Wednesday, July 24, 2024

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IRS wins Tax Court case against micro captives owned by Texas medical practice

The owner of a number of San Antonio medical practices has been told by the US Tax Court that he cannot deduct millions in premiums paid to micro captives because they are being used to avoid tax.

Dr Bernard Swift formed two St Kitts domiciled micro captives, Castlerock Insurance Co and Stonegate Insurance Co, in 2010.

A micro captive is a common name give to those captives that take the 831(b) tax election, meaning they are one taxed on their investment income. At the period in question, the annual premium limit was $1.2m.

On each of their joint federal income tax returns for 2012 through 2015, the Swifts deducted more than $1m in premiums paid and miscellaneous legal fees.

Between 2012 and 2015 the Swift captives participated in two risk distribution pools – Jade Reinsurance Group, in 2012 and 2013, followed by Emerald International Reinsurance, in 2014 and 2015.

Swift was advised by New York-based lawyer Celia Clark, infamously implicated in the 2017 Avrahami v. Commissioner case that also delivered Tax Court win for the IRS, and his certified public accountant Tim Schultz.

“Jade and Emerald were both Alabama captive insurers, formed to ‘function as . . . vehicle[s] to pool diverse risks ceded to them by’ Clark-related micro captive insurance companies,” the Court filings said.

Under certain reinsurance agreements, the Swift captives paid reinsurance premiums to Jade and to Emerald to reinsure a portion of their risk.

As part of quota share retrocession agreements, Jade and Emerald returned to the Swift captives 99.59% and 98.74% of the reinsurance premiums paid to Jade in 2012 and 2013, respectively, and 94.98% and 98.99% of the reinsurance premiums paid to Emerald in 2014 and 2015, respectively.

These amounts would not be released to the captives immediately but held in a trust account and released to the participating captives in tranches throughout the year.

The Jade and Emerald premiums also produced loss ratios that deviated significantly from the industry standard.

In his report, the Commissioner’s expert Dr David Russell stated that the industry loss ratios for reinsurance companies averaged 66.1%, 56.4%, 69.6%, and 66.3% in 2012, 2013, 2014, and 2015, respectively.

Jade’s and Emerald’s loss ratios ranged between 0.13% in 2012 and 7.91% in 2015.

“Although we do not contest the Swifts’ representation that Jade and Emerald together paid out millions of dollars in claims, this point is of no moment when seen in the context of the loss ratios,” the Court filing noted.

“The tiny loss ratios suggest that the premiums were priced much higher than what the risks called for, which calls into question whether these were actual insurance arrangements intended to distribute risk.”

Clark had emphasised to Swift the need for the captives to obtain risk distribution to be considered an insurance company for federal income tax purposes.

“Relying on her interpretation of our Court’s caselaw and IRS actions, Clark asserted that 30% of the micro captive’s total premiums would need to come from unrelated businesses in order for the arrangement to pass muster.”

The reinsurance premium for terrorism and political violence coverage fluctuated as necessary to achieve 30% risk distribution.

Jade and Emerald agreed to reinsure such coverage “depending on the client’s preference,” providing a flexible tool to adjust the reinsurance premiums to “whatever level necessary” to hit the 30% risk distribution overall.

“Based on the factors discussed above, we find that Jade’s and Emerald’s policies were not bona fide insurance arrangements,” the Court ruled.

Referring to its five previous 831(b) cases, the Tax Court stated: “In our [five] prior micro captive cases, we have focused on the elements of risk distribution and ‘commonly accepted notions of insurance.’

“We will do so again, and we again reach the conclusion that the microcaptive arrangement before us does not constitute insurance.”