The flood of U.S. Tax Court opinions regarding microcaptive transactions continues, with now a third opinion for just this year alone coming in Patel v. CIR, T.C. Memo. 2024-34 (March 26, 2024), which you can read here, and an earlier opinion deciding a motion for summary judgment on whether penalties could be assessed, Patel v. CIR, T.C. Memo. 2020-133 (Sep. 22, 2020), which you can read here. The old saw that “if you have seen one, you have seen them all” is applicable here. Suffice it to say that all these recent opinions are about alike, and the taxpayers/captive owners lose this case for the same reasons as the rest: Absence of an arm’s length transaction, premiums that were artificially inflated and bore not even the most tenuous link to reality, there was no insurance going on in the generally accepted sense, the taxpayer started out looking for a deduction as opposed to managing risks, etc. & etc.
Because this Tax Court opinion is like so many of the others, there is no need for any deep dive analysis. Instead, there are a few interesting issues that will be the focus of discussion. As usual, to the extent that my commentary diverges from the Tax Court opinion, if at all, the opinion should control. Note also that this opinion is also subject to appeal, which could theoretically reverse its findings.
This case involves a doctor in Abilene, Texas, by the name of Sunil S. Patel, who did some research on his own and decided that he wanted to form a captive insurance company. Eventually, in 2011, the doctor ended up meeting Sean King of captive manager CIC Services, LLC and Sean King further referred the doctor to Alabama tax attorney James Coomes, who purported to specialize in captive insurance companies. In 2011, the doctor, Coomes and Sean King met to discuss the captive, and the doctor retained Coomes for that purpose. That same year, Coomes caused Magellan Insurance Company to be formed in St. Kitts for the doctor and that jurisdiction issued a captive insurance license to Magellan. The new insurance company was owned 35% by the doctor, 35% by his wife (who was also a doctor), and 30% by the Patel Business Trust for the benefit of their children.
According to the evidence at the trial, there was no feasibility study done before Magellan was formed about its role as a captive insurer. Instead, there was a report done about the financial, tax and estate planning advantages of Magellan. Indeed, soon after Magellan was formed and had received its first premium payments from the doctor’s operating businesses, Magellan formed an LLC as a subsidiary called Magellan Investments LLC. Money was apparently transferred from Magellan Insurance to Magellan Investments, and that money was used to purchase a life insurance policy from Minnesota Life Insurance Company with an annual planned premium of $1,150,000 (which just happened to be about the total amount of premiums to be received by Magellan Insurance from the doctor’s operating businesses), and which had a death benefit of over $43 million. The life insurance policy was purchased in 2012, but in 2016 the doctor transferred another 30% ownership in Magellan Insurance (and thus 100% of Magellan Investments) to the Patel Business Trust to attempt to avoid federal income taxes.
In 2016, the doctor was contacted by an IRS agent about Magellan. Concerned about Magellan’s ownership structure (Congress has just modified section 831(b) in 2015), Sean King’s father, Thomas King, who was also involved with CIC Services, told the doctor that he should talk to Coomes about responding to the IRS agent. Coomes talked with the IRS agent and apparently didn’t think much of it, while the doctor’s tax attorney nephew sent him an article stating that 831(b) captives were anticipated to come under heightened scrutiny.
At any rate, all this caused the doctor to start thinking about forming a second captive. Thereafter, Coomes, Sean King and a tax attorney by the name of Norm Lofgren conferred with the doctor and by December 8, 2016, Plymouth Insurance Company was formed and licensed in Tennessee. Plymouth was owned 100% by Linus Capital LLC, which was formed in Texas and owned by the Sunil Patel 2016 Irrevocable Trust that was created a few days later.
The insurance policies that were issued by Magellan and Plymouth covered a number of the doctor’s business risks, mostly business interruption or related risks. However, Coomes advised the doctor that according to certain IRS guidance and case law that around 30% of the total premiums that were received by Magellan, and later Plymouth, need to come from an unrelated third-party source to meet the tax law requirements of risk distribution. For this purpose, Coomes had also formed his own reinsurance company called Capstone Reinsurance Company, Ltd. In the Turks & Caicos Islands. [Note: Capstone Reinsurance, which will be referred to henceforth as “Capstone Re”, apparently as no relation to the prolific Houston captive manager also known as Capstone.] Coomes and his wife were the officers and directors of Capstone Re.
It would be Capstone Re which would serve as the risk pool for Magellan, Plymouth, and apparently other clients of Coomes and CIC Services to theoretically allow them to meet their risk distribution requirements. The way this worked is that for a reinsurance premium paid by Magellan and Plymouth, Capstone Re would agree to reinsure 51% of the ultimate net losses attributed to each insurance policy underwritten by Magellan and Plymouth. The reinsurance premium paid to Capstone Re was itself calculated at the same 51% of the total premiums received by Magellan and Plymouth from the doctor’s operating businesses, plus a $5,000 “ceding fee” charged by Capstone Re.
