
respectively, for its liabilities on both notes.
Risk Retention made a third $300,000 loan to RMS on
December 10, 2014, which was also evidenced by a promissory note
(VEBA Stop Loss Note). The loan carried an annual interest rate of 10%.
Although the VEBA Stop Loss Note states that it was secured by a
contemporaneous security agreement, petitioners did not produce a copy
of the security agreement. The VEBA Stop Loss Note came due on
March 1, 2015. The VEBA Stop Loss Note was repaid in full on March 2,
2015.
d. Deductible Agreements
RMS and United States Fire Insurance Co., the company through
which RMS obtained workers’ compensation insurance from
Crum & Forster, executed a deductible agreement in 2009. RMS and
Risk Retention together executed various deductible agreements with
United States Fire Insurance Co. beginning in July 2011 and continuing
throughout the years at issue. Under its agreements with RMS and
Risk Retention, United States Fire Insurance Co. was responsible for
making initial payment of any deductibles owed under the applicable
workers’ compensation policies, and RMS and Risk Retention were
responsible for reimbursing it. The agreements required RMS and Risk
Retention to ensure that a collateral fund contained a minimum amount
of cash. Risk Retention paid substantial sums into the collateral fund
before and during the years at issue.
5. Risk Retention
Mr. Keating and Mr. Candland owned Risk Retention equally
during the years at issue, and Risk Retention’s board of directors
consisted of Mr. Keating and Mr. Candland. Risk Retention held annual
board meetings during the years at issue. More than 60% of Risk
Retention’s assets were highly liquid assets during the years at issue.
42
[*42] Risk Retention’s books and records included a general ledger, a
balance sheet, a profit and loss statement, and an adjusted trial balance.
6. Capitalization of Provincial and Provincial Pool
We first discuss the capitalization of Provincial generally because
Provincial was a fronting insurer under both the facultative and
quota-share reinsurance agreements. We then specifically discuss the
capitalization of the Provincial Pool, which is relevant only to the
quota-share reinsurance portion of the captive arrangement.
a. Provincial
Although Provincial reported substantial cash on hand
throughout the years at issue, Provincial held minimal capital by other
measures. Provincial’s reported current liabilities either exceeded, or
were only marginally exceeded by, its current assets on each of its
balance sheets for the years at issue. The disparity was most marked at
yearend 2014, when Provincial had only $21,861,284 in current assets,
compared to $34,982,548 in current liabilities. 42
b. Provincial Pool
Beginning on June 1, 2013, Artex withheld 2% of the pool
premiums paid by each captive insurer as a risk pool claim reserve. 43
Artex was unable to pay pool claims quickly before that date because it
generally collected funds from each pool member as each claim arose. 44
42 Provincial also had little equity to draw upon to meet its liabilities.
Provincial reported $1,193,735 in equity at yearend 2012 compared to $89,037,865 in
current liabilities; $1,181,908 in equity at yearend 2013 compared to $132,933,824 in
current liabilities; and $368,427 in equity at yearend 2014 compared to $34,982,548 in
current liabilities.
43 Artex held the claim reserves in a non-interest-bearing “Reserve Account”
that was recorded as an asset on each captive insurer’s balance sheet and other
financial documents.
44 Jeremy Huish at Artex described the change in an email on May 1, 2013,
stating: “[W]e are starting a reserve account to pay pool claims in the future. Under
our current system, we can’t pay out a pool claim until the middle of the next year
because of the time it takes to gather funds from everyone. While a slow insurance
payment has been fine in the fast [sic], there may be claims in the future where a quick
payment is needed.”
43
[*43] In 2013 and 2014 45 the Master Reinsurance Agreements also
required all captive insurers participating in the Provincial Pool to
provide funds as collateral to support potential pool claims, either by
allowing Provincial to hold the funds or by holding the funds in a
collateral account. Risk Retention had provided pledged accounts to the
Provincial Pool pursuant to a separate pledge agreement before this
time although the record is not clear with respect to participating
reinsurers other than Risk Retention.
IV. Dividends
In 2012 Risk Retention paid Mr. Candland and Mr. Keating
dividends of $500,000 each. In April 2014 Risk Retention paid Mr.
Candland and Mr. Keating dividends of $200,000 each. In October 2014
Risk Retention paid Mr. Candland and Mr. Keating additional dividends
of $300,000 each. In both 2012 and 2014 Risk Retention issued copies
of Form 1099–DIV, Dividends and Distributions, reporting the
dividends paid to Mr. Candland and Mr. Keating.
V. Sale of RMS
In 2015 petitioners sold a controlling interest in RMS to a third
party. Before that sale, in 2012, Mr. Candland discussed a sale of RMS
with a potential buyer. Mr. Candland emailed a calculation of EBITDA
(i.e., earnings before interest, taxes, depreciation, and amortization) to
the potential buyer. The EBITDA calculation provided by Mr. Candland
added back into earnings the amounts paid to Risk Retention as
insurance premiums (less claims), as well as other amounts not typically
understood as interest, taxes, depreciation, or amortization, such as
$200,000 in “[p]erks” for petitioners.
VI. Tax Reporting
A. RMS
RMS was an accrual basis taxpayer during the years at issue.
RMS timely filed its Form 1120S, U.S. Income Tax Return for an
S Corporation, for each year at issue.
45 The 2012 Master Reinsurance Contract did not address the subject of
collateral.
44
[*44] 1. 2012
RMS reported gross receipts of $65,750,508 and net ordinary
business income of $59,397 on its Form 1120S for its 2012 taxable year.
RMS deducted $1,229,089 that is in dispute here, comprising $1,160,921
in captive insurance premiums, $38,400 in fees paid to Artex, 46 and
$29,768 for the 2.5% administrative fee.
2. 2013
RMS reported gross receipts of $78,078,987 and net ordinary
business income of $270,269 on its Form 1120S for its 2013 taxable year.
RMS deducted $1,262,380 that is in dispute here, comprising $1,193,380
in captive insurance premiums, $38,400 in fees paid to Artex, and
$30,600 for the 2.5% administrative fee.
3. 2014
RMS reported gross receipts of $84,464,179 and a net ordinary
business loss of $226,863 on its Form 1120S for its 2014 taxable year.
RMS deducted $1,229,111 that is in dispute here, comprising $1,160,943
in captive insurance premiums, $38,400 in fees paid to Artex, and
$29,768 for the 2.5% administrative fee.
B. Risk Retention
Risk Retention filed an election as a foreign insurance company
to be treated as a domestic corporation under section 953(d) on
February 18, 2009, which the IRS accepted. Risk Retention filed a
Form 1120–PC, U.S. Property and Casualty Insurance Company Income
Tax Return, for each year at issue. Risk Retention attached its Foreign
Insurance Company Election under section 953(d) and a Small
46 Regarding the fees paid to Artex, Artex would periodically issue invoices for
its captive management services to RMS. Artex typically invoiced RMS $3,200
monthly for these services during the years at issue. An October 6, 2008, engagement
letter between Tribeca and RMS states that the management fee paid for the following
fees and services: insurance management fees; costs for annual reviews regarding
policies and premiums; reviewing and determining insurable risks; underwriting and
drafting policies; consultation regarding qualification of the captive insurance
company; preparations of financial statements; auditing fees; consultation regarding
business operations; preparation and filing of tax returns; annual insurance license
fees; and annual corporate fees for the captive.
45
[*45] Insurance Company Election under section 831(b) to its income
tax return for each of the years at issue. 47
C. Petitioners
Petitioners timely filed Forms 1040, U.S. Individual Income Tax
Return, for each year at issue. Mr. Candland and Mr. Keating reported
the dividends they received from Risk Retention in both 2012 and 2014
as qualified dividends on their respective individual income tax returns
for each year and paid tax on the dividends at the qualified dividend
rate. See § 1(h)(11).
OPINION
I. Evidentiary Matters
As a preliminary matter, the Court must address the
admissibility of certain documentary or other nontestimonial evidence
introduced at trial but for which we reserved ruling. Our evidentiary
rulings are determined under the Federal Rules of Evidence. See § 7453;
Rule 143(a).
Under the Federal Rules of Evidence, irrelevant evidence is not
admissible. See Fed. R. Evid. 402. An item of evidence is relevant to the
extent it tends to make a fact more or less probable and the fact is
consequential to determining the action. See Fed. R. Evid. 401. When
the relevance of evidence depends on a fact, proof must be introduced
sufficient to support a finding that the fact does exist. See Fed. R.
Evid. 104(b); see also David S. Schwartz, A Foundation Theory of
Evidence, 100 Geo. L.J. 95, 140 (2011) (“[C]onditional relevance is a
requirement that foundations be complete rather than relying on
generalizations to do the work of case-specific, evidenced facts.”).
Most of the outstanding evidentiary determinations involve
instances where (1) we advised the offering party that the proposed item
of evidence required a foundation to be established at trial or (2) the
offering party advised us that the proposed item of evidence could be
introduced during the course of trial or explored further in conjunction
with witness testimony. Cf. Jerden v. Amstutz, 430 F.3d 1231, 1237 (9th
Cir. 2005) (stating that a trial court “may not exclude evidence before
trial [on the ground of lack of foundation] without allowing the parties
47 Risk Retention did not request that the Secretary of the Treasury revoke
either of these elections for its 2008–14 taxable years.
46
[*46] to lay a foundation for its admission”). The offering party never
examined any witness about, or else failed to establish an adequate
foundation for, the following Exhibits: 17-R, 18-R, 19-R, 21-R, 22-R,
23-R, 29-R, 30-R, 31-R, 32-R, 33-R, 34-R, 35-R, 57-P, 58-P, 60-R, 61-R,
100-R, 523-R, 524-R, 525-R, 1503-R, 1714-R, 1715-R, 1716-R, and
1717-R. The relevance of these Exhibits is entirely speculative without
an adequate foundation established through witness testimony or other
means at trial. We therefore exclude them from evidence.
Other evidentiary determinations involve instances where we
excluded an Exhibit at trial but did not expressly rule on the
admissibility of a related Exhibit. Our review of the following Exhibits
shows that they lack an adequate foundation, and their relevance is
entirely speculative, in view of our exclusion of related Exhibits: 1-R,
526-R, and 528-R. We therefore exclude them from evidence.
