IRS Audits of Captive Insurance

Last week, the IRS lost what is at least its third major insurance case in two years in U.S. Tax Court.  The case is titled R.V.I. GUARANTY CO., LTD. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent, and it comes on the heels of two major losses in captive insurance cases in 2014, Rent-A-Center (CLICK HERE) and Securitas (CLICK HERE).

While RVI Guaranty was not a captive insurance company, this decision has significant bearing on the captive insurance industry.  The Tax Court answered two key questions in its opinion, and both answers undercut arguments the IRS frequently makes when attacking self-insurance arrangements, captive insurance companies and other non-traditional insurance companies.  The first question is, “What constitutes real insurance?”  And, the second is, “Who gets to decide what constitutes real insurance?”

Brief Overview Of The Case

The U.S. Tax Court held its trial in R.V.I. Guaranty Co. Ltd. v. Commissioner (IRS) to decide whether residual value insurance policies are insurance for federal income tax purposes.  R.V.I. Guaranty Co. Ltd. (RVI), argued that its insurance policies in question fit into the insurance regulatory framework.  RVI is an insurer that offers residual value insurance, which protects insureds’ property from unexpected declines in value over the life of a contract.  Specifically,  RVI insures taxpayers engaged in the business of leasing passenger vehicles, commercial real estate, and commercial equipment.  Under the contracts, RVI is obligated to pay the insured the excess of the predicted residual value of the protected asset over the fair market value at the end of the lease.

In 2012 the IRS had issued a notice of deficiency to RVI for 2006 alleging a $55 million underpayment in taxes.  The IRS argued the insurance contracts were not insurance for federal tax purposes.  RVI argued that all state courts that have addressed whether residual value insurance is insurance for state regulatory purposes have decided that it is insurance.  The IRS argued that residual value insurance covers a loss in expectation, which is not an insurance risk.  The Service argued that the case revolves around “pure risk” and “speculative risk.”  The Service also argued that risk distribution generally requires the law of large numbers and does not exist in these types of policies because the types of events that would cause a payout would affect all insureds, not just a few of them. The Court rejected the Service’s arguments and delivered an opinion in favor of the tax payer.

To read the entire case, CLICK HERE.

Arguments Considered By The Tax Court

What Constitutes Real Insurance?

The IRS argued that residual value insurance is not insurance, at least under the circumstances of this case.  Its reasoning as to why is important to owners of captive insurance companies (CICs) because the IRS sometimes attacks CICs using the same lines of attack.

First, the IRS argued that no true insurance arrangement existed because there was no transfer of meaningful risk from the insured to the insurance company.   As it often does in cases involving captive insurance companies, the IRS argued that the insurance company’s low claims frequency, or low “claims ratio” over several years evidenced that RVI assumed insufficient  risk.  The court dismissed this argument on both theoretical and practical grounds.  The court’s theoretical argument was short, simple, and extremely important:

Both parties’ experts analogized the RVI policies to “catastrophic” insurance coverage, which insures against earthquakes, major hurricanes, and other low-frequency, high- severity risks. An insurer may go many years without paying an earthquake claim; this does not mean that the insurer is failing to provide “insurance.” [The IRS’s expert] Mr. Barrett acknowledged that, under many catastrophic coverages, the odds of a loss occurring may be quite low. He was aware of no instance in which an insurance regulator had determined that the risk of loss on a policy of direct insurance was too “remote” for the product to be treated as “insurance.” And respondent offers no plausible metric by which a court could make this assessment.

In short, the court stated unequivocally that, when it comes to insuring low-frequency but high-severity risks, frequency of claims and low claims ratios have very little probative value  in determining the legitimacy of the insurance arrangement.  Neither is a “plausible metric” that supports the IRS’ argument.  Low frequency risks are clearly the proper subject of insurance, and “going many years without paying…a claim” under such policies is to be expected of insurers of these risks.  The court’s conclusion on this point explicitly contradicts one of the IRS’ theories of attack against captive “risk pools”—that low claims ratios or low claims frequency is de facto evidence of a sham.

Second, the IRS argued that RVI did not insure “pure” risks but rather only “speculative risks” (sometimes called “business risks” by the IRS) OR “investment risks” neither of which are, the IRS argued, properly the subject of real insurance arrangements. This is consistent with the IRS’ position in its 2015 “Dirty Dozen” listing where the Service cautioned taxpayers to be careful of captive insurance companies that issue “policies to cover ordinary business risks” as opposed, presumably, to those that cover “pure risks.”

