Although a micro-captive insurance entity was organized as an insurance company, paid claims, and met capitalization requirements, the Tax Court found that it did not operate like an insurance company, issued policies with unclear and contradictory terms, and charged unreasonable premiums. As a result, the entity’s election to be taxed as a small insurance company under Code Sec. 831(b) was invalid. Premium payments were not for insurance, were not an ordinary and necessary business expenses and were not deductible under Code Sec. 162(a), the court held.

Take away. “For several years, the IRS has devoted significant resources to examinations of captive insurance arrangements and numerous cases are the subject of Tax Court petitions. There are several cases pending in the Tax Court post-trial. In light of the Avrahami decision, the IRS is likely to continue devoting resources to scrutinizing and challenging captive insurance arrangements it believes are abusive,” Jennifer Benda, Partner, Fox Rothschild LLP, Denver, told Wolters Kluwer.


In a micro-captive arrangement, a person directly or indirectly owns an interest in an entity (the insured) conducting a trade or business. That person, or individuals related to that person (or both), also directly or indirectly own another entity (the captive). The captive may enter into a contract with the insured that offers coverage only to persons related to or affiliated with insured, or sometimes also to other entities represented by a person who promotes the micro-captive transaction. The captive may enter into a reinsurance or pooling agreement under which a portion of the risks covered under the contract are treated as pooled with risks of other entities and the captive assumes risks from other entities. Alternatively, the captive indirectly enters into the contract by reinsuring risks that the insured has initially insured with an intermediary.

In either arrangement, the insured, the captive, and the intermediary (if any) treat the contract as an insurance contract for federal income tax purposes. The insured claims a deduction for the premiums paid under Code Sec. 162. The captive excludes the premium income from its taxable income by electing under Code Sec. 831(b) to be taxed only on its investment income.

Tax Court case

In the case before the Tax Court, the taxpayers, a married couple, owned a chain of retail stores as well as several real estate companies. In 2007, the couple incorporated a captive insurance entity in a foreign jurisdiction with the wife as its sole shareholder. The entity elected to be treated as a domestic corporation for federal tax purposes and to be taxed as a small insurance company under Code Sec. 831(b). The micro-captive sold property and casualty insurance policies to businesses owned by the taxpayers. These businesses also continued to buy insurance from third-party commercial carriers. The IRS disallowed deductions for the cost of premiums paid to the micro-captive.


According to the court, in 2009 entities owned by the couple paid the micro-captive $730,000 in premiums for direct coverage and, in 2010, $810,000 in premiums for direct coverage. No claims were filed against the micro-captive in 2009 or 2010. Because no claims were filed, the captive insurance company accumulated a surplus, which it transferred to the wife and to a limited liability company (LLC) that was owned by the taxpayers’ three children. The LLC’s primary asset was 27 acres of land. The insurance company transferred money to the LLC as mortgage and real estate loans. The LLC then issued a promissory note payable to the insurance company for the same amount.

Court’s analysis

The court first found that a pure captive insurance company is one that insures only the risks of companies related to it by ownership. To be considered insurance the arrangement must involve risk-shifting; involve risk-distribution; involve insurance risk; and meet commonly accepted notions of insurance. Risk distribution, the court found, occurs when the insurer pools a large enough collection of unrelated risks. “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,” the court observed.

Here, the court found that the micro-captive issued seven types of direct policies. These policies covered real property as well as employees. “While we recognize that [the entity] is a micro-captive and must operate on a smaller scale…we can’t find that it covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities,” the court held.

The court also looked to the micro-captive’s operations. The court found that the micro-captive “dealt with claims on an ad hoc basis.” According to the court, the micro-captive “made investment choices only an unthinking insurance company would make.” By the end of 2010 more than 65 percent of the micro-captive’s assets were tied up in long-term, illiquid, and partially unsecured loans to related parties, the court found.

Additionally, the court found that the policies were “less than a model of clarity.” The court disagreed with the taxpayers’ argument that the policies were claims-made policies. The policies said otherwise, the court found. Some terms were indicative of both a claims-made policy but other terms were indicative of an occurrence policy, the court found.

Further, the court found that the premiums paid to the micro-captive were unreasonable. The taxpayers had paid some $150,000 in premiums to third-party insurers before the formation of the micro-captive. The couple paid $1.1 million for insurance costs in 2009 and $1.3 million in 2010 after the formation of the micro-captive. The couple also continued to pay for their third-party insurance during this time. Accordingly, the payments were not for insurance, were not an ordinary and necessary business expenses and were not deductible under Code Sec. 162(a), the court found.


Because the micro-captive was not an insurance company its election to be treated as a domestic corporation was also not valid, the court held.

Turning to the transactions between the micro-captive and the LLC, the court found the transaction were bona fide loans. The LLC had adequate assets to satisfy the loans, plus interest, and the loans were properly papered.


The IRS argued that the court should apply the substance-over form and step-transaction doctrines to construe the transfer as a constructive dividend to the wife. The court found that the economic reality of the transaction was a bona fide loan between the parties.

Transactions of interest

In Notice 2016-66, the IRS identified instances where in an abusive structure, owners of closely-held entities create captive insurance companies and cause the creation and sale of the captive insurance policies to the closely-held entities. The policies may cover ordinary business risks or esoteric, implausible risks for exorbitant premiums while the insureds continue to maintain their far less costly commercial coverages with traditional insurers. Captive insurance policies may attempt to cover the same risks as are covered by the entities’ existing commercial coverage, but the captive policies’ premiums may be double or triple the premiums of the policy owners’ commercial policies, the IRS explained.

Transactions that are either the same as the one described in Notice 2016-66, or are substantially similar, were designated as transactions of interest as of November 1, 2016, the IRS explained. Taxpayers who enter into the transactions on or after November 2, 2016, must disclose the transaction in accordance with the notice or be subjected to penalties.

For more information on captive insurance tax questions, contact Scott Rogers.