Double Tax?! IRS Prevails in Disallowing Deductions to Insured and Taxing Premium Income to Captive in Latest Tax Court Win Against Section 831(b) Microcaptive

The IRS just won its third consecutive battle in its war against Section 831(b) microcaptive arrangements with the Tax Court’s decision in Syzygy Ins. Co., et al vs. Commissioner released on April 10, 2019.  Although the Tax Court refused to impose penalties, it otherwise handed a landslide victory to the IRS, sustaining the tax deficiency against the insured businesses based on disallowed premium deductions while at the same time taxing those identical premiums as income to the microcaptive. This decision will serve to embolden an already-confident IRS in its audit campaign against microcaptives, increasing the importance of early strategizing with trial counsel. Will your client’s current, or proposed, microcaptive arrangement pass muster? 

In a typical Section 831(b) captive arrangement, the insuring business incurs, and deducts for income tax purposes, insurance premiums paid to the captive.   The captive, in turn, will retain part of the earned premiums and use the remainder to reinsure the risks of the policies through a third-party reinsurance arrangement.  When done correctly, the captive is entitled to exclude the premium monies from income (up to certain amount, historically $1.2 million) and only pays taxes on investment returns.  Thus when the dust settles, the insuring business gets to deduct 100% of the premium payments and the captive gets to exclude 100% of the premiums received from income – pretty powerful tax planning.  Of course this tax benefit is only available for true risk management plans, and the IRS has identified ,and actively pursued, various captive arrangements which it believes are more akin to tax plays rather than insurance transactions.


Enter the Jacob family, which owned and operated Highland Tank and its related companies engaged in the steel-tank business.   Through captive management company Alta Holdings, LLC, the Jacoby family formed Syzygy, a Delaware company, in 2008 and made an election under Section 831(b) to be taxed as a small insurance company.    For the next five years, Highland Tank and its affiliates purchased captive insurance policies whereby 49% of the premium was ceded to Syzygy and the remaining 51% was ceded to a reinsurance pool insuring policies of 40-50 unrelated companies.   Syzygy agreed to insure its quota-share percentage of the losses of the reinsurance pool, i.e., ratio of Highland Tank premiums to the total premiums of the pool.   The risk of loss under the Highland Tank policies, however, was not shared equally across these two “layers” of insurance.   Under the first layer, borne solely by Syzygy, the captive was responsible for the first $250,000 of losses.    Losses above that, up to policy limits – i.e., the second layer, was borne by the reinsurance pool.   The IRS raised the usual challenges to this captive arrangement, arguing that (i) Highland Tank’s payments were not deductible insurance premiums, (ii) Syzygy’s Section 831(b) election was not valid because it was not an “insurance” company”, and (iii) the premiums received by Syzygy were taxable income.  The IRS also proposed accuracy-related penalties on the resulting income deficiencies.


The Tax Court ruled in favor of the IRS on the underlying income tax deficiencies.  This had the effect of double taxing the captive participants, as the Tax Court held that the premiums paid by Highland Tank and its affiliates were not deductible, and those same premiums when received by Syzygy were income taxable to it.  [Practice Note:  This arguable whipsaw creates a heightened risk exposure for taxpayers participating in microcaptive insurance arrangements.] Among the factual findings underlying the Tax Court’s holdings were: