The Tax Court's decision in Swift v. Commissioner[1], rendered on February 1, 2024, marked yet another instance of disallowed deductions for premiums paid to micro-captive insurance companies. Judge Patrick J. Urda presided over the case, continuing the trend of the Tax Court's skepticism toward such arrangements. Dr. Bernard T. Swift Jr. and his wife were the taxpayers in question, embroiled in a dispute with the Internal Revenue Service (IRS) over deductions claimed for premiums paid to their micro-captive insurance companies for the tax years 2012 through 2015.
The taxpayers, who operated a medical clinic practice encompassing numerous urgent care centers and physical rehabilitation facilities in and around San Antonio, Texas, utilized captives for insurance coverage related to their practice. The Swift’s first captive insurance company was owned by a family trust and the second and third captive insurance companies were owned by two separate trusts for the benefit of their children.
The crux of the IRS's argument lay in the contention that the captive insurance arrangements lacked the essential characteristics of genuine insurance. The premiums paid were deemed exorbitant and unreasonable compared to prevailing commercial rates. For instance, premiums for terrorism coverage, which amounted to $1.5 million, far exceeded the norm of approximately $5,430. Moreover, the policies failed to distribute risk effectively and displayed irregularities in claims processing, including approving claims filed well after the filing deadline.
Risk Distribution:
Generally, to pass IRS muster, a microcaptive arrangement must show that the captive at issue pools a large enough bundle of unrelated risks or risks that are not subject to the same losses and perils from a single event. This notion is based on the law of large numbers whereby a large group of small independent risks helps to smooth an insurer’s claim volatility. The Swift’s arrangement attempted to utilize, but to no avail, directly written policies to Dr. Swift’s enterprises and reinsurance pools to achieve risk distribution.
The direct written policies did not support a finding of risk distribution because not enough entities with not enough different lines of coverage were insured. During the tax years under review, the direct policies insured at most three entities with only six to nine lines of direct coverage.
The Court noted that Dr. Swift incorrectly looked to doctor-patient interactions as the appropriate metric for applying the law of large numbers. Instead, the Court found that the number of doctors is the appropriate metric. In the context of Dr. Swift’s captive medical malpractice policies and the Texas two-year statute of limitations, approximately 199 physicians was not large enough to support risk distribution in the single line of coverage.
In terms of geographic and industry diversity, the Court ruled that risk distribution was not achieved. The terrorism and political violence insurance coverage for clinics that were all within a 100-mile radius did not sufficiently distribute risk. Because the medical clinics operated in a well-defined sub-section of the medical industry, the Court also found that there was no risk distribution relative to Dr. Swift’s malpractice tail coverage. Moreover, the Court mentioned that Dr. Swifts “tightly controlled physician practice . . . to achieve uniformity of performance and desirable outcomes” contradicts Dr. Swift’s argument of industry diversity.
The Court was not persuaded by Dr. Swift’s argument in the alternative that participation in reinsurance pools distributed risk. The reinsurance pool’s circular flow of funds, whereby approximately 94.98%-99.59% of reinsurance premiums paid by Dr. Swift’s arrangement were ultimately retroceded back into the arrangement. The Service and the Tax Court have viewed these sorts of arrangements with serious skepticism.
Additionally, the question of the existence of arms-length contracts was resolved against Dr. Swift where the Court found that the matching of premiums was not supported by any evidence as to their reasonableness despite the difference the variance in the different types of risks assumed. Instead, the Court found that the pool sponsors reverse-engineered the reinsurance pool premiums based on email evidence.
Because of the reverse-engineered approach to pricing, the very low loss ratios (no more than 10% compared to reinsurance industry standard of approximately 65%), and the amount of pricing control given to pool participants, the Court determined the reinsurance pool’s policies were not actuarially supported.
Because of these reasons, the Court found that the reinsurance pools were not bona fide insurance arrangements and could not support the claims that the Swift arrangement achieved risk distribution via the quota-share arrangements. Because the direct policies did not independently achieve risk distribution, it seems that there was no risk distribution in the arrangement.