That was Step #1 of the Capstone Re program. Step #2 was getting money from Capstone Re back to Magellan and Plymouth, less of course the $5,000 ceding fee. This was accomplished by something known as a Quota Share Retrocession Agreement, whereby all the participating insurance companies who had bought reinsurance from Capstone Re, including Magellan and Plymouth, agreed to collectively assume 100% of the losses that Capstone Re suffered under all the policies that it was underwriting for all the reinsured insurance companies in its risk pool — except each insurance company’s own losses on its own policies. In other words, were Magellan to suffer a reinsured loss, then Capstone Re would pay 51% of that loss, and all the other participating insurance companies in the pool (including Plymouth) would collectively pay their share of that loss, based on their percentage of reinsurance premiums as a whole.
For participating in the quota share deal, each participating reinsurance company would be paid back the amount of the reinsurance premium that they had originally paid to Capstone Re, less the $5,000 ceding fee and their share of any losses. Since the participating reinsurance companies wanted their money back as soon as possible, Capstone Re obliged by paying 50% of it back almost immediately as a quota share premium, another 35% or so within about six months, and the remaining 15% or so around the end of the year. The upshot was that Capstone Re only held about 50% of the premiums for about six months and only 15% by year’s end to be able to pay claims. Which, as it turned out, was almost none. As the IRS’s expert witness pointed out, this was all just a circular flow of funds with money passing from Magellan and Plymouth to Capstone Re and then very soon right back to Magellan and Plymouth.
Interestingly, during the tax years in question (2012 to 2016), the doctor’s operating businesses paid a total for all years of $462,704 in premiums to ordinary commercial insurance companies, such as Travelers, for insurance covering most of the doctor’s likely risks. Yet, during those same years, the doctor’s operating businesses paid a whopping $4.5 million in premiums to Magellan and Plymouth. Why so much?
We now come to the actuary who provided the risk analysis to be used in this microcaptive transaction, being the ubiquitous Allen Rosenbach of ACR Solutions Group, whose work was criticized in the landmark Avrahami microcaptive opinion, derided in the Swift opinion, and would be given “very little weight” in this case. Here, the court looked at Rosenbach’s Premium Development reports which were done at the time and noted that they “contain little to no explanation for how he arrived at the amounts he ultimately recommended.”
For the trial of this case, Rosenbach submitted an expert report wherein he attempted to explain how he arrived at certain premiums. This was done, Rosenbach claimed, by taking an industry-wide base rate and applying additional factors as applicable to each risk. These additional factors, however, were not factors ordinarily used by actuaries and the premiums reached were “so large that they bear no relation to the commercial rates that he starts with,” including at one time a premium rate that was 12 times higher for the two captives as opposed to similar commercial premiums. Moreover, as the captives developed loss histories which showed that their losses were anywhere near that originally predicted, Rosenbach did not reduce the premiums accordingly. But even worse than that, Rosenbach’s premium calculations simply did not make much sense in the context that he predicted most of the risks would be low frequency, i.e., would occur rarely, yet the premiums were priced as if they materialized much more often.
Not that Rosenbach’s premium calculations were put to much use at the relevant time, since the evidence at trial showed that the doctor was really driving the premiums and trying to get the premium amounts close to the $1.2 million limit of 831(b). Here, this case is simply the same as all the other microcaptive cases so far, where premiums were artificially inflated and “backed in” to try to reach the $1.2 million limit.
Things were even worse when it comes to the pricing of the reinsurance premiums since “[t]here is no documentation demonstrating that an actuary—whether Mr. Rosenbach or another person—determined the reasonableness of the reinsurance premiums for each captive.” Instead, the court started by looking at the claims activity of the Capstone Re pool.
Here, the court found something very interesting in that some of the CIC Services folks, being Sean King, Thomas King and Bryan Ridgway, themselves owned a captive that was participating in the Capstone Re pool even while they managed the captives — including handling claims — of their captive clients in that same risk pool. Even Coomes, in 2014, “raised concerns about employees of CIC Services approving claims when they owned a captive in the same pooling arrangement.” The court then went on to note that for 2015, there was one claim which was 14% of all the claims paid by the pool, and this was a claim by Thomas King for a loss of $605,668 because he had been selling life insurance to at least some of the CIC Services’ captive clients (including the doctor here, more on this later) and Minnesota Life Insurance was no longer allowing its life insurance policies to be sold to captives. Notably, this claim was for the 2015 policy period, but the claim was not submitted until 2017, well after the policy period had expired.
Also interesting was that the doctor attempted to compare the Capstone Re pool to another well-known risk pool which exists in the non-tax captive world known as the Green Island Insurance Treaty. This attempt was demolished by the court in a lengthy footnote which pointed out no less than six major differences between what Capstone Re was doing (or, really, not doing) as opposed to Green Island, such as adjusting premium pricing to reflect actual losses.
