The Tenth Circuit Court of Appeals recently affirmed the tax court’s decision that a captive insurance arrangement that reinsured a number of other captive insurers did not qualify for a tax exemption.

Reserve Mechanical Corp. issued a number of insurance policies to Peak Mechanical Corp. Reserve and Peak had the same owners, and the arrangement was a form of captive insurance. The arrangement may have been an attempt to obtain tax benefits pursuant to a program that allowed both the deductibles and premiums to be exempt from taxation.

To attempt to qualify for that program, Reserve tried to ensure that at least 30% of its premiums came from companies not affiliated with it. It therefore arranged, among other things, through Capstone Associated Services Ltd. to reinsure a number of other captive insurers that worked with Capstone. Capstone also arranged for each captive insurer it worked with to assume a small percentage of risk from coinsuring thousands of vehicle service contracts.

The IRS concluded that this arrangement did not qualify for an exemption and assessed taxes.

The Tenth Circuit affirmed. It agreed with the IRS that Reserve had not satisfied its burden to demonstrate that its purported insurance transactions were truly arrangements for insurance. Although Reserve complied with some, but not all, of the formalities for insurance companies and went through some of the motions associated with pricing insurance premiums, the record reflected that no “experience, expertise, or studies supported the need for Peak to obtain the policies” and the “premiums for [certain] additional insurance were not supported by any study of similar commercially available policies or careful analysis of Peak’s risks of loss.”

With respect to the reinsurance agreements, the Tenth Circuit concluded that those agreements “did not create any meaningful risk for Reserve” and noted that “Reserve did not satisfy even the distribution threshold that Capstone set for it — obtaining 30% of its insurance premiums by insuring unaffiliated risks.”

Reserve Mechanical Corp. v. Commissioner of Internal Revenue, No. 18-9011 (10th Cir. May 13, 2022).