But neither the court nor the IRS’ experts could come up with any principled means of distinguishing between “pure” risk and the other more “speculative” or “investment” types criticized by the IRS in the case and its “Dirty Dozen” release.  The court concluded:

In any event, we find respondent’s attempt to distinguish between a “pure risk” and a “speculative risk” in this setting as essentially metaphysical in nature.

When the court calls your argument “metaphysical”, you can be sure that you are going to lose.  And lose the IRS did.  The court concluded:

[The IRS’s]  efforts to split hairs by disentangling the causes of “loss” are philosophically interesting.  But we do not think they carry much weight in determining whether the RVI policies constitute “insurance” for Federal income tax purposes.

Regarding whether “investment risks” (as characterized  by the IRS) are properly the subject of true insurance arrangements, the court settled things (hopefully) once and for all:

Finally, [the IRS] urges that we find the RVI policies to entail mere “investment risk” by analogizing its policyholders to investors who have purchased put options to protect their stock. The problem with this argument is that the insureds are not investors and the policies are not derivative products. Investors invariably purchase stock in the hope that it will appreciate in value, enabling them to sell the shares for a capital gain. The assets petitioner insured are not investment assets; in the hands of the lessors or finance companies, they are ordinary business assets in the nature of inventory or equipment. The insureds do not acquire these assets expecting them to appreciate in value and be sold to generate gain.

Analogizing the RVI policies to put options, moreover, is little more than a simile. In the real world, put options are typically settled for cash rather than by actual transfer of the underlying shares. At a conceptual level, many insurance products could be likened to put options. A mortgage guaranty policy, for example, could be said to give the policyholder the right to put the mortgage loan to the insurer unless the insurer pays the insured the difference between the remaining balance of the loan (the strike price) and its value on the exercise date. Even a fire insurance policy could be likened to a put on the fire-damaged house that is settled by the insurer’s payment of the damage claim.

For all these reasons, we reject [the IRS’s] contention that the RVI policies involve an uninsurable “investment risk.” These policies were designed and marketed as insurance products. Similar products were sold in the insurance market by other major insurance companies. These policies were undergirded by insurance strength ratings from the major insurance rating agencies. For more than 80 years the courts have recognized that contracts insuring against the risk that property will decline in value can involve “insurance risk.” The types of events that cause losses under these policies closely resemble the events that cause losses under policies of mortgage guaranty and municipal bond insurance. Most importantly, every State in which petitioner does business recognizes these policies as involving insurance risk and regulates them as “insurance.” Respondent is correct that these policies have some features that are atypical of what might be called “standard” insurance policies. But these differences are driven by the economics of the underlying business transaction and do not nullify the existence of “insurance risk.”

Finally, the IRS made its standard “homogeneity” argument (often used against CIC risk pools) suggesting that the pooling of different types of independent risks does not achieve risk distribution (an inherent element of any true insurance arrangement) because, according to the IRS,  “the law of large numbers” does not apply in that context. The IRS argued that for risk distribution to occur, the risks pooled by the insurance company must be the same or very similar in nature—that is, homogenous.

The Court rejected the IRS’s argument on this point, flatly noting the following:

As we have explained previously, losses under RVI policies are caused by fortuitous events outside of its control. And its policies clearly do pool [such] risks to take advantage of the law of large numbers.

The court concluded:

The legal requirement for “insurance” is that there be meaningful risk distribution; perfect independence of risks is not required. See Rent-A-Center, Inc. & Subs. v. Commissioner, 142 T.C. 1, 24 (2014) (“Risk distribution occurs when an insurer pools a large enough collection of unrelated risks (i.e., risks that are generally unaffected by the same event or circumstance”); Harper Group, 96 T.C. at 55, 59-60 (finding sufficient risk distribution where insurer insured numerous unrelated insureds even though the risks “were not statistically independent * * *,but rather were highly correlated”); Gulf Oil Corp., 89 T.C. at 1025 n.9 (stating that sufficient risk distribution may exist if risks are independent “to some minimum extent”). We have no difficulty concluding, as respondent’s expert Mr. Cook ultimately did, that the RVI policies accomplish sufficient risk distribution to be classified as “insurance” for Federal tax purposes.

