Tenth Circuit Issues Landmark Microcaptive Insurance Company Opinion In Reserve Mechanical

I have previously written about the IRS’s win against so-called “microcaptive” transactions in the Reserve Mechanical case, with a detailed explanation of the U.S. Tax Court’s opinion in that case in my article: Analysis Of The IRS’s Big Win Against Risk-Pooled Small Captives In Reserve Mechanical (June 25, 2018). That Tax Court decision was later appealed to the U.S. Court of Appeals for the Tenth Circuit, which finally issued its ruling on May 13, 2022, that you can read for yourself in full here.

Suffice it to say that the Reserve Mechanical case attracted a lot of attention within the small captive insurance sector. Numerous state captive insurance groups supported the captive insurance company in the appeal as amici curiae (albeit I found their brief to be very pedestrian, if not at points just plain awful, and the Tenth Circuit apparently didn’t make much of it either). This support for the taxpayer in the case indicated that pretty much the very existence of the risk-pooled small captive insurance industry teetered on the outcome of this case: If the IRS lost and the captive won, perhaps microcaptive transactions could survive after all. If the captive lost and the IRS won, it was all over for risk-pooled small captives.

Sneaking a peek at the last chapter, the IRS wins in a blowout and the involved captive tax shelter gets its appeal poured out in all particulars. After this decision, risk-pooled small captives are no longer tenable, period. The final nail in the coffin of the legal viability of microcaptives has now been driven in, and hard. Nonetheless, it is important to understand exactly how and why the Tenth Circuit reached this result so that similar fatal mistakes within the captive industry as a whole may be avoided in the future.

Readers will here be spared a rehash of the facts, other than as noted to be of interest by the Tenth Circuit. Suffice it to say that Reserve Mechanical was formed as a captive insurance company, and managed by Capstone which also managed the risk pool and the other 50 or so captives (owned by unrelated third-parties) that were in the risk pool. We’ll get to the risk pool later.

Capstone drafted some 13 policies of insurance for Reserve Mechanical to issue to the mining business of the two taxpayers involved (Zumbaum and Weikel) with premiums of a little more than $400,000. Some of the policies were illusory because they overlapped with other commercial coverage purchased by Zumbaum’s and Weikel’s companies. But even worse:

“Several of these policies were executed with singular carelessness. For example, two of the policies erroneously listed Pacific Arts Entertainment, LLC and Pacific Arts Presents, LLC as the insureds, rather than Peak, RocQuest, and ZW. And although the directors-and-officers policy stated that it covered the specific officers and directors listed in Schedule 1-A, an attachment to the policy, Schedule 1-A did not list a single insured person, so the policy—for which Peak paid $17,122—would provide no coverage. Also, in the apparent rush to issue the policies (and pay premiums that would be deductible in 2008), Peak paid for three policies—employment-practices liability, weather-related business disruption, and cyber risk—that apparently were deemed unnecessary after a little further consideration, as they were dropped in 2009, after being in place for less than one month. (Notably, the later-issued feasibility study described one of the discontinued coverages—employment-practices liability—as a ‘major liability concern[ ]’ for Peak. Aplt. App., Vol. 7 at 2062.)”

The “singular carelessness” of Capstone seems to be a recurring theme throughout this case, which is remarkable is that Capstone was paid as the captive manager for the very purpose of getting stuff like this right. The Tenth Circuit found similar errors in Capstone’s pricing of the policies issued by Reserve Mechanical, with even Reserve Mechanical’s attorney having to admit at oral argument on one such issue that “It certainly strikes me as an error.” Hardly a propitious beginning.

Yet, Capstone’s errors in calculating the premium amounts paled in comparison to Capstone’s method of arriving at those amounts. While Capstone apparently spent a good deal of time at identifying those risks, it apparently made little or no effort to quantify those risks, and the Tenth Circuit quickly picked up on this:

“The core task in setting premiums for an insurance policy is predicting risk: the size and frequency of losses covered by the policy. [] But the record is devoid of evidence of the necessary risk assessment by Reserve. Peak had no history of any losses that would be covered by the Reserve policies, so the premiums could not be based on Peak’s actual experience. The feasibility study briefly described the risks that would be covered by the policies, but it contained no discussion of the probability or size of the risks. For example, when the feasibility study discussed Peak’s need for employment-practices liability coverage, it merely stated that this liability ‘has become a hot topic over the past several years as complaints and legal action nationwide have skyrocketed for wrongful termination, discrimination, harassment, and other employment-related practices.’ “

Nor did Capstone bother to consult insurance industry data on those risks or compare what other insurance companies were charging for those risks. Instead, for Reserve Mechanical, Capstone “based the rates on the premiums charged by other captive insurers managed by Capstone.” This, of course, was circular: “Nor was there any evidence showing that the premiums charged by the other Capstone entities (who likely had the same tax incentive as Reserve to charge as high a premium as possible) were themselves reasonable.”