Finally, Exhibit 50-P is a spreadsheet in Excel format that shows
statistics regarding certain captives as of March 3, 2021. Exhibit 49-P
is a copy of the same spreadsheet in another format that we excluded at
trial because petitioners did not adequately establish that it was an
accurate summary of voluminous records pursuant to Rule 1006 of the
Federal Rules of Evidence. Cf. United States v. Lynch, 735 F. App’x 780,
785 (3d Cir. 2018) (“Rule 1006 summaries . . . must be supported by a
foundation showing that the exhibit is an accurate summary of the
underlying materials . . . .”); United States v. Scales, 594 F.2d 558, 563
(6th Cir. 1979) (“[E]ven under Rule 1006, the summary or chart must be
accurate, authentic and properly introduced before it may be admitted
in evidence.”). Exhibit 50-P is the same document, albeit in a different
format, and we exclude it for the same reason.
II. Jurisdiction and Burden of Proof
Where a notice of deficiency issued to an S corporation
shareholder includes adjustments to both S corporation items and other
items unrelated to the S corporation, 48 we have jurisdiction to determine
the correctness of all adjustments in the shareholder-level deficiency
48 An S corporation is governed under the rules in subchapter S of chapter 1 of
subtitle A of the Code. S corporations are not generally themselves subject to federal
income tax but, like partnerships, are conduits through which income flows to their
shareholders. See § 1366; Gitlitz v. Commissioner, 531 U.S. 206, 209 (2001)
(“Subchapter S allows shareholders of qualified corporations to elect a ‘pass-through’
taxation system under which income is subjected to only one level of taxation.”).
47
[*47] proceeding. 49 See Johnson v. Commissioner, 160 T.C. 18, 28 (2023)
(citing Winter v. Commissioner, 135 T.C. 238, 245–46 (2010)). We thus
have jurisdiction to redetermine the correctness of respondent’s
adjustments to petitioners’ flowthrough share of RMS’s income and any
other determinations in the notice of deficiency.
The Commissioner’s determinations in a notice of deficiency are
generally presumed correct, and the taxpayer bears the burden of
proving that the determinations are incorrect. See Rule 142(a)(1); see
also Welch v. Helvering, 290 U.S. 111, 115 (1933); Rockwell v.
Commissioner, 512 F.2d 882, 885–87 (9th Cir. 1975), aff’g T.C. Memo.
1972-133. However, if the Commissioner raises a new matter, seeks an
increase in deficiency, or asserts an affirmative defense, the
Commissioner has the burden of proof as to the new matter, increased
deficiency, or affirmative defense. Rule 142(a)(1).
Gross income generally includes all income from whatever source
derived, including dividends. See § 61(a); Commissioner v. Glenshaw
Glass Co., 348 U.S. 426, 429–30 (1955); Wilcox v. Commissioner, 848
F.2d 1007, 1008 (9th Cir. 1988), aff’g T.C. Memo. 1987-225; Treas. Reg.
§§ 1.61-1(a), 1.61-9(a). Deductions are a matter of legislative grace, and
taxpayers bear the burden of proving that they are entitled to any
deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79,
84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
A taxpayer claiming a deduction on a federal income tax return must
demonstrate that the deduction is provided for by statute and must
maintain records sufficient to enable the Commissioner to determine the
correct tax liability. See § 6001; Hradesky v. Commissioner, 65 T.C. 87,
89–90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Treas. Reg.
§ 1.6001-1(a).
Under section 7491(a), if the taxpayer provides credible evidence
concerning any factual issue relevant to ascertaining the taxpayer’s
liability and complies with certain other requirements, the burden of
proof shifts to the Commissioner as to the factual issue. Petitioners do
not contend that the burden of proof shifts to respondent under
49 RMS is not a party to these cases. The unified subchapter S corporation
audit and litigation procedures formerly set forth in subchapter D of chapter 63 of
subtitle F of the Code were repealed for taxable years beginning after December 31,
1996. See Allen Family Foods, Inc. v. Commissioner, T.C. Memo. 2000-327, slip op.
at 5 & n.3. Neither RMS nor respondent has revoked or terminated RMS’s
S corporation election.
48
[*48] section 7491(a) as to an issue of fact. 50 Therefore, petitioners bear
the burden of proof on all issues. 51 We discuss the burden of proof
applicable to the accuracy-related penalties that respondent has
determined against petitioners separately in connection with our
discussion of those penalties.
III. Credibility and Fact-Finding
“The most important and most crucial action the courts take in [a
trial] is to resolve facts.” United States v. Gainey, 380 U.S. 63, 88 (1965)
(Black, J., dissenting); see Diaz v. Commissioner, 58 T.C. 560, 564 (1972)
(“[T]he distillation of truth from falsehood . . . is the daily grist of judicial
life.”). The fact-finding process often requires the Court as the finder of
fact to evaluate the credibility of witness testimony before making
findings on the basis of that testimony. This Court has stated that in
determining credibility,
[w]e observe the candor, sincerity, and demeanor of each
witness in order to evaluate his or her testimony and
assign it weight for the primary purpose of finding disputed
facts. We determine the credibility of each witness, weigh
each piece of evidence, draw appropriate inferences, and
choose between conflicting inferences in finding the facts of
a case. The mere fact that one party presents unopposed
testimony on his or her behalf does not necessarily mean
that the elicited testimony will result in a finding of fact in
that party’s favor. We will not accept the testimony of
witnesses at face value if we find that the outward
50 Petitioners asserted in their respective Petitions that “the Commissioner has
the burden of proof with respect to all issues raised in his Notice of Deficiency,” but
they have not raised this issue on brief. We therefore deem any argument by
petitioners that section 7491(a) is applicable to have been waived or conceded. See
Estate of Atkinson v. Commissioner, 115 T.C. 26, 35 (2000) (deeming issue not
addressed in posttrial brief to be waived or conceded), aff’d, 309 F.3d 1290 (11th Cir.
2002); Estate of Blount v. Commissioner, T.C. Memo. 2004-116, slip op. at 55 n.29
(deeming burden of proof shift under section 7491 waived when the taxpayer failed to
raise it), aff’d in part, rev’d and remanded in part, 428 F.3d 1338 (11th Cir. 2005); see
also Mendes v. Commissioner, 121 T.C. 308, 312–13 (2003) (“If an argument is not
pursued on brief, we may conclude that it has been abandoned.”).
51 This statement does not apply to respondent’s invocation of the duty of
consistency, which is an affirmative defense as to which respondent bears the burden
of proof. See Estate of Ashman v. Commissioner, T.C. Memo. 1998-145, slip op. at 5,
aff’d, 231 F.3d 541 (9th Cir. 2000). Nonetheless, as explained below, we find it
unnecessary to reach respondent’s duty of consistency argument.
49
[*49] appearance of the facts in their totality conveys an
impression contrary to the spoken word.
Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 84 (2000), aff’d,
299 F.3d 221 (3d Cir. 2002). As the trier of fact we may credit evidence
in full, in part, or not at all. We may credit the part of a witness’s
testimony that is not self-serving, while requiring some form of
corroboration before crediting the portion that is. See Factor v.
Commissioner, 281 F.2d 100, 114 n.27 (9th Cir. 1960) (“The Tax Court
may accept parts and reject other parts of a witness’s testimony.”), aff’g
T.C. Memo. 1958-94; Baumgardner v. Commissioner, 251 F.2d 311, 321
(9th Cir. 1957) (“The Tax Court was willing to accept in part the
taxpayer’s claim of alleged profits from buying and selling improvement
bonds. It was not required to accept it in full.”), aff’g T.C. Memo.
1956-112.
It is “the exclusive province of the fact finder to determine the
credibility of witnesses, resolve evidentiary conflicts, and draw
reasonable inferences from proven facts.” United States v. Hubbard,
96 F.3d 1223, 1226 (9th Cir. 1996); see Anderson v. City of Bessemer City,
N.C., 470 U.S. 564, 573–74 (1985) (stating that if the trial court’s view
of the evidence is plausible in light of the record, a reviewing court may
not disturb it absent clear error, even when the trial court’s findings “do
not rest on credibility determinations, but are based instead on physical
or documentary evidence or inferences from other facts”); United States
v. Yellow Cab Co., 338 U.S. 338, 342 (1949) (stating that where there are
two permissible views of the evidence, the factfinder’s choice between
them is not clearly erroneous); United States v. U.S. Gypsum Co.,
333 U.S. 364, 395 (1948) (stating that a finding is clearly erroneous
when “the reviewing court on the entire evidence is left with the definite
and firm conviction that a mistake has been committed”); Estate of Rau
v. Commissioner, 301 F.2d 51, 54 (9th Cir. 1962) (“The Tax Court
personally observed the witnesses . . . and from that vantage point was
in a position to evaluate their testimony in the light of their attitude and
demeanor while being interrogated.”), aff’g T.C. Memo. 1959-117. As
the Ninth Circuit has stated in relation to the allowability of deductions
in particular, “[t]he question of whether a taxpayer is allowed a
deduction for particular expenses is a question of fact to be established
by the taxpayer’s evidence, the credibility of the taxpayer, and the
credibility of supporting witnesses. . . . [T]he Tax Court determines the
credibility of the proffered testimony.” Schachter v. Commissioner,
255 F.3d 1031, 1034 (9th Cir. 2001), aff’g T.C. Memo. 1998-260,
supplemented by 113 T.C. 192 (1999); see Norgaard v. Commissioner,
50
[*50] 939 F.2d 874, 878 (9th Cir. 1991), aff’g in part, rev’g in part
T.C. Memo. 1989-390; see also McKay v. Commissioner, 886 F.2d 1237,
1238 (9th Cir. 1989), aff’g 89 T.C. 1063 (1987). We determine the
credibility of witnesses, resolve evidentiary conflicts, and draw
inferences from the voluminous record developed by the parties with
this framework in mind.
IV. Microcaptive Arrangement
We begin by briefly explaining the taxation of microcaptive
insurance companies and the deductibility of payments to them. We
have recently considered other purported microcaptive insurance
arrangements. See Avrahami v. Commissioner, 149 T.C. 144 (2017);
Caylor Land & Dev., Inc. v. Commissioner, T.C. Memo. 2021-30; Syzygy
Ins. Co., T.C. Memo. 2019-34; Reserve Mech. Corp. v. Commissioner,
T.C. Memo. 2018-86, aff’d, 34 F.4th 881 (10th Cir. 2022); cf. Patel v.
