Reserve Mechanical: Microcaptive Insurance Arrangement Denied on Appeal

Jul 21, 2022

In our monthly Blue J Predicts column, we use tax research software to analyze pending or recently decided federal income tax cases. This month we analyze the judgment of the Tenth Circuit in Reserve Mechanical,1 which addressed whether a microcaptive insurance arrangement constituted insurance so that the premiums received were exempt from taxation under section 501(c)(15).

Several months ago, we examined the Tax Court’s decision in Reserve Mechanical and predicted with 77 percent confidence that the taxpayer’s appeal would be dismissed and the Tax Court’s decision affirmed.2 That prediction was correct.

In its decision, the Tenth Circuit reiterated that the outcome in Reserve Mechanical should not be regarded as an indictment of all microcaptive insurance arrangements. Instead, the particular facts of the case indicated that the taxpayer was not engaged in the business of insurance. Still, we expect that the result in Reserve Mechanical will have a significant effect on the captive insurance industry. Notably, since the release of the decision, the IRS has issued a statement warning taxpayers to beware of microcaptive insurance arrangements.3 The IRS said, “Taxpayers should be alert to these schemes, normally peddled by promoters, as they will ultimately cost them.” It added that “these transactions will result in serious economic loss to taxpayers, including the loss of deductions, required income inclusion, and penalties.”4 This is not new guidance: Since 2015 the IRS has included abusive microcaptive insurance arrangements on its “Dirty Dozen” list.5

In this analysis, we explore the relative merits and prospective strengths of three of the grounds for appeal advanced by Reserve Mechanical Corp. (Reserve). As it happens, all three were rejected by the Tenth Circuit. First, Reserve argued that the Tax Court erred in classifying the insurance arrangement as one of “excess” insurance only. Second, it claimed that the Tax Court erred in assessing the bona fides of a reinsurer who is not the taxpayer. Third, Reserve argued that the Tax Court erred in determining that the premiums were unreasonably high. We explore the key factors underpinning each of these grounds and use the insurance arrangement predictive module in Blue J Tax to assess how significant the three specific factual characterizations were to the overall decision.6 We then perform a series of distinct analyses, varying the mix of assumptions to identify scenarios that could have in principle led to Reserve succeeding in its appeal.

There are two critical takeaways from our analysis of the facts in Reserve Mechanical. First, the most significant factor driving the result in the government’s favor was whether captive insurance premiums were set using objective methods, such as actuarial data. Second, the factors with a more modest effect were whether the insured maintained complete coverage from other insurers and whether there was a circular flow of funds.

1 Reserve Mechanical Corp. v. Commissioner, No. 18-9011 (10th Cir. 2022).

2 Benjamin Alarie and Bettina Xue Griffin, “Captive Insurance Appeal in Reserve Mechanical Will Likely Fail,” Tax Notes Federal, Aug. 30, 2021, p. 1431.

3 Chandra Wallace, “IRS Doubles Down on Microcaptives Enforcement,” Tax Notes Federal, June 13, 2022, p. 1765.

4 IR-2022-118.

5 IR-2015-19 (IRS “Dirty Dozen” list).

6 Visit bluej.com for more information.