Capstone did employ the services of an underwriting firm to support its pricing, there was no evidence as to how that underwriter had arrived at its figures either, and the underwriter was not called to testify as a witness at trial. Who Reserve Mechanical did call at trial were two expert witnesses, the first of which, Esperanza Mead, based her conclusions on what the Tenth Circuit characterized as “questionable assumptions” since she also did not rely on any insurance-industry data, assumed what Capstone was charging its other captive clients was reasonable, and ultimately assumed that Capstone’s other captives would pay out close to 75% of their premiums in claims — a number she apparently pulled out of the thin blue sky.

Reserve Mechanical’s other expert witness was just as bad, because instead of opinion on whether the insurance premiums charged by the captive were reasonable on a policy-by-policy basis, he instead opined that the total premiums charged were “reasonable in the aggregate”, whatever that means. The Tenth Circuit noted that, tellingly, “[n]either expert examined what the real risks to Peak were.”

The Tenth Circuit also focused on the pricing relationship of Reserve Mechanical’s policies to those commercial polices that were available in the insurance marketplace, noting that while Capstone’s feasibility study talked about Reserve Mechanical issuing policies that were not commercially available, in fact Reserve Mechanical issued six policies that were commercially available. In coming up with the premiums to be charged for those six policies, Reserve Mechanical simply ignored the price they could have been otherwise obtained.

But even worse, from the Tenth Circuit’s viewpoint, was that “there is also no evidence in the record that the choice of policies, or their specific contents, was based on an assessment of Peak’s particular needs.” While Capstone’s owner, Steward Feldman, testified that one of the advantages of a captive was to tailor “coverages directly to the needs of the business,” there was no evidence that such actually happened with Reserve Mechanical. Instead, Capstone had Reserve Mechanical issue what the Tax Court described as “cookie-cutter” policies that were pretty much the same for all of Capstone’s captive clients.

When the Tenth Circuit reached how Reserve Mechanical handled claims, things get even worse. The taxpayer’s operating business, known as Peak, purchased a special-risk policy from Reserve Mechanical that insured against Peak’s loss of a major customer. In 2009, Peak made a $164,820 claim against this policy for its loss of orders from the Stillwater Mining Company, which allegedly represented 35% of Peak’s sales. Reserve Mechanical apparently never investigated the claim, or even examined it to see if it was a covered claim, and Peak submitted no evidence to substantiate the claim. If that’s not bad enough, the loss allegedly occurred on January 5, 2009 — and the policy itself did not go into effect until January 1, 2009.

A real insurance company would likely have challenged the claim on the basis that Peak knew that it had a claim prior to the policy being issued and should have disclosed it (and, thus, the claim would have been excluded from policy coverage). Nonetheless, Reserve Mechanical immediately paid the bulk of the claim, being $150,000 with two weeks, and thereafter Reserve Mechanical and Peak “settled” the claim the next month. This settlement, which caused Reserve to pay the $14,820 balance of the claim, purported to “completely release[] and forever discharge[] [Reserve] from any and all part or present claims … [that] may in any way grow out of the specified loss.” Nonetheless, four months later, Reserve made yet a third payment on this same already-“settled” claim for $175,000.

All this now brings us to Reserve Mechanical’s participation in the Capstone risk pool (in the form of a reinsurance company called “PoolRe”), and its reinsurance agreements with that pool. About 50 other captives managed by Capstone similarly participated in PoolRe. The participation by Reserve Mechanical in PoolRe was by two arrangements.

The first arrangement was a straight reinsurance policy. Peak was insured by Reserve Mechanical, and Reserve Mechanical was reinsured by PoolRe for certain stop-loss coverage. In exchange for PoolRe’s reinsurance, PoolRe received about 20% of the premiums paid by Peak to Reserve Mechanical. This arrangement was defended on the basis that, at least in Reserve Mechanical’s first few years, Reserve Mechanical did not have the capital or reserves to fully cover its potential liabilities on the policies it issued, and thus needed PoolRe to provide a backstop to its policies. But the Tenth Circuit saw right through this: “But PoolRe did not provide much of a backstop. The amount that PoolRe could be required to pay each year on the stop-loss coverage was strictly limited, and the requirements for it to make any payment at all were intricate, restrictive, and highly unlikely to materialize.”

The first problem identified by the Tenth Circuit is that Reserve Mechanical had to itself first pay out about $450,000 in claims before the PoolRe stoploss kicked in. Then, PoolRe would pay the claim, but only to 150% of Reserve Mechanical’s premiums, being an upper limit of $672,000 as compared to the $8 million in total potential liability on Reserve Mechanical’s policies, i.e., a drop in the bucket and nothing even close to a full backstop.

It gets worse from there, as the Tenth Circuit noted. The amount available to Reserve Mechanical from its PoolRe backstop was also limited by a condition that PoolRe’s total exposure for all the captives who participated in this arrangement maxed out at 125% of the total premiums ($8 million) paid for stop-loss coverage for all of PoolRe’s captives. Thus, if a sufficient number of other captives made claims against their own stop-loss policies, the amount available to Reserve Mechanical could be reduced substantially, or even to zero.

Yet, this really wasn’t that big of a problem because, in the words of the Tenth Circuit, “[a]nother feature of the PoolRe coverage, however, made the above limitations more theoretical than real. The limitations were unlikely to ever come into play because PoolRe would incur liability only if what the policy called an “Attachment Point” were satisfied.” These “attachment points” were conditions of the reinsurance agreement between Reserve Mechanical and PoolRe that imposed further restrictions on PoolRe’s potential liability. The attachment points (there were four), required that Peak suffer at least two losses that were each caused by a separate event and each exceeded $100,000 in policy liability, or three losses exceeding $60,000 in policy liability, four of $36,000 in policy liability, or five of $20,000 in policy liability. On top of that, PoolRe was not required to pay more on claims than the amount that the first attachment point was reached. “For example, if the first claim was for $1 million, and the second was for $125,000, PoolRe would pay only $25,000, the amount by which the second claim exceeded the $100,000 threshold.”

The real amount of exposure to PoolRe on its reinsurance agreement with Reserve Mechanical was, therefore, de minimis, and thus of corresponding little value to Reserve Mechanical. But even what little exposure that PoolRe had was not real, because another part of the PoolRe program was that Reserve Mechanical and the other participating captives in the PoolRe deal further reinsured PoolRe against its own losses by way of stop-loss coverage. Thus, according to the Tenth Circuit:

“In other words, PoolRe was essentially only an intermediary. The liability for paying for stop-loss claims incurred by a captive insurer ultimately rested on all the captive insurers as a group. This risk-pooling reinsurance arrangement, which was called a quota-share agreement, gave the appearance that each captive insurer (such as Reserve) was spreading its risk beyond its affiliated companies (such as Peak) by incurring liability on the stop-loss coverage provided for the benefit of the other captive insurers.”

In essence, PoolRe was wired so that whatever premiums that it received from an operating business were passed through by way of reinsurance premiums to the operating company’s affiliated captive, and then each captive covered PoolRe’s exposure in the same percentage so that PoolRe effectively wasn’t insuring anything. The Tenth Circuit recognized this:

“The nature of the arrangement can be illustrated by a simplified example. Say, the PoolRe risk pool had three captives, A, B, and C, which respectively reinsure 50%, 30%, and 20% of the total stop-loss risk, because A’s insureds pay 50% of the premiums to PoolRe for the stop-loss coverage, B’s pay 30%, and C’s pay 20%. If Captive B’s insured has a covered claim that requires PoolRe to pay it $100, then Captive A must pay PoolRe $50, Captive B must pay $30, and Captive C must pay $20. B ends up reducing its potential $100 loss to $30, while the other pool members are out $50 and $20. No matter which captive insurer incurs the loss, the loss is ultimately borne in the same 5:3:2 proportions by the three captives.”

This is what happened with Reserve Mechanical: It was all just a passthrough or cover-back, such that PoolRe wasn’t actually taking on any risk. It didn’t help that during the years in question, no claim against the PoolRe coverage was made by any of the approximately 400 businesses that were reinsured by PoolRe — why make such a claim when you’re going to end up paying it yourself anyway?