Insurance in the Commonly Accepted Sense
Yet again, the Court noted though the lack of risk distribution is sufficient grounds to upset a captive insurance arrangement, the Court indulged itself in what has now become an almost standard line of independent analysis relative to whether an arrangement constitutes insurance in the commonly accepted sense. The Court determined this was an alternative ground to find that the Swift arrangement was not insurance.
The Court noted that the Swift’s captives made investment choices that did not reflect the choices that an insurance company in the commonly accepted sense would invest. Specifically, a substantial portion of the captives' assets were invested in illiquid real estate investment partnerships that facilitated the development of additional medical clinics for the Swifts. In 2013, Dr. Swift issued a put option requiring him to purchase the investments if needed immediately. A substantial portion of the remaining funds in the captive arrangement were held in equities through brokerage accounts.
Further supporting the notion that the captives were not operated as typical insurance companies was the very low claim volume, which often did not occur in a timely manner as required by the coverage terms. Additionally, the Court found it highly abnormal that Dr. Swift would negotiate insurance settlements without consulting the captives or its managers and was not required to receive their approval.
Last, the Court found that the captive’s premiums were not reasonable in that they generally represented a pricing approach that were developed to hit a predetermined price for purposes of beneficial tax elections. The Court noted that much of the data used to support the pricing did not relate to the specific risks and perils faced by the insured or that the premiums were otherwise reasonable and actuarially determined. In conclusion, the Court found that the premiums charged by the Swift captives “were nonsense.”
In sum, the Court found that the Swift’s captives overwhelmingly did not exhibit the characteristics of an insurance company in the commonly accepted sense. This served as an alternative ground for the Court to rule that the arrangement was not an insurance arrangement.
The Result of Losing Insurance Company Treatment
Because the Court determined that Dr. Swift’s companies were not insurance companies, this determination impacts several kay areas.
First, the clinic’s claimed deductions for insurance premiums were disallowed. Because the companies are not insurance companies, the premium payments were not ordinary and necessary expenses deductible under IRC § 162. Accordingly, the Swift’s personal income tax returns, whose Schedule C included the medical clinic activity, would pick up the additional income associated with denying the premium expense deductions.
Furthermore, the St. Kitts-based captive insurance companies were instructed to declare and pay tax on the purported premium income, as the provisions of Section 831(b) did not apply due to the non-insurance nature of the policies. Additionally, because the companies are not insurance companies, they are no longer eligible for special insurance company election for treatment as domestic corporations. While not discussed in the opinion, the Swift’s may likely have exposure relative to foreign disclosure obligations.
Last, the Court upheld the 20% accuracy-related penalty imposed by the Service under IRC § 6662. The Court found that the Swifts could not rely on a defense of reasonable cause as to reliance on tax professionals. First, the promoter of the arrangement could not be reasonably relied upon. Second, the Swift’s personal CPA was involved in the entire structuring of the program, and even if the promoter label was, the Swifts could not “establish the content of any substantive advice provided by [him] on which they relied. Because the Swifts raised the substantial authority argument in an answering brief, the Court did not entertain this argument.
MarksNelson Observations
Notably, the court invalidated a similar micro-captive arrangement promoted by Artex Risk Solutions Inc. earlier on January 4, reinforcing the stance that such arrangements do not constitute legitimate insurance. Despite the taxpayers' assertion of having relied on advice from legal counsel specialized in micro-captive formations, the court dismissed this claim, citing the primary promoter's involvement and ongoing scrutiny by the IRS.
The decision in Swift underscores the continued scrutiny and skepticism surrounding micro-captive insurance arrangements. While taxpayers may seek to leverage such structures for tax benefits, they face increasing challenges in demonstrating the genuine insurance nature of their arrangements. As evidenced by the trend in Tax Court decisions, the burden remains on taxpayers to establish the legitimacy of their captive insurance arrangements, necessitating careful consideration and scrutiny of such structures to avoid adverse tax consequences.
While the recent cases involve old facts dating back to 2012, taxpayers will want to review their current or prospective captive insurance arrangements taking into consideration the Court’s recent opinions when determining what constitutes a valid insurance arrangement for federal income tax purposes.
[1] Swift v. Commissioner, T.C. Memo 2024-13.
