The US Tax Court has held in a case involving a ‘microcaptive’ insurance company that the arrangement between the captive insurer and its policyholders did not qualify as insurance for tax purposes (Syzygy Insurance Co., Inc. v. Commissioner, T.C. Memo 2019-34). As a result, the insurer’s Section 831(b) election was invalid and amounts received by the taxpayer as premiums were recognized as income. Further, premium payments and any fees paid under the arrangement were not deductible by the insureds as either payments for insurance or as payments for other ordinary and necessary expenses.
Qualification of an arrangement as insurance is important to both the insurer and policyholder. For the policyholder, characterization of payments as premiums may mean the difference between deducting and not deducting the payments. For the issuer, in addition to the ability to elect under Section 831(b) to be taxed only on investment income, insurance company status may confer favorable accounting methods for premium income and losses, and the ability for a foreign company that is otherwise a controlled foreign corporation (CFC) to elect under Section 953(d) to be taxed as a domestic US corporation.
Similar to other recent microcaptive insurance cases, the Tax Court in Syzygy looked to longstanding standards employed in determining whether arrangements qualify as insurance and issuers qualify as insurance companies. Although, in Syzygy, the court’s conclusion was that it was not an insurance company, other more traditional captive insurance companies may still qualify as such.
For microcaptives, the Syzygy case is a reminder of the importance of operating in a manner consistent with that of a commercial insurance arrangement between unrelated parties.
The court’s failure to identify what the Syzygy arrangement was, if not insurance, may add further to existing uncertainty surrounding microcaptive companies. The court determined that payments under the arrangement were not deductible, and that amounts received by Syzygy were taxable income (though not premiums). Implicitly this suggests that loan or capital characterizations were ruled out. In Reserve Mechanical, the court likewise did not characterize the payments, yet concluded the payments were subject to a 30% withholding tax under Section 881(a)(1) as fixed, determinable, annual, or periodical (FDAP) income. An explicit conclusion on what the arrangements were would have facilitated their proper reporting.
Further, the court’s determination that the premiums paid were not deductible as ordinary and necessary business expenses has a whipsaw effect, given premiums are taxable to the reinsurer but not deductible by the policyholder.
Perhaps most importantly, Syzygy indicates the IRS’s continued resolve to challenge microcaptive insurance transactions generally. The transactions remain on the IRS ‘Dirty Dozen’ list, and remain ‘transactions of interest’ under Notice 2016-66. Therefore, they are subject to reporting and disclosure requirements. A large number of cases remain in the pipeline for litigation.
Insurance Tax Services Leader, PwC US