The Tenth Circuit went on in its analysis to consider what the result might be if, assuming arguendo, PoolRe was not illusory. This lead to a discussion of whether the premiums charged by PoolRe, and the reinsurance premiums charged by Reserve Mechanical, were reasonable. Although there was a letter introduced as evidence from Robert Snyder of Myron Steves, which determined the premiums to be “reasonable”, there was no evidence that Snyder had even looked at Peak’s risks specifically or attempted to analyze the confusing attachment point regime in the PoolRe policies. The Snyder letter was also chock-full of disclaimers, which seemed to amuse the Tenth Circuit:

“The letter explains, however, that its ‘analysis and observations are limited to general commentary regarding stop loss insurance and the reinsurance pooling concept, and specifically, our assessment of the proposed premium structure.’ [] It does not indicate that Snyder had undertaken any specific assessment of the risks arising from the underlying insurance policies of the PoolRe captives or examined how any particular provisions of the stop-loss coverage, such as the highly restrictive attachment points, affected the insurer’s risks. It noted that a review of the premiums was ‘necessarily subjective,’ id., and stated that the premiums employed by PoolRe are reasonable, ‘recognizing that in our judgment stop loss coverage in general might fairly be priced at anywhere from 2.5% to 30% of written premium.’ [] Talk about going out on a limb.”

The Tenth Circuit also found it curious that PoolRe charged 18.5% to all the 50 or so captives in the pool, without looking at the risks (and thus PoolRe’s potential liability) of any individual captive or policy. To the contrary, the Tenth Circuit noted that “[t]here is no evidence Capstone performed any further risk analysis before settling on 18.5% as the price paid by all captive insureds in 2008 and 2009.” Instead, Capstone apparently just pulled that number out of the air and applied it across-the-board to all the captive in PoolRe.

Likewise, the Tenth Circuit noted that there was an absence of evidence that Reserve Mechanical had done anything at all to try to figure out the right price for the reinsurance that it charged to PoolRe, much less why the premium charged by Reserve Mechanical just happened to be in the exact same percentage charged by every other captive reinsuring PoolRe. “One would think that pool members would want to make sure that the premium prices, and therefore their quota-share percentages, accurately reflected the risks involved because if one of the captives’ stop-loss endorsements triggered a disproportionate number of claims, then that captive would receive a greater benefit than the rest of the pool members.”

This now brought the Tenth Circuit to the second arrangement by which PoolRe (and thus Reserve Mechanical) attempted to distribute risk, which was by way of the so-called credit-coinsurance arrangement. This particular deal was so hinky that Reserve Mechanical would have done better by just not raising it at all, but they did.

The coinsurance deal involved a company called CreditRe, which itself assumed the risk on certain vehicle service contracts issued to consumers by Lyndon Property Insurance Company. CreditRe ceded PoolRe (which is another way of saying that PoolRe insured CreditRe) a portion of CreditRe’s risk on the Lyndon contracts. PoolRe then itself ceded Reserve Mechanical about 1% of PoolRe’s exposure on these contracts, and the premiums received (at least on paper) by Reserve Mechanical were about 15% of Reserve Mechanical’s total premiums. This was a further attempt by Capstone to mix up Reserve Mechanical’s risks so that it appeared that Reserve Mechanical was distributing risks.

The Tenth Circuit saw through this deal pretty easily. First, there was no evidence that any significant amounts of premiums actually changed hands, although large premiums were booked by Reserve Mechanical on paper. In fact, Reserve Mechanical actually received the whopping sum of $530 in premiums to take on this risk. Worse, CreditRe’s owner, Gary Fagg, when questioned at trial couldn’t himself identify exactly what liability CreditRe was taking over (or that it passed on to PoolRe or Reserve Mechanical), or how the premium amounts were calculated.

Turning to the technical tax issues, the Tenth Circuit noted that the Tax Court had determined that Reserve Mechanical’s insurance transactions lacked economic substance and were not insurance transactions for tax purposes, and thus Reserve Mechanical was not an insurance company for tax purposes. Further, Reserve Mechanical was liable for so-called “FDAP Income” that is subject to a 30% tax rate, and could not instead treat the premiums it received as capital contributions.

The focus of whether there is risk distribution depends upon the presence of the so-called “law of large numbers”, the Tenth Circuit reiterated. Policy coverage for a small number of risks does not suffice, but there instead must be enough insured risks that the insurer can predict losses with some degree of accuracy. Reserve Mechanical did not challenge that its insurance of Peak’s risks alone did not meet this criteria, but instead attempted to meet risk distribution through its PoolRe arrangements.