Commissioner, T.C. Memo. 2020-133 (deciding the issue of timely
supervisory approval for penalties pursuant to section 6751(b) in the
context of a purported microcaptive insurance arrangement).
Insurance companies (other than life insurance companies) are
generally taxed on their income in the same manner as other
corporations. See §§ 11, 831(a). However, section 831(b) provides an
alternative taxing structure for certain small insurance companies.
During the years at issue, an insurance company with net written
premiums (or, if greater, direct written premiums) that did not exceed
$1.2 million for the year could elect to be taxed under section 831(b). 52
§ 831(b)(2). A small insurance company that makes a valid section
831(b) election is subject to tax only on its investment income,
§ 831(b)(1), and is not subject to tax on its earned premiums, see id.
When a captive insurance company 53 makes a section 831(b) election, it
is commonly referred to as a microcaptive insurance company.
Typically, amounts paid for insurance are deductible under
section 162(a) as ordinary and necessary expenses paid or incurred in
52 Amendments to section 831(b) in 2015 increased the premium ceiling to
$2.2 million (adjusted for inflation) and added new diversification requirements that
an insurance company must meet to be eligible to make a section 831(b) election. See
Syzygy Ins. Co., T.C. Memo. 2019-34, at *27 n.25.
53 A captive insurance company is typically a corporation whose stock is owned
by one or a small number of shareholders and which handles all or a part of the
insurance needs of its shareholders or affiliates. See Harper Grp. v. Commissioner,
96 T.C. 45, 46 n.3 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992).
51
[*51] connection with a trade or business. See Treas. Reg. § 1.162-1(a).
Section 162(a) does not prohibit deductions for microcaptive insurance
premiums. When such a deduction is available, an insured may be able
to deduct a premium payment to its affiliated microcaptive insurance
company without a corresponding inclusion of the premium in income
by the microcaptive insurance company. See Syzygy Ins. Co.,
T.C. Memo. 2019-34, at *28.
Nonetheless, the deductibility of insurance premiums depends on
whether they were truly payments for insurance. See Avrahami,
149 T.C. at 174, 199; Syzygy Ins. Co., T.C. Memo. 2019-34, at *28; see
also Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th
Cir. 1987) (“In lieu of purchasing insurance, one may elect to self-insure,
paying off claims as they arise or setting aside fixed sums into a reserve
account to pay off intermittent losses. While insurance premiums are
deductible, amounts placed into self-insurance reserves are not. . . . The
appropriate starting point of our analysis is the meaning of
‘insurance.’”), aff’g 84 T.C. 948 (1985); Caylor Land & Dev., Inc.,
T.C. Memo. 2021-30, at *31. In addition, as explained below, the
characterization of the dividends paid by Risk Retention to Mr.
Candland and Mr. Keating as ordinary or qualified dividends depends
on whether Risk Retention transacted in insurance. Thus, these cases
hinge on whether the captive insurance arrangement meets the
definition of insurance. 54
A. Whether the Arrangement Is Insurance
Neither the Code nor the Treasury Regulations define insurance,
and we are guided by caselaw in determining whether a transaction
constitutes insurance. See Avrahami, 149 T.C. at 174; Syzygy Ins. Co.,
T.C. Memo. 2019-34, at *28–29. Courts have looked to four criteria in
deciding whether an arrangement constitutes insurance: (1) the
arrangement involves an insurance risk; (2) the arrangement shifts the
54 In his Simultaneous Opening Brief respondent argues that we should apply
various substance-over-form doctrines in order to disregard the transactions at issue.
However, because we consider the transactions at issue in accordance with their actual
form and particular facts (i.e., without resort to recharacterizing their form) and
conclude that they do not constitute insurance for federal income tax purposes, we need
not decide whether any substance-over-form doctrine would apply in these cases. See
Avrahami, 149 T.C. at 197 (“In light of our holding [that the transactions at issue are
not insurance for federal tax purposes] we need not address the Commissioner’s other
arguments—i.e., that the amounts deducted as insurance expenses should be
disallowed under the economic-substance, substance-over-form, and step-transaction
doctrines.”).
52
[*52] risk of loss to the insurer; (3) the insurer distributes its risk among
its policyholders; and (4) the arrangement is insurance in the commonly
accepted sense. See Avrahami, 149 T.C. at 177; Rent-A-Center, Inc. v.
Commissioner, 142 T.C. 1, 13 (2014); Black Hills Corp. v. Commissioner,
101 T.C. 173, 182 (1993), supplemented by 102 T.C. 505 (1994), aff’d,
73 F.3d 799 (8th Cir. 1996); Harper Grp., 96 T.C. at 58; AMERCO &
Subs. v. Commissioner, 96 T.C. 18, 38 (1991), aff’d, 979 F.2d 162 (9th
Cir. 1992); Syzygy Ins. Co., T.C. Memo. 2019-34, at *29. Each part of
the test must be satisfied. Harper Grp., 96 T.C. at 58. These four
criteria are “nonexclusive,” Avrahami, 149 T.C. at 177, although we
have noted they are “rarely supplemented,” Caylor Land & Dev., Inc.,
T.C. Memo. 2021-30, at *32. Respondent concedes on brief that we “can
assume without deciding that the transaction involved risk shifting,” so
we assume that point. Respondent has also made a similar concession
regarding insurance risk, so we assume that the arrangement involved
insurance risks.
We find for the reasons stated below that petitioners have not met
their burden of proof to show that the microcaptive arrangement is
insurance in the commonly accepted sense, and we therefore determine
that it is not insurance for federal income tax purposes. See Avrahami,
149 T.C. at 190–91 (“[T]he cases tell us that in deciding whether an
arrangement is insurance we can also look at whether it looks like
insurance in the commonly accepted sense. This is an alternative
ground.”); Rent-A-Center, Inc., 142 T.C. at 13 (“[T]he arrangement must
. . . meet commonly accepted notions of insurance.”); Harper Grp.,
96 T.C. at 58 (stating that “each part” of our test for “determining the
propriety of claimed insurance deductions by a parent or affiliated
company to a captive insurance company . . . must be satisfied,”
including “whether the arrangement was for ‘insurance’ in its commonly
accepted sense”); Syzygy Ins. Co., T.C. Memo. 2019-34, at *37 & n.26; see
also Reserve Mech. Corp. v. Commissioner, 34 F.4th at 913–16
(upholding finding that microcaptive insurance policies “did not satisfy
the requirement that they be insurance in the commonly accepted
sense”); AMERCO v. Commissioner, 979 F.2d at 165; Caylor Land &
Dev., Inc., T.C. Memo. 2021-30, at *39. It is unnecessary for us to
address whether the arrangement involves risk distribution. After
outlining the reasons for our conclusion that the microcaptive
arrangement is not insurance in the commonly accepted sense, and
therefore does not constitute insurance for federal income tax purposes,
we discuss the legal effect of that conclusion in the next subsection.
53
[*53] 1. Commonly Accepted Notions of Insurance
To determine whether an arrangement constitutes insurance in
the commonly accepted sense, we look at numerous factors including:
(1) whether the insuring 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
premiums were reasonable and the result of arm’s-length transactions;
and (5) whether claims were paid. See Avrahami, 149 T.C. at 191 (first
citing R.V.I. Guar. Co. v. Commissioner, 145 T.C. 209, 231 (2015); then
citing Rent-A-Center, Inc., 142 T.C. at 24–25; then citing Harper Grp.,
96 T.C. at 60; and then citing Securitas Holdings, Inc. & Subs. v.
Commissioner, T.C. Memo. 2014-225, at *27); see also Caylor Land &
Dev., Inc., T.C. Memo. 2021-30, at *39–40; Syzygy Ins. Co., T.C. Memo.
2019-34, at *37–38; Reserve Mech. Corp., T.C. Memo. 2018-86, at *48; cf.
Syzygy Ins. Co., T.C. Memo. 2019-34, at *41 (noting that “whether the
fronting carriers operated in a bona fide fashion” is also relevant). We
will address each of these factors in turn.
a. Organization, Operation, and Regulation
Risk Retention and Provincial were organized as insurance
companies in Anguilla, and they were regulated by the Anguilla
Financial Services Commission. Generally, they complied with the
requirements of Anguillan law. They obtained insurance licenses,
satisfied Anguilla’s low capitalization requirements, and filed required
documents with regulators. The record also shows that Risk Retention
held annual board meetings, kept organizational books and records, and
maintained separate bank accounts. Apart from generally observing the
requisite formalities, however, the facts demonstrate that Risk
Retention and Provincial were not operated as insurance companies. Cf.
Reserve Mech. Corp., T.C. Memo. 2018-86, at *50.
Under the management of Artex, and with some significant input
by Mr. Candland, Risk Retention and Provincial operated during the
years at issue in a manner in which only unthinking insurance
companies would operate. Insurance transactions, including premium
pricing, premium payments, and claims approval, were completed after
the fact, even though in a typical insurance program they would be
completed prospectively. Cf. Caylor Land & Dev., Inc., T.C. Memo.
2021-30, at *41–42. Underwriting for policies in the Risk Retention
captive program often occurred well into the coverage period or after the
coverage period had expired. In any case, underwriting was based on
54
[*54] woefully inadequate information and methods, and it was
disproportionately influenced by meeting target premiums near the
$1.2 million section 831(b) limit, regardless of the coverage being
provided. Artex and Provincial backdated documents, approved of
retroactive policy changes, and permitted the late issuance of insurance
contracts 55 and even later premium payments. RMS paid a
disproportionate share of its captive premiums during the years at issue
toward the end of, or after, each coverage period. RMS never paid
premiums on a regular schedule of any kind, as opposed to making
payments whenever it decided to do so. Artex’s own invoice to one of its
other clients that is in the record makes the point best: “One typical
attribute of an insurance transaction[] is that premium is paid up front,
monthly, or quarterly. It is not commonly paid in one lump sum at the
end of the policy term.”