Thus the court stuck a dagger in the heart of the IRS fallacious argument, often launched at captive risk pools, that true insurance arrangements only pool “homogeneous” risks.  In the court’s mind, a pooling of unrelated risk is sufficient to achieve risk distribution, at least in some contexts.

Who Decides What Constitutes Real Insurance?

Consistent with both the Rent-A-Center and Securitas cases, the Court once again showed great deference to the determination of domicile regulators on these issues and the determination of what constitutes valid insurance.  In deciding whether risk transfer occurred in the RVI case, the court said:

[The IRS’s expert] was aware of no instance in which an insurance regulator had determined that the risk of loss on a policy of direct insurance was too “remote” for the product to be treated as “insurance.” And respondent offers no plausible metric by which a court could make this assessment.

In deciding that certain types of investment risk are properly the subject of valid insurance arrangements, the court noted:

Most importantly, every State in which petitioner does business recognizes these policies as involving insurance risk and regulates them as “insurance.”

Why did the court give such deference to state regulators in defining insurance?  Well, the court tells us why:

Congress has delegated to the states the exclusive authority (subject to exception) to regulate the business of insurance.” AMERCO, 96 T.C. at 42 (citing the McCarran-Ferguson Act, 59 Stat. 33, as amended, 15 U.S.C. secs. 1011-1015 (1998)). We have repeatedly emphasized the significance of State insurance regulation in determining whether an entity should be recognized as an “insurance company.” See Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61, 101 (1991), aff’d in part, rev’d in part, 972 F.2d 858 (7th Cir. 1992); Harper Group, 96 T.C. at 60; AMERCO, 96 T.C. at 42; Securitas Holdings, T.C. Memo. 2014-225, at *5-6.

The “exclusive authority” vested in the states to “regulate the business of insurance” almost certainly includes (within reasonable limits) the ability to define the term, else that authority is largely meaningless.

And this may be the most significant and under appreciated (so far) import of the court’s ruling:  The court’s reliance on state regulators in this case was so extensive and so consistent that one might be forgiven for concluding that the burden of proof in such matters has now shifted to IRS.  Where the taxpayer makes out a prima facie case demonstrating that the states have characterized a certain arrangement as one of “insurance,” or  a certain corporation as a “insurance company,” the IRS will seemingly be required to offer up much evidence to prove the contrary.  In this case it was not up to the challenge.

Conclusion

The RVI Guaranty Case is a significant win for the taxpayers, captive insurance companies and businesses that are served by non-traditional risk management approaches.  The ruling by the Court is broadly worded and completely undermines the IRS’ attempts to draw an artificial distinction between “insurance” risks on one hand and “business” or “speculative” or “investment” risks on the other.  The ruling also bolstered the position of many re-insurance (or risk distribution) pools commonly employed by small captive insurance companies.  Finally, it is clear that insurance policies and companies approved by state insurance regulators will, in the absence of significant proof to the contrary, generally be respected by the Tax Court.  A well-managed captive insurance company in a well-regulated domicile is clearly on an even stronger footing today than it was two weeks ago.

Insert below: October 8, 2015 article of Sean King – click here to read the original article.

When you think of legal catch-phrases in America, what comes to mind?  If you enjoy watching police detective shows, you may be thinking, “You have the right to remain silent…anything you say may be used against you in a court of law.”  And, here is another legal phrase anchored firmly in the Constitution and the U.S. legal tradition: “Innocent until proven guilty.”

It’s very easy to take this fundamental right of presumed innocence for granted.  Nevertheless, our rights as citizens are turned on their heads when it comes to tax law and civil disputes with the IRS.  You may or may not be aware that taxpayers are not presumed innocent in court when the IRS has determined via audit that the taxpayer underpaid taxes.  When the Service issues a Notice of Deficiency, the burden of proof falls on the taxpayer to demonstrate their innocence or compliance with U.S. tax laws.

The burden of proof determines who wins the case in the absence of evidence.  Said another way, if the IRS has issued a Notice of Deficiency after an audit, the case goes to tax court, and neither the IRS nor the taxpayer offer up any factual evidence to the court, the IRS automatically wins.  In the absence of proof the government wins, hence the “burden of proof” is on the taxpayer.