One of these arrangements was the quota-share deal, and the Tax Court had found that PoolRe itself was not an insurance company; thus, that arrangement was not “insurance” and there could be no risk distribution for Reserve Mechanical’s participation in it. While Reserve Mechanical squabbled on appeal about whether PoolRe was an insurance company, or whether it could issue insurance policies even if not an insurance company, that missed the point according to the Tenth Circuit:

“The heart of the problem was not that PoolRe was not an insurance company but that its product was not actual insurance. The court concluded that ‘the facts surrounding Reserve’s quota share policies with PoolRe establish that those agreements were not bona fide insurance agreements.’ [] We agree with the Commissioner’s characterization of the Tax Court’s analysis: ‘[T]he Tax Court did not invalidate the quota share arrangement on the ground that PoolRe failed to meet the formal definition of an insurance company. Rather, it invalidated the quota share arrangement on the ground that, as a matter of substance, PoolRe did not perform the functions of an insurance company—regardless of label—vis-à-vis the quota share arrangement.’ [] In short, what the Tax Court determined is what Reserve contends should have been determined—whether the quota-share arrangement was a true insurance arrangement for the distribution of risk.

“The Tax Court did not err when it assessed PoolRe’s bona fides. * * * On the contrary, the Tax Court opinion, if anything, understates the compelling evidence that the quota-share arrangement was a sham.”

Up next was the CreditRe credit-coinsurance arrangement, and the Tenth Circuit not surprisingly found that it did not distribute risk either. First, Reserve Mechanical never proved that this deal actually involved any risk; and, second, even if it did, the amounts involved ($530 over three years) were too small to constitute risk distribution in any meaningful sense.

The Tenth Circuit likewise affirmed the Tax Court’s ruling that Reserve Mechanical’s policies were not “insurance in the commonly accepted sense”, which is also required for such policies to be treated as insurance policies for tax purposes. Here, the Tenth Circuit opinion really slams the PoolRe deal:

“We have already discussed at some length the evidence supporting the Tax Court’s determination that Reserve did not act like a company in the business of writing legitimate insurance policies. Its only true insured was Peak. The arrangements with PoolRe lacked substance. There was no apparent business reason for the credit-coinsurance contracts. And the Tax Court was fully justified in determining that the quota-share reinsurance arrangement was a sham. The attachment points that had to be met before PoolRe had any liability to the Capstone captive insureds defied explanation. Reserve provided no evidence to overcome the logical inference that the reason to set such intricate limitations on liability was to ensure that PoolRe would never have to make a payment (particularly when the risk of loss under any of the underlying policies issued by the captive insurers was apparently low to start with), so there was really nothing for Reserve or the other captive insurers to reinsure.”

The Tenth Circuit noted that there was no evidence that any risk assessments for Peak had been done so that a determination could even be made as to whether it needed the additional coverages. There was also no evidence that premiums which Reserve Mechanical charged Peak were worth it as to Peak. Then the opinion turns ugly:

“And Reserve was hardly run like a business. The preparation of the original one-month policies in an apparent rush to obtain a large business deduction for Peak in 2008 was laughable. It suffices to note that on two of the policies the listed insureds, rather than Peak, RocQuest, and ZW, were ‘Pacific Arts Entertainment, LLC’ and ‘Pacific Arts Presents, LLC.’ Nor did Reserve operate in a more businesslike fashion thereafter. No self-respecting insurance company would have paid $340,000 on the loss-of-customer claim without any investigation or supporting documentation. And it was clear from his testimony that Zumbaum, the Chief Executive Officer of Reserve, knew zero about its business. The Tax Court was fully warranted in its finding that ‘Reserve’s transactions were not insurance transactions in the commonly accepted sense.’ “

Reserve Mechanical attempted to argue on appeal that the Tax Court had misread certain of its policies as excess policies, but the Tenth Circuit found no error because the policies (or at least the majority of them) in fact had clauses which clearly stated that they would only pay excess claims. Nor did the Tenth Circuit buy Reserve Mechanical’s argument that the premiums that it charged were neither reasonable or executed at arm’s length. The fundamental problem, however, was that even Reserve Mechanical could not explain how it arrived at the premium amounts charged:

“Most important, however, was Reserve’s utter failure to provide a reasonable explanation of how it calculated the risks covered by those policies. The best it could do at the hearing before the Tax Court was to suggest, through the testimony of experts who were not familiar with Peak, that the premiums were in line with the premiums charged for similar insurance by other captive insurers managed by Capstone. But there was no evidence that those other captive insurers faced risks similar to those of Peak, nor was there any evidence that the premiums charged by those other captive insurers were themselves reasonable.