Mr. Candland, Mr. Keating, and RMS also treated Risk Retention
as if it were a tax-free savings account rather than a bona fide insurance
company with which they were dealing at arm’s length. Risk Retention
posted collateral with United States Fire Insurance Co. to fund
deductibles under RMS’s commercial workers’ compensation policy
without any clear obligation for it to do so, other than its self-imposed
one under the deductible agreements. Risk Retention never documented
its purported loan to finance Mr. Keating’s and Mr. Candland’s buy-sell
life insurance policy premiums on each other, and it is unclear whether
these loans were enforceable or secured. Artex also characterized the
purported loan repayments from RMS to Risk Retention in excess of
principal repayment not solely as interest but also as (1) premiums paid
and (2) as “extra” money that is “circled back out pretty quickly” to pay
further life insurance premiums. 56
While RMS and Risk Retention documented miscellaneous loans
for hardware, software, and excess group health plan claims with
promissory notes and repaid some of them in accordance with their
terms, other aspects of these loans are concerning. RMS failed to repay
55 Despite petitioners’ assertion to the contrary, we do not see any credible
evidence in the record that binders were in place during the coverage period until final
insurance policies were issued.
56 These characterizations are consistent with petitioners’ use of Risk
Retention as a de facto tax-free savings account because a bona fide insurance company
would require interest on a loan to compensate it for its impairment to its capital base,
its ability to pay claims, and its ability to generate investment income. It would not
likely treat interest as “extra” money that it could “circle[] back out pretty quickly” to
fund further loans or related-party expenses unless it expected few claims.
55
[*55] the First and Second Stop Loss Bridge Notes timely and indeed
had not made any payments by their maturity dates. Risk Retention
did not take any action to enforce either note following default. The
Second Stop Loss Bridge Note and the VEBA Stop Loss Note were not
accompanied by any security agreement that is in the record. The
July 16, 2012, promissory note documenting the software loan contained
a patent error on its face that calls its enforceability into question.
While RMS repaid the PFAs timely in accordance with their
terms, Mr. Candland notified Artex of the PFAs only after the fact,
instead of obtaining advance approval from Artex for the related-party
dealings he was organizing. His commitment to paying a “much higher”
interest rate to Risk Retention than RMS had paid in the past to finance
its commercial insurance policy premiums is not supported by any
legitimate business purpose discernible from the record. In any case, it
casts doubt on the reasonableness of the interest rate charged in the
PFAs.
We also have significant concerns about the reinsurance aspects
of the microcaptive arrangement. We agree with respondent’s expert
James MacDonald that Artex’s failure to disclose that it reserved the
right to cede 100% of the premium for some coverages to either the
captive or the Provincial Pool was a significant departure from
applicable reinsurance customs and practices. Neither is there any
credible evidence in the record that Risk Retention performed adequate
due diligence on the quota-share risks that it assumed through the
Provincial Pool. Overall, in numerous facets of their operations, Risk
Retention and Provincial did not operate as bona fide insurers or
reinsurers would.
We also accord some weight to the nontax characterizations of the
microcaptive arrangement by the parties to it. See Sears, Roebuck & Co.
v. Commissioner, 96 T.C. 61, 101–02 (1991) (considering whether “the
arrangements . . . are characterized as insurance for essentially all
nontax purposes”), supplemented by 96 T.C. 671 (1991), aff’d in part,
rev’d and remanded in part, 972 F.2d 858 (7th Cir. 1992). The parties
to the arrangement did not characterize it as insurance for essentially
all nontax purposes. RMS and Artex did not consistently recognize
RMS’s premium payments as separate from the amounts that Risk
Retention ostensibly received for providing facultative or quota-share
56
[*56] reinsurance to Provincial. 57 This characterization is consistent
with a near-circular flow of funds or, when considering it together with
the various loans, dividends, and other disbursements that Risk
Retention made, a circular one. 58 Mr. Candland also described the
arrangement to an external auditor as a means by which RMS self-
insured workers’ compensation claims. Furthermore, Mr. Candland
emailed an EBITDA calculation to a potential buyer of RMS that added
back into earnings the amounts paid to Risk Retention as insurance
premiums (less claims), as well as other amounts not typically
understood as interest, taxes, depreciation, or amortization, such as
$200,000 in “[p]erks” for petitioners. We take this to mean that a
potential buyer of RMS did not need to subtract the captive insurance
expenses from this metric of RMS’s profitability because they did not
detract from RMS’s profitability in an economic sense. Overall, the
characterizations of the arrangement by the parties to it reflect their
understanding that Artex’s approach gave RMS the benefit of an
upfront, tax-deductible premium charge without a loss of control over its
disposition of the funds that had proverbially been moved from one
pocket to another (i.e., to Risk Retention).
b. Capitalization
We have consistently held that an insurer is adequately
capitalized if it meets the relevant jurisdiction’s minimum capitalization
requirements. See Avrahami, 149 T.C. at 193; Caylor Land & Dev., Inc.,
T.C. Memo. 2021-30, at *43; Syzygy Ins. Co., T.C. Memo. 2019-34, at *41;
Reserve Mech. Corp., T.C. Memo. 2018-86, at *53. Risk Retention and
Provincial met Anguilla’s minimum capitalization requirements during
the years at issue. We do not upset the consensus here.
57 For example, during the years at issue, Mr. Candland asked for Artex’s help
in getting a premium deposited “back into” Risk Retention’s bank account and “moved
through the system and back,” and he also asked how long it would take to “turn the
funds around and deposit [them] in [Risk Retention’s] bank account.”
58 This is further supported by the facts that (1) Risk Retention’s quota share
of pool premiums was equal to the net premiums Provincial received from RMS for
excess coverage from at least 2009 to 2014 and (2) Risk Retention’s quota share of pool
claims and loss adjustment expenses was relatively low as a percentage of the pool
premiums paid by RMS for each year at issue (0.325% for 2012, 3.333% for 2013, and
3.152% for 2014). We also think that intent and absence of mistake are demonstrated
by the feasibility study that Tribeca prepared for RMS, which assumed no claim losses
and payment of a $1.2 million premium each year.
57
[*57] c. Valid and Binding Policies
We have held that policies were valid and binding when “[e]ach
insurance policy identified the insured, contained an effective period for
the policy, specified what was covered by the policy, stated the premium
amount, and was signed by an authorized representative of the
company.” Securitas Holdings, Inc., T.C. Memo. 2014-225, at *28; see
also R.V.I. Guar. Co., 145 T.C. at 231 (finding that policies were valid
and binding when the insured filed claims for covered losses and the
captive insurance company paid them). We have also examined factors
beyond whether the policies are simply binding such as conflicting or
cookie-cutter policy terms or the delivery of claims-made policies after
the end of the claims period. See Avrahami, 149 T.C. at 194 (examining
conflicting policy terms); Caylor Land & Dev., Inc., T.C. Memo. 2021-30,
at *44 (“Writing and delivering ‘claims made’ insurance policies after the
claim period is, we find, abnormal and is to any reasonable observer just
plain silly.”); Reserve Mech. Corp., T.C. Memo. 2018-86, at *54
(describing policies as cookie-cutter and not necessarily appropriate); see
also Syzygy Ins. Co., T.C. Memo. 2019-34, at *42 (“Here the dispute
surrounding valid and binding policies centers on whether the policies
were timely issued, identified the insured, and specified what was
covered by the policies.”). Overly restrictive provisions generally
indicate that the parties to an arrangement intended their arrangement
to look like insurance without actually providing it. Cf. Syzygy Ins. Co.,
T.C. Memo. 2019-34, at *32.
We find that the policies were not valid and binding. Our first
concern is the delivery of claims-made policies well into the coverage
period without binders in place in the interim. 59 See Caylor Land &
Dev., Inc., T.C. Memo. 2021-30, at *44. While RMS’s captive policies
during the years at issue were issued midway through their coverage
periods, rather than after, the late issuances still create substantial
doubt about the validity and binding effect of the policies. In the absence
of a binder, an insurer might choose to increase premiums or change the
policy terms before issuing the policies, or simply not issue the policies
at all, if, for example, a covered loss occurred between the coverage
period inception date (i.e., January 1) and the policy issuance
59 Similarly, we are also concerned by the January 28, 2013, Change
Endorsement that materially changed RMS’s Worker’s Compensation Deductible / SIR
Reimbursement policy after the end of the coverage period.
58
[*58] date. 60 It is also unclear whether Provincial or Risk Retention
would have been obligated to pay a claim made between those dates
under a policy that had not yet been issued.
The only apparent purpose for issuing restrictive claims-made
policies was to accommodate the desire of pool participants to receive
their funds back relatively quickly after they were paid. The policies
also contained ambiguous wording. For example, an independent
adjuster could have concluded that the Workers’ Compensation
Deductible / SIR Reimbursement policies applied only to accidents
occurring during the policy year that resulted in a deductible invoice
received during the policy period. The failure of the policies to make
clear whether this was the case is a significant failing given that all paid
claims that RMS filed under its 2012–14 captive policies were made
under this policy. Cf. Avrahami, 149 T.C. at 194 (discussing a policy
with terms indicative of both a claims-made policy and an occurrence
policy).
The 2013 and 2014 general terms and conditions also conditioned
claims payment on a requirement that the insured be in compliance with
all terms of its engagement letter with Artex, as well as all terms of the
Master Reinsurance Agreement between Provincial and any applicable
reinsurer, and remain an ongoing client of Artex. The binding effect of
the policies, if any, therefore depended in substantial part on
considerations extraneous to the policies themselves.
The parties to the arrangement did not themselves treat the
policies as valid and binding. They used board resolutions to pay claims
when the terms of the policies did not support the claims, or to document
claims that had already been paid. Alternatively, RMS simply took and
repaid loans from the captive on its own terms if a policy did not cover a
desired use of the funds. Mr. Candland sometimes decided the amount
60 While, in addition to the annual coverage periods, evergreen policy periods
nominally allowed each policy to remain in force until canceled, the record is clear that
the essential terms of each policy were set forth in annual renewal endorsements that
used an annual coverage period. The policies are devoid of any indication, for example,
of whether any additional premiums were due and owing during an evergreen period
for which no renewal endorsement was in place; what coverage obtained during the
interregnum (e.g., the coverage for the last renewal endorsement or the coverage for a
later-issued renewal endorsement that purported to have a retroactive coverage
period); how claims made during it were to be handled; or whether procedures differed
depending on whether a later renewal endorsement was or was not issued. We regard
it as nothing more than an attempt by Artex and Provincial to imbue their practice of
belatedly issuing insurance contracts with a legitimacy on paper that it lacked in fact.
59
[*59] of premiums that he wished to pay at the end of the year, and
Artex facilitated this practice.
