The IRS has won its ninth microcaptive tax shelter case in Jones v. CIR, T.C. Memo. 2025-25 (March 25, 2025). The only real wonder at this point is why taxpayers keep spending the attorney fees to take their case to the U.S. Tax Court knowing ― or at least their attorneys knowing ― that their case is almost certainly to be a loser. Anyway, you can and should read the Tax Court’s opinion for yourself, which is found here.
In a nutshell, a California-based company called Sani-Tech West, Inc., was a distributor of high-purity process components, such as tubing, filters and gaskets. In later years, STW would grow by selling such products to the pharmaceutical industry. Later, a wholly-owned subsidiary of STW was formed, called SaniSure, Inc., which manufactured these materials. Concerned about shipping losses for some of its products, although apparently these losses would be covered in whole or some part by STW’s commercially-purchased insurance, the owners of STW started looking into a captive in late 2014.
Eventually, STW’s owners engaged Captive Planning Associates to look into a possible captive for STW, and Captive Planning Associates hired an actuary to prepare a feasibility study. The actuary did so, but about everybody could see that the premium to be charged by the captive for policies were too high and some coverages were not needed by STW or SaniSure. The actuary changed his report accordingly, and soon thereafter, in 2015, Clear Sky Insurance Co., Inc. (“CSI”), was formed as a Montana captive insurance company.
Despite the formation of CSI and its issuing insurance policies to STW to cover a wide variety of risks, STW kept its commercial coverages in place although there appears to have been substantial overlap in the coverages which would have rendered much of CSI’s coverages to be duplicative and unnecessary.
Also, because CSI would only cover STW risks, CSI would not meet the IRS test for risk distribution. Therefore, CSI participated in a typical pro rata risk pool of 31 other Captive Planning Associates’ clients known as OMNI.
For its part, OMNI took in premiums from its clients’ businesses for insurance and passed those premiums to those same clients’ captives as reinsurance on the insurance it had underwritten. Tellingly, however, OMNI retained only 12.5% of the reinsurance premiums in trust to pay claims, which was a pretty good indication that OMNI did not expect claims to exceed that 12.5%.
As mentioned the captive was formed in 2015 and did business that year and in 2016. During 2016, another company (Shor) commonly owned with STW’s owners needed cash to purchase a larger facility for STW’s operations, and so ― against Captive Planning Associates’ advice ― CSI loaned Shor $400,000.
Then, at the end of 2016, a decision was made by STW’s owners to stop the captive program and allow CSI to go dormant. This ran against the feasibility study which advised that a captive required no less than a five to ten year commitment. Thereafter, in 2017, CSI surrendered its insurance license in Montana and was dissolved. After which, STW’s owners apparently had a change of heart and instead resurrected CSI, but converted it to an ordinary Montana for-profit corporation and changed its name to Clear Sky Holdings, Inc.
The IRS audited STW and ultimately disallowed STW’s $813,256 in 2015 premiums and $781,977 in 2016 that it had paid to CSI. Because STW had made the election to be treated as an S-Corporation, these disallowances triggered additional taxable income to STW’s owners. After which, CSI and STW’s owners (or at least some of them) filed their petitions to challenge these deficiencies with the U.S. Tax Court which resulted in this opinion.
I’m not going to dwell on the technical aspects of the Tax Court’s opinion because it could be summarized as little more than the “same old, same old” of the other microcaptive tax shelter opinions. The Tax Court found that the CSI captive program did not constitute “insurance” for federal income tax purposes, because it did not meet the risk distribution requirements and was not insurance in the commonly-accepted sense.
The OMNI risk pool was also found not to distribute risk (which, of course, has potential negative tax consequences for every captive in that pool). The Tax Court likewise found that the OMNI risk pool did not involve arm’s-length contracts and, because it only kept 12.5% of the premiums in trust, could not have satisfied claims if they had turned out as actuarially predicted. But on that point, the Tax Court found that the OMNI really wasn’t charging actuarially-determined premiums in the first place, but instead (as so common in these cases) had adopted a one-size-fits-all approach to premium pricing that simply charged everybody the same percentage without regard to the specific risks being insured and then reinsured.
The Tax Court also noted that while an actuarial study had been conducted, there had been no underwriting of CSI’s insurance risks ― and underwriting is an entirely different animal than actuarial analysis. As the Tax Court stated:
“In simple terms, actuaries use published rates and large datasets for particular risks to define the rating scheme, that is, determine the premium that should be charged for applicants that fit into a given bucket (think risk profile) while adjusting for policy limits, deductibles, prior loss experience, etc. Underwriters decide which bucket (or risk profile) an insurance applicant fits into; they determine whether an applicant is insurable and on what terms. The underwriter relies on information disclosed by the prospective insured on insurance applications issued by the insurance company. The application form includes questions the insurance company deems necessary to properly underwrite the risk (for example, questions about the applicant’s loss history).”
Here, the actuary was basically not told the specific facts surrounding the risks that were being underwritten by CSI but instead just worked with (as actuaries do) general industry-wide data not specific to STW’s particular risks. This is not underwriting.
The Tax Court also looked at the “unusual financing arrangement” of the $400,000 loan to Shor and noted that it was not reasonable for an insurance company to loan out 40% of its investment portfolio for a deal like this, particularly without receiving any collateral to ensure repayment.
In general, held the Tax Court, the premiums charged by CSI to STW were neither reasonable nor the result of an arm’s length transaction. The fact that there was considerable overlap between STW’s commercially-purchased insurance policies ― which STW kept in place during 2015 and 2016 ― and the policies issued by CSI during the same period meant that much of CSI’s policies were redundant and should never have been purchased. Moreover, the premiums charged by CSI were far more expensive than STW’s commercially-purchased insurance. There were also other warts in CSI’s policies that would have made then commercially unattractive on the open market.
The bottom line was the premiums paid by STW to CSI were not an ordinary and necessary business expense and so, therefore, the deductions taken by STW for its premiums paid to CSI were improper and would be disallowed. The $400,000 that went from CSI to Shor was also determined not to be a loan but rather a constructive dividend. This was the ruling of the Tax Court as to STW’s deductions and the $400,000 with the Tax Court stating that it would consider penalties in a subsequent opinion.
As with the last several of these opinions from the U.S. Tax Court, the real question does not go to the technical questions addressed therein, which are old hat with the opinions preceding them, but is instead why anybody would take this dog of a case to the U.S. Tax Court in the first place. In light of all the previous opinions, this case was so bad that it was basically dead out of the gate so why waste the money to litigate it?
There are a couple of more of these 831(b) microcaptive tax shelter cases that have been tried and the written opinions in those cases are expected soon, but there is really no compelling reason to believe that they will come out any differently.
Guess we’ll see.