Reserve Mechanical also faulted the Tax Court for considering the fact that Peak did not have a history of significant losses, analogizing the situation to that of a driver being insured who had yet to have a wreck. The Tenth Circuit swatted this argument away easily by noting that although Peak had never even come close to exhausting the coverage limits of its commercially-available policies, by switching over to Reserve Mechanical’s policies, Peak increased its insurance cost by 400%. The bottom line was that the Tax Court did not err in determining the Reserve Mechanical policies sold to Peak to be unreasonably priced and not negotiated at arm’s length.

Another complaint by Reserve Mechanical was that it meant little that Zumbaum didn’t know anything about insurance as he ran Reserve Mechanical, since actually Capstone was doing everything as the captive manager. The Tenth Circuit recognized this as essentially a strawman argument, since the real issue was that neither Zumbaum as the “responsible officer” of Reserve Mechanical, or anybody else (including Capstone’s McNeel) were able to explain how Reserve Mechanical arrived at the pricing of its policies. ” It is one thing to seek technical and administrative assistance from professionals; it is quite another to abandon all responsibility for how your company is handling $400,000 of insurance and simply believe everything Capstone says,” wrote the Tenth Circuit.

That ended the Tenth Circuit’s discussion of whether Reserve Mechanical was operated as an insurance company in the insurance sense, or whether its policies were insurance contracts in the tax sense. They were not. But the Tenth Circuit still had to determine what the consequences of that ruling, and it proceeded to that issue.

Reserve Mechanical argued that if the premiums that it received were not insurance premiums, then they should instead be treated as capital contributions from its shareholders. However, the Tax Court held that whether a payment was to be treated as a capital contribution rested upon whether that was the purpose of the payment, and that was not the purpose of the premium payments which were intended (however misguidedly) to be insurance premiums. The problem for Reserve Mechanical is that the burden of proven this purpose, and it failed to do so at trial.

Faced with this conundrum of its own making, Reserve Mechanical tried to argue that there could be no other purpose for the payments other than as a capital contribution. But the Tenth Circuit was having none of that:

“Here, the objective reality is that Peak and Reserve entered into contracts that required Reserve to pay Peak if Peak suffered losses covered by the contracts. Although the Tax Court held that those contracts were not insurance contracts and that the policies, with their unreasonable premiums, had no legitimate business purpose, that does not mean that the transfer of funds from Peak to Reserve could not serve a legitimate business purpose. The court’s findings are consistent with the characterization of the transaction proffered by the Commissioner—namely, that the transaction was just a movement of funds offshore “to self-insure against business losses.’ “

The opinion continues:

“In any event, what is totally absent here is proof of the essential element of motive, purpose, or intent—evidence from which one can infer that Peak intended to make a capital contribution. The Tax Court’s finding that the policies issued by Reserve were not true insurance policies said nothing about Peak’s intent. The finding was based on objective facts regarding risk distribution and conducting affairs as an insurance business. Reserve has not suggested any reason why Peak or its owners would want to make a capital contribution to Reserve. Nor has it presented any argument why a factfinder could not infer that Peak’s intent was simply the intent to create a plausible insurance company through which Peak could obtain a substantial tax deduction without reducing the funds available to its two owners. The intent behind the act does not change just because the act failed to achieve its purpose. (In fact, the arrangement did accomplish Peak’s purpose. Counsel for the Commissioner reported at oral argument that it was too late to challenge Peak’s business deductions for insurance premiums paid to Reserve for 2008–10.) By the same token, Reserve earned income by creating the appearance of issuing insurance policies to Peak, even if it ultimately failed to convince the Commissioner that the policies were bona fide. Reserve could have reported the transactions with Peak on its tax returns as the receipt of capital contributions, but it did not do so.”

The Tenth Circuit thus rejected Reserve Mechanical’s capital contribution argument, and with that affirmed the U.S. Tax Court’s judgment across the board: Reserve Mechanical did not win on a single issue.