Other discrepancies underscore our lack of confidence that the
policies were valid and binding. The provision in the general terms and
conditions that all premiums were earned at inception exclusively
benefits the insurer at the expense of the insured and is at odds with the
typical insurance industry practice of providing refunds (less early
cancellation penalties). Cf. Syzygy Ins. Co., T.C. Memo. 2019-34, at *32.
While such a provision is not necessarily fatal, we view its inclusion as
unusual under the circumstances here. The feasibility study’s failure to
mention RMS’s workers’ compensation needs, which featured
prominently in the captive program, while mentioning goodwill and
identity protection policies, which RMS never purchased, undermines
petitioners’ contention that the policies were intended to provide valid
and binding coverage for actual insurance needs. In sum, the policies
were designed only to resemble insurance policies superficially while in
reality giving the parties to the arrangement the option to proceed, or
not to proceed, with funding the policies until well into the coverage
period.
d. Reasonableness of Premiums
The next question is whether Provincial’s premiums were
reasonable and the result of an arm’s-length transaction. See Avrahami,
149 T.C. at 194–96. We find that they were not. Mr. Candland provided
Artex with an amount he was willing to pay or a target premium for all
policies purchased regardless of coverage. Mr. Candland sometimes
requested increases in RMS’s premiums. Cf. Syzygy Ins. Co.,
T.C. Memo. 2019-34, at *33–34 (“In an arm’s-length negotiation, an
insurance purchaser would want to negotiate lower premiums instead
of higher premiums.”). The target premiums Mr. Candland provided
played an outsized role in Artex’s purported underwriting.
Before discussing premium determination and underwriting in
detail, we pause to consider RMS’s coverage needs. RMS had a
comprehensive program of insurance obtained in the commercial
marketplace, some of which it negotiated at arm’s length with its clients.
While some carriers that Mr. Hill approached declined coverage, there
is no credible evidence that RMS was unable to obtain any type of
insurance coverage that it sought or that it did not maintain a robust
program of commercial insurance during the years at issue.
60
[*60] Given that RMS agreed to insurance requirements in its client
contracts and passed on insurance costs to its clients, it is odd that there
is no evidence that RMS consulted in any detail with its clients about
the massive insurance costs that it incurred through the captive
program. In any case, the reasons Mr. Candland offered at trial for
obtaining each policy were largely pretextual. While we grant that some
of his testimony may explain why he chose a given coverage over other
captive coverages that Tribeca or Artex offered, they do not explain why
he would have paid such exorbitant sums for them in the context of
RMS’s business. Taking RMS’s tax returns literally, the amounts paid
for insurance reduced RMS from a profitable enterprise to one that was
approximately breaking even. Most of the captive coverages were not
required by RMS’s contracts with its clients, and there is no credible
evidence indicating that RMS replaced any of its commercial coverages
with any of the captive coverages. 61 A much more detailed explanation
of the need for such expensive policies was warranted than the ones
provided by Mr. Candland. This is especially true given RMS’s
specialization in dealing with insurance issues on behalf of its clients.
Moving on to premium determination, the Provincial policies
were not objectively rated by evaluating the risk and magnitude of loss
on a prospective basis informed by detailed underwriting. The
premiums were also inflated by numerous subjective, judgment-driven
factors, each of which could modify the premiums significantly; and
there is very little documentation to support how Artex applied these
factors. The captive risk factor was especially inappropriate because its
stated object should have been addressed by making capital
61 Regarding the Worker’s Compensation Deductible / SIR Reimbursement
policies, petitioners argue that the premiums RMS paid for this coverage were
“significantly less than the discount provided by Crum & Forster for the large
deductible.” Petitioners thus appear to argue that these policies replaced the
deductible amount on the corresponding Crum & Forster policies in a cost-effective
manner.
We are not convinced. Mr. Candland emailed an Artex employee during the
years at issue to inform him that RMS had raised its deductible from $100,000 to
$250,000 on the Crum & Forster policy and stated: “This should make it easier to
justify our $1,200,000 captive contribution.” It thus appears that petitioners used the
deductible amount on the Crum & Forster policies to justify the captive contribution,
not that the captive coverage replaced the Crum & Forster deductible amount in a
demonstrably cost-effective manner. Furthermore, petitioners did not present credible
evidence to prove how Crum & Forster calculated the discount listed on its billing
statements for large deductibles, how the amount of the discount varied with the
amount of the deductible, or that Artex incorporated the amount of the deductible or
the large deductible discount in its purported underwriting of the captive policies.
61
[*61] contributions or obtaining aggregate stop-loss reinsurance, not
charging the insured additional premiums. See Caylor Land & Dev.,
Inc., T.C. Memo. 2021-30, at *47. This is not merely an academic
proposition: RMS’s own VEBA had stop-loss insurance coverage.
Furthermore, total annual premiums on RMS’s captive coverages
always hovered around $1.2 million, the section 831(b) limit, even when
coverage types or limits varied or RMS’s revenue or payroll changed.
The amounts of premiums charged were also patently
unreasonable. The average rate-on-line for RMS’s captive policies
during the years at issue was more than ten times greater than the
average rate-on-line for comparable commercial insurance policies, even
though there is no credible evidence indicating that RMS had major
issues with its existing commercial insurance coverage, or in obtaining
the insurance required by its client contracts. A higher rate-on-line
means that insurance coverage is more expensive per dollar of coverage
and could therefore lead to a greater deduction for premiums. See
Syzygy Ins. Co., T.C. Memo. 2019-34, at *31. There is no credible
evidence in the record that these charges were justified by a substantial
loss history from RMS or the pool. 62
We are also unconvinced that the Artex underwriting staff had
sufficient expertise to exercise the judgment required by these
subjective factors and the numerous types of policies they underwrote.
Moreover, Artex did not take into account the fact that it was often
underwriting claims-made policies toward the end of the applicable
claims period when it priced premiums. While captive insurance
companies may legitimately be more profitable than large commercial
insurance companies in some cases, the substantial profits during the
years at issue here appear to be derived mostly from a failure to
determine the premiums actuarially.
The premium determination process was not adequately
supported by detailed underwriting. While Artex appeared familiar
with the practice of obtaining detailed applications in insurance
underwriting, it obtained virtually no information from RMS that would
have informed the underwriting process. Nor did Artex underwriters
adequately account for RMS’s loss experience over time. The Provincial
policies could hardly have had reasonable premiums without adequate
62 Neither is there any credible evidence in the record indicating that Artex,
the Provincial Pool, or Risk Retention were burdened by unusually high overhead
expense.
62
[*62] information and expertise to price the policies. While the
proverbial broken clock may be right twice a day, this is an inadequate
method for pricing insurance policies.
Neither is there any credible evidence in the record that RMS
achieved cost savings through the captive program. Risk Retention
actually had a significant enough surplus during the years at issue that
it financed some of RMS’s commercial insurance premiums through the
use of the captive insurance premiums that it received. Risk Retention
also financed group health plan claims for RMS and buy-sell life
insurance premiums for Mr. Keating and Mr. Candland, and it extended
miscellaneous loans to RMS to finance its operations and posted
collateral for its workers’ compensation deductibles. Repeated execution
of these agreements shows confidence on RMS’s and petitioners’ part
that Risk Retention’s surplus would not be needed to pay substantial
claims on the captive policies and that Provincial was overcharging for
the coverage provided. Likewise, petitioners’ failure to consult Mr. Hill
or another qualified insurance broker about whether the captive
coverages were available on a more cost-effective basis in the
commercial marketplace shows their intent not to use the captive
arrangement to provide actual insurance.
We also briefly discuss some issues related to premium
determination in the Provincial Pool specifically. There is no apparent
reason for allocating each captive’s premiums approximately 51% to the
pool policies and 49% to the facultative policies other than to come
within a perceived IRS safe harbor. In a typical captive arrangement
involving quota-share reinsurance, one would expect members to pay
individually and actuarially determined premiums based on the
expectation of each member’s losses. A one-size-fits-all approach to
allocating premiums between layers of reinsurance, like the one used
here, suggests that the allocation is inconsistent with an actual
actuarial determination. See Avrahami, 149 T.C. at 186; Syzygy Ins.
Co., T.C. Memo. 2019-34, at *36; Reserve Mech. Corp., T.C. Memo.
2018-86, at *43. The one-size-fits-all approach was particularly strange
here because the Provincial Pool reinsured dozens of lines of coverage
during the years at issue, not a homogenous pool of risks, and because
other insureds operated businesses that were highly dissimilar to
RMS’s. Cf. Avrahami, 149 T.C. at 186–88 (finding a one-size-fits-all
approach to risk pool premium pricing objectionable even when only one
form of coverage was at issue).
63
[*63] e. Payment of Claims
Risk Retention and Provincial paid claims. Nonetheless, the
process by which those claims were handled was abnormal. See Caylor
Land & Dev., Inc., T.C. Memo. 2021-30, at *42–43, *48 (holding that the
abnormal payment of claims supports a conclusion that an arrangement
is not insurance in the commonly accepted sense).
RMS used a board resolution to pay the legal settlement with
Wausau from Risk Retention’s funds despite numerous defects with that
claim. Throughout the years at issue RMS also frequently provided
Artex with deductible billing invoices on its workers’ compensation
policy with Crum & Forster only after Risk Retention had already paid
the invoices. Not only is it highly unusual for claims approval to occur
after claims payment, but it also shows that Artex gave little timely
review to these claims.
Artex effectively allowed RMS to manage its own claims under
the Worker’s Compensation Deductible / SIR Reimbursement policy.
Artex also failed to place proper controls on RMS’s insistence that it be
allowed to directly manage the claims process as though no formal
captive insurance program were in place. Risk Retention, a purported
reinsurer, played an inappropriate role in the direct payment of claims.
For 2012, 2013, and 2014 the Provincial Pool paid claims
amounting to 0.324%, 3.322%, and 3.019% of total pool premiums,
respectively, which resulted in $1,921, $20,209, and $18,732
quota-share payments by Risk Retention for the respective years at
issue. These amounts are relatively small compared to the
approximately $1.2 million that RMS paid in captive premiums each
year, or even compared only to the 51% or so of those premiums that
Artex allocated to pool premiums. The Provincial Pool had a very low
ratio of losses to premiums compared to the insurance industry as a
whole, which resulted in nearly a full round trip of premiums,
considering that the captives participating in it were affiliated with
their insureds.
