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Caylor Land & Development v. Commissioner (T.C. Memo. 2021-30)

On March 10, 2021, the Tax Court issued a Memorandum Opinion in the case of Caylor Land & Development v. Commissioner (T.C. Memo. 2021-30). The primary issues presented in Caylor Land & Development were whether consulting payments made between the petitioner and its microcaptive insurance company were ordinary and necessary business expenses or insurance expenses.

Brief Background (to Lay a Foundation for Judge Holmes’ Puns)

The Caylors, Bob and Rob, founded and kept afloat, a thriving construction company for over 50 years.  The company needed insurance, and having found the traditional route too expensive, Bob and Rob decided to get into the microcaptive insurance industry.  Insurance cost the company $60,000 per year, but beginning in 2007, the company increased their insurance bill by taking out policies from a related microcaptive insurer at a cost of $1.2 million annually. At the same time, consulting payments between the Caylor entities grew by about $1.2 million. “These developments were not unrelated.”

A Bit Heavy-Handed on the “Authority,” but Point Taken

In Avrahami v. Commissioner, 149 T.C. 144 (2017), the Tax Court found that a microcaptive didn’t actually provide insurance because it failed to distribute risk and didn’t act as an insurer commonly would. In Reserve Mech. Corp. v. Commissioner, T.C. Memo. 2018-86, 115 T.C.M. (CCH) 1475 (2018), the Tax Court found that a microcaptive didn’t actually provide insurance because it failed to distribute risk and didn’t act as an insurer commonly would. Then in Syzygy Ins. Co. v. Commissioner, T.C. Memo. 2019-34 (2019), the Tax Court found that a microcaptive didn’t actually provide insurance because it failed to distribute risk and didn’t act as an insurer commonly would. “We will break no new ground today.

The Microcaptive is Formed

After a quick lunch-and-learn, and some Googling, Bob and Rob decided that captive insurance was the bees’ knees and formed a captive insurance company under the laws of Anguilla, electing to be treated as a domestic corporation under IRC § 953(d) and to be taxed solely on investment income, so long as its annual premiums did not exceed $1.2 million (the microcaptive limit).  The same day, Bob’s construction company paid Rob’s microcaptive insurance company…wait for it…$1.2 million, which it deducted as an insurance expense on its 2007 return.  The trouble, as Judge Holmes points out, is that in 2007 the underwriting process had barely even begun, and by the end of the year Bob’s company received at most 10 days of coverage. 2008 was not much better.

A Sticky Wicket

For both 2009 and 2010, Bob’s company deducted the payments that it made to Rob’s company as consulting expenses. All of Bob’s entities reported their payments to Rob’s company as a combination of deductible insurance expenses, legal fees, accounting fees, and management fees. The microcaptive insurance company reported itself as a microcaptive, and therefore did not include the $1.2 million in premiums as taxable income for either year.

As Judge Holmes points out, “one might expect there to be something odd about this. One would be right.”

Although Bob and Rob consulted advisors (mostly Google), said advisors never provided a tax opinion or memorandum about the requirements for a microcaptive insurance company to work under the Code or, for that matter, reviewed any actual materials, documents, spreadsheets, sticky notes, doodles, etc.

The Puns Begin

After 28 pages of background, Judge Holmes notes (regarding the construction company), “[w]ith our foundation laid, we can get to work.”

Consulting Payments

IRC § 162 allows the deduction of all ordinary and necessary business expenses. The Tax Court is, however, a skosh “more skeptical” about expenses between related parties. See, e.g., Harwood v. Commissioner, 82 T.C. 239, 258 (1984), aff’d without published opinion, 786 F.2d 1174 (9th Cir. 1986). The reason is that “expenses” from one related party to another are more likely to be distributions of profits, which are not deductible. See Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983), rev’g and remanding on other grounds T.C. Memo. 1980-282; Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1156 (1980).

Still, it’s entirely possible for one company legitimately to incur or pay business expenses to a related company. See Chapman v. Commissioner, T.C. Memo. 2014-82 (2014). To allay the Tax Court’s suspicions, it looks to see if there is any corroborating evidence related to these expenses—invoices, records, dates, hours worked, or projects worked on. See ASAT, Inc. v. Commissioner, 108 T.C. 147, 174-75 (1997) (no deduction for consulting fees where no evidence of how fees are determined, no written contract, no detailed invoices, and no evidence of what might warrant consulting fees); Fuhrman v. Commissioner, T.C. Memo. 2011-236 (2011); Weekend Warrior Trailers, Inc. v. Commissioner, T.C. Memo. 2011-105 (2011) (no deduction of management fees to related corporation without proof of specific services performed); Kimm v. Commissioner, T.C. Memo. 2003-215 (2003).