ANALYSIS

The practical effect of this opinion is to vitiate risk pools as a method for small captive insurance companies to meet the risk distribution requirements for tax purposes. While some captive managers may claim that “our risk pool is different” or “we’re the best in our class” or some similar nonsense, the bottom line is that risk pool arrangement as they are currently structured for small captives (and Series LLC deals) have very little chance of withstanding a U.S. Tax Court challenge.

This opinion does not foreclose risk pools entirely, but instead the opinion states at one point that “We recognize that a legitimate pool with a similar arrangement might properly distribute risk among insurers, even captive insurers.” But what would such a pool look like? It would not look like PoolRe, or anything close to it. A valid risk pool under this decision requires at the very least that there be real sharing of risk, to the point that any captive participant in the pool has the very real risk that they will incur losses from the claims of other participants’ businesses in excess of the premiums that they are receiving by way of reinsurance premiums into their captives. Who exactly is going to sign on for that particular risk?

The Tenth Circuit frankly labels the PoolRe arrangement as a “sham” and it is because the pool is structured in a way that the owners of the pool are not really sharing full liability with other participants, but instead the deal has been wired so that — after one cuts through all the obfuscation — each captive owner is basically responsible for their own losses and little more. But this is the way that pretty much every risk pool works, since probably nobody could sell the deal to a prospective business owner who is advised that she will take on a substantial amount of the risk of other business owners totally unknown to her.

Even if somebody were able to design a pool to overcome that particular hurdle, then the next hurdle is in the pricing of premiums and trying to meet the arm’s length requirements. This is yet another place that risk pools stumble: The captive manager is the one actually arranging things on all sides of the transaction, so it can never really be anything like arm’s length. Then, everybody in the deal would have to negotiate their own premiums based on their own risks, and the actuarially-perceived risks of the pool involved, and that would be a big mess where there are numerous captive owners involved with each independently bargaining for the best deal on pricing and risk. Frankly, it’s a non-starter.

At least as far as I have seen, and I have seen a lot of the risk pools of a lot of captive managers, none come close to meeting the requirements the Tenth Circuit imputes in this decision. A lot of managers think that their risk pools work, and some even have some pretty thick opinions letters telling them that they work, but they’re wrong. Just flat wrong, and this opinion tells why.

It would be easy think of maybe distinguishing this case because of how Capstone designed the PoolRe arrangement, and the incidents of amazing sloppiness of Capstone’s work. Truth is, the PoolRe deal was designed in a very typical fashion common to about every small captive risk pool, and there is no captive manager out there without some warts on their work. Reserve Mechanical didn’t lose this case because Capstone did something much worse than other captive managers: Reserve Mechanical lost this case because the whole idea of risks pools within the small captive sector was fundamentally flawed from the very beginning.

Going forward after Reserve Mechanical, these risk pool arrangements are simply not tenable to prove risk distribution before the U.S. Tax Court. Taxpayers who are in a risk pooled captive have a very high chance of losing for lack of risk distribution, unless they can find some technical error in the way that the IRS assessed which gives them a get-out-of-jail card. Put otherwise, it’s over. The tax strategy known as the risk pooled 501(c)(15) or 831(b) small captive is dead and now buried.

That does not mean, of course, that Reserve Mechanical will be the end of the so-called microcaptive tax shelter. Even now I get calls from folks who are being pitched this strategy, although it has batted a perfect .000 in the U.S. Tax Court. Usually, the variant involved in the proposal is not a standalone “pure” captive, but instead is the Series LLC deal where a client buys insurance from their own series unit, and then one of the other series (typically, “Series A” or “Series 1”) serves as the risk pool for all. But these “series risk pools” are not any better than the PoolRe-type deals (arguably, they are an even greater sham because there are indemnification agreements hidden in the Series Master Agreement as well), and basically the clients are being defrauded into a tax shelter that the promoter knows or should know doesn’t work. (I also get calls from folks being pitched the uber-abusive Puerto Rico deals, which are nothing short of outright tax fraud, but that’s for another day.)

What it does mean is that the Reserve Mechanical decision finally gives the IRS the green light to come down heavy on the remaining microcaptive transactions. Not just a few captive professionals were getting the feeling that the IRS was holding off its most aggressive actions, such as promoter injunctions, until Reserve Mechanical was decided. It has now been decided, and don’t be surprised if the IRS doesn’t take greater action to finally pinch off the remaining promoters and their continued selling of these now utterly untenable risk pooled small captive deals.

CITE AS

Reserve Mechanical Corp. v. Commissioner, Case 18-9011 (1oth Cir., May 13, 2022).