On 13 May 2022 in the Reserve Mechanical Corporation against the Commissioner, The U.S. District Court of Appeals for the Tenth District upheld the Tax Court’s ruling that a microinsurance insurance company was not eligible for income tax exemption as a small insurance company under IRC § 501 (c) (15). Therefore, the estimated premium payments that the company has received are fixed, determinable, annual or recurring (FDAP) income, taxable at the rate of 30% under IRC § 881 (a). The IRS scrutinizes micro-capture transactions because of their potential for tax evasion. For the purposes of disclosure requirements, the IRS has identified certain micro-retained transactions as “listed transactions” in Notice 2016-66. The court recently annulled Notice 2016-66 for non-compliance with the Administrative Procedure Act; However, Reserve Mechanical illustrates that micro-capture transactions remain essentially vulnerable.
At Reserve Mechanical, two shareholders owned and operated the mining company Peak Mechanical Corp. (Peak). Years ago, Peak had commercial insurance coverage and paid annual premiums of $ 100,000. In 2008, the two shareholders consulted with Capstone Associated Services, Ltd. (Capstone) on the creation of a microinsurance insurance company. Capstone has promised to provide shareholders with a feasibility study; however, shareholders proceeded to establish the Reserve Mechanical Corp. (Reserve) in the British West Indies before reviewing this information. The reserve had no staff. Capstone provided management services to the Reserve, including policy making and premium setting. One of the shareholders testified that they were not satisfied with their commercial insurance policies, but Peak continued to maintain its commercial coverage after the creation of the Reserve.
In 2008-2010, Reserve issued 13 direct policies to Peak and two affiliated corporations in exchange for annual premiums of $ 400,000. There have been a number of problems with direct policies, including that several policies list the wrong policyholders and other policies overlap with Peak’s existing commercial coverage. Capstone has informed the Reserve that it will have to receive at least 30% of its premiums from non-affiliated companies in order to qualify as an insurance company. To this end, Reserve participates in a pool reinsurance policy with PoolRe, a risk pool comprising 50 captive insurance companies managed by Capstone. Under this agreement, Reserve and other Capstone entities agreed to bear some of the risks that PoolRe took. The policy is structured so that the Reserve fees received from PoolRe are equal to the fees that PoolRe receives from Peak. In addition, Reserve entered into a joint credit insurance agreement with PoolRe, including CreditRe. There was no evidence that Reserve received premiums under the co-insurance agreement.
Peak deducted the insurance premiums he paid to the Reserve as business expenses in his federal tax returns. As Reserve receives premiums of less than $ 600,000 each year, it concludes that it is a tax-exempt insurance company under IRC § 501 (c) (15) and does not pay tax on premium payments it receives from Peak. The IRS has determined that the Reserve is not entitled to exclude tax premiums and proposed estimates for each year.
IRC § 501 (c) (15) (A) (i) provides that insurance companies are exempt from tax when: (i) gross annual income does not exceed $ 600,000; and (ii) more than 50% of gross revenue consists of premiums. The central question in Reserve Mechanical was whether Reserve was an insurance company so that it could benefit from the tax exemption in § 501 (c) (15). Insurance is not defined by the Internal Revenue Code. The courts have adopted a four-part framework for assessing insurance agreements: (i) the agreement must include insurance risks; (ii) the agreement must transfer the risk of loss to the insurer; (iii) the insurer must share the risk of loss among its policyholders; and (iv) the agreement must be insurance in the conventional sense.
Applying this framework, the Tax Court concluded that the reserve agreement was insufficient on two grounds: (i) it does not provide for risk-sharing because direct policies include too few insured and PoolRe is not a bona fide insurance company; and (ii) it is not insurance in the conventional sense, as Reserve did not operate as an insurance company and the premiums were unreasonable and not set out in an act. The tenth district upheld the decision of the Tax Court on both grounds. Each ground is discussed below.
(i) The reserve agreement did not provide for risk-sharing
On appeal, Reserve did not challenge the Tax Court’s finding that the direct policies issued to Peak did not lead to a distribution of risk. Rather, he argues that the reinsurance and co-insurance agreements with PoolRe have led to a sufficient allocation of risk for Reserve to be a valid insurance company. Reserve claims that the Tax Court misapplied the risk-sharing test by focusing on whether PoolRe is a bona fide insurance company. The tenth round acknowledged that, in theory, an agreement that provides for risk-sharing can be insurance, even when there is no insurance company. However, the PoolRe product was not insurance. According to the court, the reinsurance agreement is nothing more than a circular flow of funds without a meaningful distribution of risk. In addition, there was no evidence that the co-insurance agreement with PoolRe even existed because it did not receive premiums or pay claims in 2008-2010. But even if co-insurance did exist, the Reserve did not take any significant risk. According to the Tenth District, the Tax Court underestimated the evidence that PoolRe was fake. The Tenth District noted that the decision of the Tax Court did not lead to a conclusion about the legitimacy of the pooling of risks in general. But it was clear that PoolRe’s risk pool did not share the risk.
(ii) The reserve agreement was not insurance in the conventional sense
On appeal, the Reserve claims that the Tax Court erred in: (i) incorrectly characterizing the policies as over-coverage policies; (ii) a conclusion that the premiums were unreasonable and not negotiated freely; and (iii) considers that Reserve is not managed as an insurance company as it is managed by Capstone. The tenth chain disagreed. First, he concluded that the Tax Court had not misread the Reserve direct policies issued to Peak. It was clear that direct policies apply only after all other insurance coverage has been exhausted. Second, the Tax Court correctly concluded that the policy premiums were unreasonable and not negotiated freely, as the premiums were four times higher than Peak’s trade policies and the Reserve did not provide an explanation for how it calculated the risks. Finally, the Tax Court is justified in concluding that Reserve did not operate as an insurance company because it had no employees; he never did business in Anguilla; his president knew nothing of his operations; and failed to investigate the only lawsuit he received before paying approximately $ 340,000. It was therefore clear that Reserve’s policies were not insurance in the conventional sense.
Reserve’s direct policies and PoolRe’s risk pool included a number of case-specific flaws. But Reserve Mechanical could strengthen the IRS’s determination to stop abuses of micro-captive transactions. Although the court said it did not reach an opinion on the legitimacy of pooling risks in general, the case set a high bar for microinsurance insurance companies in determining the distribution of risk. Taxpayers involved in micro-retention transactions may wish to consult with their tax advisor to understand how Reserve Mechanical affects them.
 129 AFTR 2d 2022-1804 (10th round 2022).
CIC Services, LLC v IRS, Case No. 3: 17-cv-110 (ED Tenn. 21 March 2022). Alert to SeeGT, the Court annulled the 2016-66 notice on micro-retention transactions, the second time the IRS notice was released this month.
 TC Note 2018-86 (2018).
Harper Grp. v. Comm’r, 96 TC 45 (1991), aff 979 F.2d 1341 (9th Cir. 1992).
© 2022 Greenberg Traurig, LLP. All rights reserved. National Review of Law, Volume XII, Number 172