And for a classic Judge Holmes’ observation, we give you the following:

The testimony and exhibits [the Tax Court has] in the record cause us to find it more likely than not that this “consulting” consisted of conversations that Rob and his dad had over breakfast. Neither one could say what this consulting concerned, what subjects they discussed, or the amount of time they spent talking business instead of the ordinary subjects fathers and sons talk about. For a father and son to have a warm and loving relationship that helps sustain and grow the family business is admirable. But it’s not deductible.

Touché.

Insurance

Insurance premiums are deductible under IRC § 162(a) as ordinary and necessary expenses if paid or incurred in connection with a trade or business. Treas. Reg. § 1.162-1(a). Insurance premiums are also included in income when received by insurance companies. See IRC § 61; Avrahami, 149 T.C. at 174. Insurance companies are generally taxed on their income in the same manner as other corporations. See IRC § 831(a). And that’s what made the $1.2 million in consulting deductions and premiums so likely to raise the IRS’s “bureaucratic eyebrows,” because $1.2 million is precisely the limit on premiums that an insurer can receive without owing tax. See IRC § 501(c)(15); IRC § 831(b).

This is a perfect example of when being greedy damns you to the fiery depths of tax hell. As my boss is wont to say, “Pigs get fat; hogs get slaughtered.” Bob and Rob were most assuredly hogs in this scenario.

An insurance company with premiums that don’t exceed $1.2 million for the year can elect under IRC § 831(b) to be taxed only on its investment income. IRC § 831(b)(1), (2). These rules are more complicated when the insurer and the insureds are related. This is because while insurance is deductible, amounts set aside in a loss reserve as a form of self-insurance are not. See, e.g., Harper Grp. v. Commissioner, 96 T.C. 45, 46 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992); see also Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978); Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78, 80 (10th Cir. 1930). However, neither the Code nor the regulations actually defines “insurance.” Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014-225 (2014).

The Supreme Court has stated that insurance is a transaction that involves “an actual ‘insurance risk’” and that “[h]istorically and commonly insurance involves risk-shifting and risk-distributing.” Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). The line between nondeductible self-insurance and deductible insurance is blurry, and we try to clarify it by looking to four nonexclusive but “rarely supplemented” criteria:

  • risk-shifting;
  • risk-distribution;
  • insurance risk; and
  • whether an arrangement looks like commonly accepted notions of insurance.[1]

Risk-Shifting

Risk distribution is one of the common characteristics of insurance identified by the Supreme Court. See Le Gierse, 312 U.S. at 539. Courts have historically found risk distribution when an insurer pools a large enough collection of unrelated risks. Avrahami, 149 T.C. at 181. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987), aff’g 84 T.C. 948 (1985).

In each of the Tax Court’s previous microcaptive-insurance cases the captive tried to show risk distribution by investing in an “insurance pool”—a way to reinsure a large number of geographically diverse third parties. See, e.g., Avrahami, 149 T.C. at 163. In each case, the Tax Court found that the “insurance pool” was not actually insurance, so it didn’t suffice to show risk distribution. See, e.g., id., 149 T.C. at 190.  Even still, Bob and Rob didn’t even try to participate in such a pool.

But was there a “large enough pool of unrelated risk?” In each of the previous Tax Court opinions, the Tax Court found there wasn’t a large enough pool of unrelated risk from the policies issued to the related entities.  This case was no different. “Absent sufficient risk distribution, what [the microcaptive] was providing was not insurance.”

Commonly Accepted Sense

While the absence of risk distribution is enough to demolish this scheme, AMERCO, 96 T.C. at 40, the Tax Court will, as an alternative ground, look to see if what the microcaptive was selling was an arrangement that looks like commonly accepted notions of insurance, see Avrahami, 149 T.C. at 190-91. Judge Holmes notes that “there is a hint of question begging here—we say something’s not insurance because it doesn’t look enough like something we do say is insurance—but it is one of the four criteria precedent tells us to look for,” so there you are.

Suffice it to say, the present arrangement did not pass Judge Holmes’ smell test.

Penalties

Judge Holmes is a realist.  He observes that Rob was pitched the idea of a microcaptive as a “tax planning solution” and a “tax planning tool.” The presentation he attended stated that this scheme would provide a tax deduction of up to $1,200,000 per year. A sophisticated businessman like Rob should have seen this as “too good to be true.”

Indeed it was.

Footnote:

[1] See, e.g., Avrahami, 149 T.C. at 177; Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1, 13 (2014); see also R.V.I. Guar. Co. v. Commissioner, 145 T.C. 209, 225 (2015); AMERCO & Subs. v. Commissioner, 96 T.C. 18, 38 (1991), aff’d 979 F.2d 162 (9th Cir. 1992).

(T.C. Memo. 2021-30) Caylor Land & Development, Inc. v. Commissioner

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