However, when it comes to insurance companies, the tax court seems (thanks to the RVI case) to be on the verge of adopting a shifting burden of proof, thus making things more challenging for the IRS going forward.

Last week, we reported that the IRS lost what is at least its third major insurance case in two years in U.S. Tax Court.  The case is titled R.V.I. GUARANTY CO., LTD. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

To, to read the RVI Guaranty case in its entirety, CLICK HERE.

While RVI Guaranty was not a captive insurance company, this decision has significant bearing on the captive insurance industry, as discussed in last week’s report.  But, perhaps the most significant and most under-appreciated (so far) import of the court’s ruling in the RVI case was the court’s explicit reliance on the determinations of state regulators as to the definitions of “insurance” and “insurance company”.  This reliance was so extensive and so consistent that, once the taxpayer made out a prima facie case that the arrangement qualifies as “insurance” under state laws, or that a given insurance company is recognized and regulated as such under state laws, the court seemingly shifted the burden of proof to the IRS to prove the contrary.

For instance, in resolving question of whether the RVI policies transferred enough risk to RVI to be treated as a true insurance arrangement under Federal tax law, the court said:

“[The IRS’s expert witness] was aware of no instance in which an insurance regulator had determined that the risk of loss on a policy of direct insurance was too ‘remote’ for the product to be treated as ‘insurance’.  And [the IRS] offers no plausible metric by which a court could make this assessment.”

This quote is enlightening because, in its Notice of Determination, the IRS hadalready made the determination that insufficient risk was transferred and that the arrangement was not therefore “insurance”.  And, because the burden of proof in such matters is on the taxpayer, that determination should be deemed correct unless the taxpayer offers up sufficient proof to the contrary.  The Service was under no obligation to “offer [the court a] plausible metric by which the court could make this assessment”, and yet the court chastised it for failing to do so. Why?

Time and again, on issue after issue, the court seemingly accepted the findings of state insurance regulators, offered up by the taxpayer, as sufficient to meet the taxpayer’s initial burden of proof on the contested matters. Once state insurance regulators contradicted the Notice of Determination, the court no longer gave it deference by presuming its findings correct.  In fact, the court began insisting that, to win, the IRS must overcome the determinations of state insurance regulators by offering up compelling evidence of its own.  When it failed to do so, the taxpayer won.

True, the taxpayer offered up lots of proof other than just the findings of state insurance regulators, and the court took that other evidence into account, but it usually did so only to the extent needed to contradict the limited and inconsistent evidence offered by the IRS. The flow of the court’s analysis was:

Court:  In the absence of additional evidence, IRS wins.

Taxpayer:  Judge, here’s uncontested evidence that state insurance regulators deemed this to be a legitimate insurance arrangement.

Court:  IRS, the taxpayer is right, and since the states are empowered to regulate insurance, I’m inclined to rule for the taxpayer. The burden is now on you to prove state regulator’s wrong.  What say you?

IRS:  Judge, state regulators are wrong on this because of X, Y, and Z.

Court:  Taxpayer, what say you to that?

Taxpayer:  Judge, X is not X, Y is not Y, and Z is not Z.  The IRS’ evidence is therefore insufficient to overcome the presumption that the state insurance regulators are correct and this is real insurance.

Court:  I agree.  Taxpayer wins.

Conclusion

The ruling by the Court in RVI is broadly worded and appears to have shifted the burden of proof from the taxpayer to the IRS in circumstances where state insurance regulators have determined that legitimate insurance exists. In future tax court cases involving issues of defining insurance and insurance companies, it may be sufficient for taxpayers to point to the determinations of state insurance regulators in these matters, thus establishing a rebuttable presumption of legitimacy that the IRS must overcome with significant contrary evidence.  In the absence of such evidence, the taxpayer is likely to win.

In addition to licensing captive insurance companies, approving business plans and approving all insurance policies written, many domiciles also regulate, examine or approve risk distribution pools (re-insurance arrangements) often employed by smaller captives to achieve risk distribution.  Industry pundits have suggested the IRS might attack risk distribution pools using many of the same theories rejected by the tax court in RVI.  If the thesis of this article is correct, the IRS will have its work cut out for it when it seeks to attack pools that have been specifically vetted and found legitimate by state insurance regulators.