The Tenth Circuit Concerning Small Captive Insurance Company and Tax Exemptions

On May 13, 2022, in Mechanical Reserve Company vs. CommissionerAnd the[1] The U.S. Court of Appeals for the Tenth Circuit confirmed the Tax Court’s decision that a small insurance company does not qualify for income tax exemption as a small insurer under IRC § 501(c) (15). Therefore, the alleged premium payments received by the company constituted fixed, determinable, annual or periodic income (FDAP) taxable at a rate of 30% under IRC § 881(a). The IRS examines captive microtransactions for potential tax evasion. For the purposes of disclosure requirements, the IRS has designated certain restricted small transactions as “listed transactions” in Notice 2016-66. A court recently invalidated the 2016-66 notification for non-compliance with the Administrative Procedures Act;[2] However, Reserve Mechanical shows that micro-transactions remain vulnerable in terms of advantages.

the facts

At Reserve Mechanical, two shareholders own and operate a mining company, Peak Mechanical Corp. (Peak). Years prior to release, Peak had commercial insurance coverage and paid $100,000 in annual premiums. In 2008, the two shareholders consulted with Capstone Associated Services, Ltd. (Capstone) on setting up a small insurance company. Capstone promised to provide shareholders with a feasibility study; However, the shareholders proceeded to create Reserve Mechanical Corp. (reserve) the British West Indies before reviewing that information. The reserve had no employees. Capstone has provided management services to Reserve, including setting policies and setting premiums. One shareholder testified that he was unhappy with their commercial insurance policies, but Peak continued to maintain its commercial coverage after the Reserve was created.

During 2008-2010, the Reserve issued 13 direct policies to Peak and two subsidiaries for annual premiums of $400,000. There were several issues with straight policies, including that many policies incorporated faulty insurance and other policies overlapping with Peak’s existing business coverage. Capstone Reserve advised that it would have to receive at least 30% of its premiums from non-affiliated companies to qualify as an insurance company. To this end, Reserve has engaged in equity stake reinsurance policy with PoolRe, a risk pool of 50 captive insurers managed by Capstone. Under this arrangement, the Reserve and other capital entities agreed to take on a portion of the assumed risks. The policy is structured so that the reserve fee for fees received from PoolRe is equal to the fee received by PoolRe from Peak. Additionally, Reserve has entered into a joint insurance arrangement with PoolRe that includes CreditRe. There was no evidence that the reserve received any premiums in connection with the credit joint insurance arrangement.

Peak deducted the premiums she paid to the reserve as a business expense on her federal income tax return. Because the reserve received less than $600,000 in premiums each year, it concluded that it was a tax-exempt insurance company under IRC § 501(c) (15) and paid no tax on the premium payments it received from the peak. The IRS has determined that the Reserve is not entitled to exclude premiums from each year’s proposed taxes and assessments.

Legal Analysis

IRC § 501(c)(15)(A)(i) states that insurance companies are exempt from tax where: (i) gross receipts for the year do not exceed $600,000; and (ii) more than 50% of the gross receipts consist of insurance premiums. The central issue in Reserve Mechanical was whether Reserve was an insurance company so that it could benefit from the tax exemption in Section 501(c) (15).[3] Insurance is not defined by the Internal Revenue Code. Courts have adopted a four-part framework for evaluating insurance arrangements: (1) the arrangement must include insurable risks; (ii) The arrangement must transfer the risk of loss to the insurer; (3) The insurer must allocate the risk of loss among the policyholders; and (iv) the arrangement must constitute insurance in the generally accepted sense.[4]

Applying this framework, the Tax Court concluded that the reserve arrangement was deficient for two reasons: (1) it did not provide for an apportionment of risk because the direct policies involved too few insured and PoolRe was not a bona fide insurer; and (ii) it was not insurance in the generally accepted sense because the reserve was not operated as an insurance company and the premiums were unreasonable and not actually set. The Tenth Circuit confirmed the tax court ruling in both cases. Each floor is discussed below.

(i) The reserve arrangement did not provide for the distribution of risks

On appeal, the Reserve did not contest the Tax Court’s finding that the direct policies issued to Peak did not spread risk. Instead, it argued that the reinsurance and co-insurance arrangements with PoolRe resulted in a sufficient risk distribution for the reserve company to be a valid insurer. The reserve claimed that the tax court misapplied the risk allocation test by focusing on whether PoolRe was a bona fide insurer. The Tenth Circuit has held that, in theory, an arrangement providing for the distribution of risk can be insurance even in the absence of an insurer. However, the PoolRe product was not insurance. According to the court, the reinsurance arrangement was nothing more than a circular flow of funds with no beneficial distribution of risks. Furthermore, there was no evidence that a co-insurance arrangement with PoolRe even existed because it did not receive any premiums or pay any claims during the 2008-2010 period. But, even if coinsurance existed, the reserve did not bear any meaningful risks. According to the Tenth Circuit, the tax court has played down evidence that PoolRe was a hoax. The Tenth Circuit noted that the Tax Court’s decision did not reach a conclusion about the legality of risk pooling in general. But it was clear that PoolRe’s risk pool did not lead to risk distribution.

(2) The reserve arrangement was not insurance in the generally accepted sense

On appeal, the Reserve argued that the tax court erred in: (1) misclassifying the policies as excess coverage policies; (ii) Conclusion that the premiums were unreasonable and not negotiated on a commercial basis; and (3) the retention of this reserve was not operated as an insurance company because it was managed by Capstone. The Tenth District is different. First, it concluded that the Tax Court had not misread the Direct Policies Reserve issued to Peak. It was clear that direct policies were only applied after all other insurance coverage had been exhausted. Second, the tax court correctly concluded that the premiums were unreasonable and not negotiated on commercial grounds because the premiums were four times higher than Peak’s commercial policies and the Reserve provided no explanation for how the risk was calculated. Finally, the Tax Court was justified in concluding that the reserve was not operated as an insurance company because it had no employees; He has never conducted business in Anguilla; Its boss knows nothing of its operations. She failed to investigate the only claim she received before paying nearly $340,000. Therefore, it was clear that the reserve policies were not insurance in the generally accepted sense.


Reserve’s direct policies and PoolRe risk group contained several flaws specific to this case. But Reserve Mechanical may strengthen the IRS’ determination to stop abusive small captive transactions. Although the court stated that it did not reach an opinion on the legality of risk pooling in general, the case sets a high standard for small captive insurers to establish a risk distribution. Taxpayers who engage in micro-transactions may wish to consult with their tax advisor to understand how the Reserve Mechanical affects them.


[1] 129 AFTR 2d 2022-1804 (10 Cir.2022).

[2]CIC Services, LLC v. IRS, Case No. 3: 17-cv-110 (ED Tenn. March 21, 2022). We seeGT alert, court revokes 2016-66 notice on captive small transactions, second time IRS notice has been invalidated this month.

[3] TC Memo 2018-86 (2018).

[4]Harper Grp. v. Comm’r, 96 TC 45 (1991), aff 979 F.2d 1341 (9th Cir. 1992).

© 2022 Greenberg Traurig, LLP. All rights reserved. National Law Review, Volume XII, No. 172