Perhaps more concerning, however, is the manner in which Artex
and Provincial handled the claims. Artex added or altered policies for
its clients retroactively in order to permit them to file claims against the
Provincial Pool or to reduce their premiums if they were unable to pay
in full. It did not consistently enforce the prior-knowledge limitation
when adjusting claims or treat claims as uncovered because no coverage
64
[*64] was in effect at the time of the loss, even though it should have. It
also approved some claims on the basis of only slight documentation.
Furthermore, the contractual linkage of consulting, insurance, and
reinsurance agreements had an inappropriate influence on claims
management, as did the staffing overlap between Artex’s underwriting
and claims functions.
Artex facilitated the use of board resolutions to provide an
end-run around the claims process. Routine use of these ex gratia
payments is counter to standard claims procedures. While a bona fide
insurance company may settle a claim with an insured because of a
reasonable expectation of coverage, its relationship with a client, or an
acknowledgment that the insurance company could have done
something better, there is no credible evidence indicating that these
reasons motivated Artex’s decision-making. Instead, the claims process
was largely illusory, and Artex used board resolutions precisely to
address situations where insureds wanted to access funds held by their
captive insurer but had no reasonable expectation of coverage.
2. Conclusion
Petitioners have not proven that RMS’s payments that they seek
to deduct as insurance expenses were for insurance in the commonly
accepted sense. Petitioners have therefore failed to prove that the
payments were for insurance for federal income tax purposes.
B. Effect on Petitioners
Having determined that the microcaptive arrangement among
petitioners, RMS, Risk Retention, Provincial, and Artex was not
insurance, we proceed to discuss the legal effect of that conclusion on
petitioners for the years at issue.
1. Section 162
Section 162(a) allows taxpayers a deduction for all ordinary and
necessary expenses paid or incurred during the taxable year in carrying
on any trade or business. To be deductible under section 162(a), an
expense must be both ordinary and necessary. Welch v. Helvering,
290 U.S. at 113. An expense is necessary if it is appropriate and helpful
to the development of the taxpayer’s business. Commissioner v. Tellier,
383 U.S. 687, 689 (1966); Welch v. Helvering, 290 U.S. at 113. An
ordinary expense is one that is “normal, usual, or customary. . . . [T]he
transaction which gives rise to it must be of common or frequent
65
[*65] occurrence in the type of business involved.” Deputy v. Du Pont,
308 U.S. 488, 495 (1940). It is “the kind of transaction out of which the
obligation [to pay] arose and its normalcy in the particular business
which are crucial and controlling.” Id. at 496. In addition to being
ordinary and necessary, as well as paid or incurred during the taxable
year, a deductible business expense must be reasonable in amount. See
United States v. Haskel Eng’g & Supply Co., 380 F.2d 786, 788–89
(9th Cir. 1967) (“An expenditure may be, by its nature, ordinary and
necessary, but at the same time it may be unreasonable in amount. In
such a case only the portion which was reasonable would qualify for a
deduction under § 162(a).”); Hopkins v. Commissioner, T.C. Memo.
2005-49, slip op. at 16–17. Whether an expense is deductible under
section 162 is a question of fact to be decided on the basis of all relevant
facts and circumstances. See Cloud v. Commissioner, 97 T.C. 613, 618
(1991).
Premium payments to a captive insurance company that are not
for insurance are generally not ordinary and necessary business
expenses and cannot be deducted under section 162(a). See Avrahami,
149 T.C. at 174, 199. We have recognized, however, that “[i]n the context
of captive insurance there may be instances where noninsurance
payments for indemnification protection might be appropriate and
helpful to the development of the insured.” Syzygy Ins. Co., T.C. Memo.
2019-34, at *46; cf. id. at *47–48. Nonetheless, “[t]he cases tell us to be
more skeptical about expenses between related parties. . . . The reason
is that ‘expenses’ from one related party to another are more likely to be
distributions of profits, which are not deductible.” Caylor Land & Dev.,
Inc., T.C. Memo. 2021-30, at *29.
Petitioners have not established that the captive premium
payments were ordinary. The payments were not for insurance. RMS’s
clients did not require RMS to obtain the captive coverages, even though
they required RMS to maintain certain insurance coverage. Mr. Hill
had never heard of some of the captive coverages, and petitioners never
directed him or any other insurance broker to seek out many of the
coverages in the commercial marketplace before implementing the
captive program. Petitioners have not attempted to establish that
businesses similar to RMS typically relied on the types of coverages
provided by Artex, on the terms provided by Artex, for their coverage
needs. While petitioners made some claims for deductible
reimbursements, we see no credible evidence in the record indicating
that businesses like petitioners’ typically purchase deductible or SIR
reimbursement policies rather than simply paying their deductibles
66
[*66] directly. Even if they do, we have not been directed to any
evidence that they purchase policies with the restrictive or ambiguous
terms found in the Artex and Provincial policies. Likewise, we have seen
no evidence that similar businesses purchase policies from insurance
companies using the irregular pricing and claims handling practices
that Artex and Provincial used.
Regarding the fees paid to Artex and PRS in particular,
petitioners have not proven that captive management fees, or fees for a
paying agent controlled by a captive management company, are normal,
usual, or customary in RMS’s line of business. Cf. Reserve Mech. Corp.,
T.C. Memo. 2018-86, at *50 (finding a captive’s management entirely by
a captive management company to be a factor weighing against a
determination that the captive operates as an insurance company).
Petitioners argue that “insurance is normal, usual and customary
for many businesses, as risk shifting has been around since groups
gathered in Lloyds coffee house in London to indemnify ship owners for
cargo they might lose at sea.” Nonetheless, our concern is not with the
ordinariness of insurance or indemnification payments in general, but
with the ordinariness of the particular “kind of transaction out of which
the obligation [to pay] arose and its normalcy in the particular business”
here. Deputy v. Du Pont, 308 U.S. at 496. Given that petitioners have
failed to establish that the expenses were ordinary, we need not decide
whether the expenses met the other requirements for deductibility
under section 162. We also need not address petitioners’ argument that
the reasonable portions of the premiums should be allowed.
2. Section 165
Petitioners argue that “[i]f the Court determines the premiums
paid are not deductible under I.R.C. § 162 or that the transaction is not
insurance or otherwise lacks economic substance, the losses paid are
deductible by RMS in the year they were sustained and paid by Risk
Retention.” Specifically, petitioners argue,
The Court must decide whether the premiums paid by
RMS are deductible insurance expenses or reserves set
aside for self-insurance. . . . If the Court determines that
the transaction is not insurance for federal income tax
purposes, the transaction should be treated as a
self-insured reserve. . . . [I]f the taxpayer utilizes a self-
insured reserve fund, the allowable deduction is limited to
67
[*67] the losses actually incurred and paid out of the reserve. . . .
Deductions are allowed for losses sustained during a
taxable year, for which a taxpayer is not compensated by
insurance, or otherwise.
Petitioners thus appear to argue that we should characterize the
arrangement as a self-insurance reserve and permit deductions as
“claims” (generally, workers’ compensation deductible payments63) were
made. Respondent disputes this argument on the merits and has also
affirmatively invoked the duty of consistency.
Petitioners’ proposed characterization of Risk Retention, a
corporation and a separate taxpayer from both RMS and petitioners, as
a mere reserve or account of RMS is not borne out by the record. Even
if it was RMS’s pocketbook, it was an incorporated one and therefore a
separate entity. 64 See Moline Props., Inc. v. Commissioner, 319 U.S. 436,
438–39 (1943) (“Whether the purpose be to gain an advantage under the
law of the state of incorporation or to avoid or to comply with the
demands of creditors or to serve the creator’s personal or undisclosed
convenience, so long as that purpose is the equivalent of business
activity or is followed by the carrying on of business by the corporation,
the corporation remains a separate taxable entity.” (Footnotes
omitted.)).
A taxpayer generally may not deduct another person’s expense or
loss. See Deputy v. Du Pont, 308 U.S. at 493–94. The Ninth Circuit has
stated that
if a taxpayer chooses to conduct business through a
corporation, he will not subsequently be permitted to deny
the existence of the corporation if it suits him for tax
purposes. . . . In particular corporate shareholders will not
be permitted to claim deductions for ordinary and
63 In 2012 Risk Retention also paid $3,452 for a claim filed under RMS’s 2011
Employment Practices Deductible / SIR Reimbursement policy.
64 Notwithstanding our conclusion below that Risk Retention’s section 953(d)
elections were invalid for the years at issue by reason of its failure to satisfy
section 953(d)(1)(B), we regard the section 953(d) elections that Risk Retention filed as
prima facie evidence that it was a foreign corporation because only foreign corporations
are eligible to make a section 953(d) election. See § 953(d)(1). We also deem
petitioners’ argument that Risk Retention’s section 953(d) elections were valid to be a
concession that Risk Retention was a foreign corporation if the section 953(d) elections
were not valid.
68
[*68] necessary expenses incurred by the corporation even
though paid by the shareholders.
Betson v. Commissioner, 802 F.2d 365, 368 (9th Cir. 1986), aff’g in part,
rev’g in part T.C. Memo. 1984-264. Neither respondent nor petitioners
dispute that RMS shifted risks, including liability for payment of certain
commercial insurance policy deductibles, to Risk Retention, a separate
taxable entity, in exchange for making premium payments. The parties
dispute whether the arrangement by which it did so was insurance or
was otherwise a deductible expense or loss, but there is no factual basis
for a finding that RMS retained the liabilities it shifted to Risk
Retention or incurred the losses when they came due. Risk Retention’s
assumption of RMS’s liability for workers’ compensation deductibles is
also evidenced by Risk Retention’s repeated execution of deductible
agreements with United States Fire Insurance Co. and the substantial
sums that Risk Retention paid into the collateral fund before and during
the years at issue pursuant to the deductible agreements. Petitioners
could have set up an unincorporated self-reserve fund or account and
deducted the losses as they occurred, but they did not do so. Petitioners’
argument also ignores the requirement that a corporation affirmatively
make an S corporation election in order for it and its shareholders to
receive passthrough entity treatment. See generally § 1362; Treas. Reg.
§ 1.1362-6. Risk Retention never did so.