The bottom line was that the Capstone Re risk pool failed to provide risk distribution for all the same common reasons as in the other microcaptive losses, such as a circular flow of funds, a lack of arm’s length contracts, and the premiums were not actuarially determined in any real manner.
The court then turned to the direct written policies issued by Magellan and Plymouth to the doctor’s operating businesses. Without the risk distribution of Capstone Re, this was an easy call for the court because Magellan and Plymouth only insured the doctor’s three businesses and this was plainly insufficient for risk distribution. Here, the doctor tried to use the fact that his operating businesses had around 30,000 patient visits and 9,000 procedures during the years in question as evidence that his captives still had adequate risk distribution. There was a problem with this, however, and a really big problem: The doctor did not use Magellan and Plymouth to cover the medical professional liability risks, but instead covered those risks by purchasing insurance policies from third-party commercial carriers as he had also done.
This finally brings us to whether Magellan and Plymouth provided “insurance in the commonly accepted sense” to the doctor’s operating businesses. The court admitted that the paperwork was in order, the two captives were licensed, and they were adequately capitalized. Pretty much everything else, however, belied that Magellan and Plymouth were operated like real insurance companies. There was no evidence that a feasibility study was done before Magellan was formed. When it came to the formation of a second captive in Plymouth, “it appears that a desire to take advantage of increased tax benefits came first, and the justification to form a second captive came second.” The final nail in this particular coffin was that the doctor, as the owner of these two captives, did any due diligence at all with respect to the Capstone Re risk pool as a person purporting to run a real insurance company would have done. Thus, the court:
“In reality, Capstone orchestrated Magellan’s and Plymouth’s activities so that they appeared to be engaged in the business of issuing insurance contracts. But the facts establish that they were not operated as insurance companies in the commonly accepted sense.” [Emphasis in original]
The court reiterated that the premium amounts involved were not based on any actuarial calculation but were simply chosen so that the doctor could get as close as possible to the limits allowed by 831(b). These premiums were also seriously out of whack in relation to the cost of comparable insurance coverage from commercial carriers. Some of the premiums charged made utterly no sense, such as a $14,000 annual premium for a legal expense policy that had a $20,000 claims limit, or as the court put it, “this would be the equivalent of purchasing collision coverage for a $20,000 car and paying a $14,000 premium for that policy.” Here, the court leveled even more criticism at Rosenbach: “We conclude that Mr. Rosenbach’s calculations were aimed not at actuarially sound decision-making but at justifying total premiums as close as possible to $1.2 (or $2.2) million, without going over, to satisfy section 831(b).”
For all these reasons, the court found that the insurance transactions involving Magellan and Plymouth were not in the nature of insurance for federal tax purposes, and thus were not deductible by the doctor’s operating businesses.
ANALYSIS
The facts of this case are so similar to those of all the other microcaptive cases, including not least importantly that the IRS won on nearly all the major issues, that the only question is why the doctor even decided to take this case to trial in the first place. At the lower levels, such as with licensing, everything was fine. At the upper levels, such as in premium pricing by Magellan and Plymouth, this program was fatally flawed from the outset and probably never had a realistic chance of being defended before the Tax Court. This arrangement waddled like a captive and quacked like a captive, but closer inspection by the Tax Court showed that it was little more than a tax shelter in a captive suit. It is difficult to imagine that anybody would spend the money to appeal this decision, but who knows.
The only thing that is different in this case is that it involved a captive that used its premiums to purchase a life insurance policy. The Tax Court’s opinion doesn’t spend much time on it, but did mention it in the opinion in the light of Magellan and Plymouth being formed more for the doctor’s estate planning purposes than for risk management purposes. Back in 2014, I warned readers in my article, Life Insurance and the 831(b) Captive Insurance Company — Wait For The Test Case Before Signing Up (April 20, 2014), that life insurance in a captive could belie its insurance purposes, but apparently here the doctor never read, or at least didn’t heed, the warnings of that article. So, I’ll just leave a simple “I told you so” right here and move on.
The other interesting thing about life insurance in a captive that was not at issue in this case goes to the potential for the large commissions typically paid for the sales of those products to be included in an assessment of promoter penalties. These large commissions certainly incentivize promoters of microcaptive shelters to more aggressively market their captive services, since the amount of money they can make by selling life insurance can be greater (and sometimes far greater) than the ordinary “street price” for captive management services. It seems that if the IRS were to assess promoter penalties, the IRS would naturally include the commissions for the life insurance products that were placed into the microcaptive structure as this would be part of the gross compensation received by the promoters. Recall that the promoter penalty is 50% of gross compensation, without any deductions, and the life insurance commissions would seem to be a part of that. But we’ll probably have to wait for a future case involving a captive who made money off life insurance commissions who is attempting to fight off promoter penalties before we see how this particular issue will shake out.
That opinion will be most interesting.
Read the full article here