Petitioners read our and the Ninth Circuit’s caselaw as requiring
a binary choice between a finding that the arrangement involved either
payments for insurance or a finding that petitioners set funds aside in a
reserve for self-insurance. Although we are skeptical of this reading, we
need not decide whether it is correct because petitioners have not
suggested any other characterizations of the arrangement; and even if
Risk Retention was a reserve for self-insurance, it was an incorporated
one. Petitioners chose to transact business through the corporate form
rather than on RMS’s or their own account; it follows that deductions
arising from the liabilities they took pains to shift to Risk Retention
belong to Risk Retention. The general rule that losses from a
self-insurance reserve are deductible as they are incurred does not
conflict with a finding that such deductions belong to a taxpayer other
than petitioners. Petitioners have failed to meet their burden of proving
that the amounts paid by Risk Retention as claims were losses incurred
by RMS.
Petitioners argue that Spring Canyon Coal Co. v. Commissioner,
43 F.2d 78 (10th Cir. 1930), aff’g 13 B.T.A. 189 (1928), provides support
69
[*69] for their position. In that case a taxpayer self-insured its workers’
compensation obligations by setting up a separate fund into which it
paid premiums. Id. at 78–79. The court held that the taxpayer was not
entitled to deduct the self-insurance premiums but noted that “its right
to deduct payments made out of the fund,” id. at 79, was not in dispute.
This case is inapposite because the taxpayer “carried the fund on its
books as an asset,” id., whereas here Risk Retention was a separate
entity. Expenses or losses paid out of the taxpayer’s fund in Spring
Canyon Coal Co. were the taxpayer’s own expenses or losses; but the
expenses or losses arising under the deductible reimbursement policies
that RMS purchased were Risk Retention’s.
Petitioners also invoke Anesthesia Service Medical Group, Inc. v.
Commissioner, 825 F.2d 241 (9th Cir. 1987), aff’g 85 T.C. 1031 (1985),
for support. In that case, the court held that a taxpayer’s contributions
to a grantor trust it established to pay potential malpractice claims
against its employees were not deductible. The court stated that
“[a]mounts placed into self-insurance reserves are not deductible
business expenses under I.R.C. § 162(a). . . . Rather, the taxpayer must
wait until a loss recognizable under I.R.C. § 165 occurs.” Id. at 242. We
agree with this general statement of the law, but the Ninth Circuit also
held that the taxpayer’s “ability to use Trust funds to discharge its
potential vicarious liability requires taxing the Trust’s income” to the
taxpayer. Id. at 243. The cited case is therefore distinguishable on the
ground that it did not involve a separate entity to which the deductions
were attributable. Instead, it involved only a grantor trust.
Furthermore, the cited case is distinguishable because the taxpayer
never shifted its risk of loss to the trust; on the contrary, it was obligated
to reimburse the trust for any shortfall caused by claims. See Anesthesia
Serv. Med. Grp., Inc., 85 T.C. at 1039–41 (holding that a contributory
agreement between the taxpayer and its trust alone indicated that the
risk of loss did not shift from the taxpayer). In the cases at bar, neither
petitioners nor respondent disputes that RMS shifted risks to Risk
Retention through the captive arrangement. Risk Retention, a separate
entity, in fact retained the risks that RMS shifted to it, and the tax
treatment follows from that fact.
Finally, petitioners argue that generally accepted accounting
principles (GAAP) support a finding that transactions not qualifying as
insurance should be treated as reserves or deposit arrangements.
Regardless of whether petitioners’ application of the accounting rules it
cites to the circumstances here is correct, nontax rules of accounting do
not control, or even necessarily inform, the determination of a taxpayer’s
70
[*70] tax liability. See AMERCO, 96 T.C. at 35–36 (rejecting
Commissioner’s expert’s reliance on GAAP in a captive insurance case
as “simply irrelevant to the tax law considerations before this Court”
and stating that “[i]t is clear that the Federal income tax does frequently
perceive related corporate entities as separate enterprises and
taxpayers”); see also Foster v. United States, 303 U.S. 118, 120–22
(1938); Old Colony R. Co. v. Commissioner, 284 U.S. 552, 562 (1932).
Given our holding that the deductions at issue belonged to Risk
Retention, not RMS, we do not reach respondent’s alternative argument
that the duty of consistency applies to bar the deductions.
3. Dividends
We must decide the tax characterization of the distributions that
Risk Retention made to Mr. Keating and Mr. Candland in 2012 and
2014. Under section 301(c), a corporation’s distribution of property to a
shareholder generally may, in whole or in part, (1) constitute a dividend,
(2) reduce the adjusted basis of the shareholder’s stock to the extent it
is not a dividend, or (3) be treated as gain from the sale or exchange of
property to the extent it both exceeds the adjusted basis of the stock and
is not a dividend. Section 316(a) generally defines a dividend as a
distribution of property made by a corporation to its shareholders out of
its earnings and profits accumulated after February 28, 1913, or out of
its earnings and profits of the taxable year without regard to the amount
of earnings and profits at the time the distribution was made.
Petitioners conceded in both their Simultaneous Opening Brief and their
Errata to Petitioners’ Simultaneous Opening Brief that “the dividends
were paid from earnings and profits.” We therefore deem petitioners to
have conceded that the distributions are dividends for purposes of
sections 301(c)(1) and 316(a).
Petitioners attempt to walk back their concession in their
Simultaneous Answering Brief, in which they argue:
Respondent has failed to calculate Risk Retention’s
earnings and profits if the transaction is not insurance for
federal income tax purposes, establishing that the
payments petitioners’ [sic] Keating and Candland received
were still paid out of earnings and profits, [and] therefore,
are dividends. Changing the character of the payments to
Risk Retention to something other than premiums would
change the earnings and profit calculation for Risk
Retention. . . . [Section 964(a)] provides the earnings and
71
[*71] profits of a foreign controlled corporation are calculated in
the same manner as a domestic corporation. Funds that
are paid out of a C Corporation that are not paid out of
earnings and profits are taxed as return of capital. I.R.C.
§ 301.
Petitioners’ late attempt to withdraw their earlier concession subverts
our briefing schedule and takes respondent by surprise by not
permitting him to respond to this new argument. We decline to allow
the withdrawal of the concession. See Estate of DeMuth v.
Commissioner, T.C. Memo. 2022-72, at *8–9 (enforcing concession that
opposing party relied on in drafting its simultaneous answering brief),
aff’d, No. 22-3032, 2023 WL 4486739 (3d Cir. July 12, 2023).
Because Risk Retention’s distributions to Mr. Keating and Mr.
Candland in 2012 and 2014 were dividends, the only issue is whether
they were ordinary or qualified dividends. Section 1(h)(11) provides
preferential tax rates for “qualified dividend income” if the dividend is
received from a domestic corporation or a qualified foreign corporation.
See § 1(h)(11)(B)(i); Avrahami, 149 T.C. at 199. We start with the latter
category. A qualified foreign corporation is generally any foreign
corporation that is either (1) incorporated in a possession of the United
States or (2) eligible for the benefits of a comprehensive income tax
treaty with the United States which the Secretary determines is
satisfactory and which includes an exchange of information program.
See § 1(h)(11)(C). Anguilla is not a possession of the United States. The
IRS has published a list of income tax treaties satisfying the statutory
requirements, see I.R.S. Notice 2011-64, 2011-37 I.R.B. 231, and
Anguilla is not on it, cf. Smith v. Commissioner, 151 T.C. 41, 57 (2018).
Risk Retention was not a qualified foreign corporation during the years
at issue.
This leaves us to decide whether Risk Retention’s election under
section 953(d) to be treated as a domestic corporation is valid. To make
a valid section 953(d) election, a controlled foreign corporation, as
defined in section 957(a), must qualify under part I (life insurance
companies) or II (other insurance companies) of subchapter L. See
§ 953(d)(1)(B); Avrahami, 149 T.C. at 198. To qualify for either part, a
company must meet the definition of “insurance company” in section
816(a). See §§ 816(a) (flush language), 831(c), 953(d)(1)(B); Avrahami,
149 T.C. at 198. This means that more than half of its business during
the taxable year must be the issuing of insurance or annuity contracts
or the reinsuring of risks underwritten by insurance companies. We
72
[*72] have already held that the captive arrangement did not constitute
insurance, and petitioners have not proven that Risk Retention had
other business that constituted insurance. Risk Retention was not an
insurance company for the years at issue, and its section 953(d) elections
were invalid. We therefore hold that the distributions Risk Retention
made to petitioners in 2012 and 2014 should be taxed at ordinary income
rates.
Petitioners argue that the dividends are qualified because section
953(d)(2)(B) provides that if a corporation which made a section 953(d)
election fails to meet the requirements of section 953(d)(1)(B) “for any
subsequent taxable year, such election shall not apply to any taxable
year beginning after such subsequent taxable year.” (Emphasis added.)
Therefore, petitioners argue, “if respondent determined that during
2012 Risk Retention first failed to meet the requirements for its [section]
953(d) election, then the election would become inapplicable beginning
in 2013.” As an initial matter, this argument, taken on its own terms,
does not aid petitioners with respect to the characterization of the 2014
dividends. In addition, this argument is wrong on the merits.
We consider the validity of a section 953(d) election at the time it
was made before deciding whether it was terminated under section
953(d)(2)(B). See Chapman Glen Ltd. v. Commissioner, 140 T.C. 294,
318–20 (2013). Risk Retention’s section 953(d) election states that it
“shall be effective as of the first day of the corporation’s taxable year
(including a short taxable year) commencing” on November 24, 2008.
Petitioners have failed to meet their burden of proving that Risk
Retention was an insurance company within the meaning of section
953(d)(1)(B) in 2008. During that year Mr. Candland met with Mr.
Kotch; and while his handwritten notes show that they discussed the
taxation of a captive insurer, they do not reflect any discussion of RMS’s
coverage needs. After Risk Retention was formed on November 25,
2008, RMS paid it only $500,000 in 2008, despite initially setting a
premium budget of $800,000 for this period of little over a month. Artex
did not even finalize the policies until 2009. After another payment in
March 2009, RMS ultimately paid over $670,000 for purported
insurance policies that, viewed charitably, offered little more than a
month of coverage. Cf. Reserve Mech. Corp., T.C. Memo. 2018-86, at *57
(noting a large amount paid for only one month of insurance coverage).
The declaration pages in the record are backdated to December 10, 2008,
and the coverage was made retroactive to November 25, 2008, despite
the policies’ preparation in 2009. This is not an insurance arrangement.
73
[*73] Petitioners have failed to prove that Risk Retention was a life or
nonlife insurance company in 2008, and Risk Retention’s section 953(d)
election was accordingly invalid when made. Furthermore, petitioners
have failed to prove that even if Risk Retention’s section 953(d) election
was valid when made, Risk Retention continued to meet the
requirements of section 953(d)(1)(B) for 2009, 2010, and 2011 as would
be necessary to prevent a termination under section 953(d)(2)(B) before
the years at issue. 65 Our review of the record shows that, if anything,
virtually all aspects of the purported insurance arrangement were even
more deficient in 2009–11 than they were during the years at issue.
Petitioners argue that section 953(d)(2)(A) provides that the
section 953(d) election, once made, applies for subsequent taxable years
unless revoked with the consent of the Secretary. This is a
misstatement of section 953(d)(2)(A), which provides that its rule
applies “[e]xcept as provided in subparagraph (B).” Petitioners also
argue that Revenue Procedure 2003-47 provides support for their
position. It does not, because it expressly states that “[o]nce approved,
the election generally remains effective for each subsequent taxable year
in which the requirements of this revenue procedure and section 953(d)
are satisfied unless revoked by the electing corporation with the consent
of the Commissioner.” Rev. Proc. 2003-47, § 4.02(1), 2003-2 C.B. 55, 55
(emphasis added). In sum, Risk Retention was a foreign corporation,
not a domestic corporation, and its dividends in 2012 and 2014 were not
qualified because Anguilla did not have a comprehensive income tax
treaty with the United States during the years at issue.
V. Accuracy-Related Penalties
The last issue is whether accuracy-related penalties under
section 6662(a) are justified. Respondent determined accuracy-related
penalties on grounds of negligence or disregard of rules or regulations,
see § 6662(b)(1), (c), or in the alternative, on grounds of substantial
understatements of income tax, see § 6662(b)(2), (d). Respondent bears
the burden of production with respect to the accuracy-related penalties.
See § 7491(c). Once respondent comes forward with sufficient evidence
65 The evidentiary objections that petitioners made to some items of evidence
on the grounds that they concerned taxable years prior to the years at issue are
somewhat confusing in view of the necessity of such evidence for petitioners to prove
that Risk Retention’s section 953(d) election did not terminate before the years at
issue. At a minimum, even without considering other grounds for their relevance,
petitioners opened the door to such evidence by placing the qualified dividend rate at
issue.
74
[*74] to show that it is appropriate to impose a particular penalty,
petitioners have the burden of proof to show that respondent’s penalty
determination is incorrect, including the burden of proving that
penalties are inappropriate because of reasonable cause. See Higbee v.
Commissioner, 116 T.C. 438, 446–47 (2001). The parties have stipulated
that respondent complied with the written supervisory approval
requirements of section 6751(b) for the accuracy-related penalties
determined against petitioners for each year at issue.
Section 6662(a) imposes a 20% penalty on the portion of an
underpayment of tax attributable to any substantial understatement of
income tax, see § 6662(b)(2), or negligence or disregard of rules or
regulations, see § 6662(b)(1). An understatement is substantial if it
exceeds the greater of (1) 10% of the tax required to be shown on the
return for the taxable year, or (2) $5,000. See § 6662(d)(1)(A).
Negligence includes any failure to make a reasonable attempt to comply
with the provisions of the Code, and disregard includes any careless,
reckless, or intentional disregard. See § 6662(c). The understatements
in these cases are substantial as an arithmetic matter for all petitioners
and for all years at issue. It is therefore unnecessary for us to determine
whether the underpayments are attributable to negligence or disregard
of rules or regulations. See Avrahami, 149 T.C. at 204–05; see also
Treas. Reg. § 1.6662-2(c) (providing that only one accuracy-related
penalty for a given year may be applied with respect to any given portion
of an underpayment, even if that portion is subject to the penalty on
more than one ground). Respondent has met his burden of production
with regard to the accuracy-related penalties, and petitioners have the
burden of proof to show that respondent’s penalty determinations are
incorrect.
Petitioners assert that they had reasonable cause for, and acted
in good faith with respect to, the underpayments. Section 6664(c)(1)
provides that the penalty under section 6662(a) shall not apply to any
portion of an underpayment if it is shown that there was reasonable
cause for the taxpayer’s position and the taxpayer acted in good faith.
See Higbee, 116 T.C. at 448. This determination is made on a
case-by-case basis, taking into account all of the pertinent facts and
circumstances. See Treas. Reg. § 1.6664-4(b)(1). Generally, the most
important factor is the extent of the taxpayer’s effort to assess the
taxpayer’s proper tax liability. See id. For underpayments related to
passthrough items, we look at all pertinent facts and circumstances,
including the taxpayer’s own actions, as well as the actions of the
passthrough entity. See id. para. (e). Reliance on professional advice
75
[*75] may constitute reasonable cause and good faith, but only if,
considering all the circumstances, such reliance was reasonable. See id.
paras. (b)(1), (c)(1); see also Freytag v. Commissioner, 89 T.C. 849, 888
(1987), aff’d, 904 F.2d 1011 (5th Cir. 1990), aff’d, 501 U.S. 868 (1991).
Advice is “any communication . . . setting forth the analysis or
conclusion of a person, other than the taxpayer, provided to (or for the
benefit of) the taxpayer and on which the taxpayer relies, directly or
indirectly, with respect to the imposition of the section 6662 accuracy-
related penalty.” Treas. Reg. § 1.6664-4(c)(2). Advice does not have to
be in any particular form. Id.
Reasonable cause exists if a taxpayer relies in good faith on the
advice of a qualified tax adviser where the following three elements are
present: (1) the adviser was a competent professional who had sufficient
expertise to justify the reliance; (2) the taxpayer provided necessary and
accurate information to the adviser; and (3) the taxpayer actually relied
in good faith on the adviser’s judgment. See Neonatology Assocs., P.A.,
115 T.C. at 99. Reliance may be unreasonable if the adviser is a
promoter of the transaction. Id. at 98. A promoter is “an adviser who
participated in structuring the transaction or is otherwise related to, has
an interest in, or profits from the transaction.” 106 Ltd. v.
Commissioner, 136 T.C. 67, 79 (2011) (quoting Tigers Eye Trading, LLC
v. Commissioner, T.C. Memo. 2009-121, slip op. at 48), aff’d, 684 F.3d 84
(D.C. Cir. 2012).
There is no credible evidence in the record that petitioners or
RMS took any substantial steps to ascertain their proper tax liability.
Petitioners rely upon advice purportedly given by Tom Goddard, an
accountant who testified at trial, to establish reasonable cause and good
faith. Petitioners argue that they “relied upon Mr. Goddard’s advice in
reporting the captive insurance premiums paid as deductible business
expenses” during the years at issue. Although Mr. Goddard was not a
promoter, petitioners’ argument lacks merit.
Neither any written tax opinion nor other contemporaneous
documentary evidence concerning any advice Mr. Goddard may have
given to Mr. Candland or RMS is in the record. Mr. Goddard did not
even testify that he provided any express advice to petitioners regarding
the tax treatment of the captive insurance arrangement. Instead, he
testified he would receive RMS’s books for the year, which included a
captive insurance deduction, and that “the communication was . . . we
weren’t objecting to their deduction in that year for the insurance
captive. To me, it was an ordinary expense, ordinary insurance expense,
76
[*76] and I felt it was necessary and reasonable.” We specifically find
that Mr. Goddard did not provide any advice to petitioners about the
microcaptive arrangement. Mr. Goddard’s lack of objection to captive
insurance deductions that petitioners had already been taking for years
before they hired him does not itself constitute advice on which
petitioners may rely in good faith. See Neonatology Assocs., P.A.,
115 T.C. at 100 (“The mere fact that a certified public accountant has
prepared a tax return does not mean that he or she has opined on any
or all of the items reported therein.”); Caylor Land & Dev., Inc.,
T.C. Memo. 2021-30, at *52 (stating that taxpayers in microcaptive cases
could not “rely on advice that was not given”); Flume v. Commissioner,
T.C. Memo. 2020-80, at *37 (“Simply employing a tax return preparer
for the years at issue does not permit [the taxpayers] to avoid
accuracy-related penalties.”).
We also specifically find that Mr. Goddard did not review, nor did
petitioners provide him with, some of the information that would have
been necessary to form an opinion on the deductibility of the captive
expenses. 66 Furthermore, the evidence of petitioners’ actual reliance,
let alone good-faith reliance, on any judgment that Mr. Goddard may
have reached is underwhelming. Cf. Avrahami, 149 T.C. at 207 (stating,
as part of a finding of reasonable reliance on professional advice, that
the adviser credibly testified that specific advice was given and that the
taxpayer credibly testified that he proceeded with a microcaptive
arrangement because of the adviser’s blessing).
Petitioners also argue that the issues are novel and complex and
were essentially ones of first impression at the time their returns were
filed and that they should be excused from accuracy-related penalties.
While the issues were somewhat novel at the time, this does not excuse
petitioners from penalties in the absence of any efforts on their part to
ascertain their correct tax liabilities or apply well-settled principles of
taxation to their situation. See Neonatology Assocs., P.A. v.
Commissioner, 299 F.3d at 234–35 (stating that taxpayers could not
avoid accuracy-related penalties, even though they were without direct
precedent to guide them, because their case “does not involve novel
questions of law but rather is concerned with the application of
66 Mr. Goddard did not review the actual policies issued by Risk Retention.
Neither did he review Risk Retention’s formation documents, engagement letter with
Tribeca, business plan, or various reinsurance contracts and agreements. In addition,
he did not review the Owners’ Manual, any of the general terms and conditions in force
for the captive insurance arrangement, or Artex’s claims handling practices.
77
[*77] well-settled principles of taxation to determine whether certain
expenditures made by close corporations are deductible as ordinary and
necessary business expenses”). While we observed as part of our
analysis of good faith in Avrahami that “[t]his is a case of first
impression,” 149 T.C. at 207, we did so only after finding that the
taxpayers actually and reasonably relied on advice from a competent
professional, see id. at 206–07. These cases are more like Caylor in that
petitioners did not actually “get advice or a professional’s judgment that
they could have reasonably relied upon.” Caylor Land & Dev., Inc.,
T.C. Memo. 2021-30, at *53. Petitioners are liable for accuracy-related
penalties across the board.
We have considered the parties’ other arguments and, to the
extent they are not discussed herein, find them to be irrelevant, moot,
or without merit.
To reflect the foregoing,
Decisions will be entered under Rule 155.