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U.S. Tax Court Rules in Favor of IRS in Syzygy Micro Captive Case

04.17.2019

The IRS secured another victory against micro captives in the U.S. Tax Court this month in Syzygy Insurance Co. v. Commissioner of Internal Revenue. The Tax Court found that the arrangements among captive insurer Syzygy, its parent company Highland Tank and Manufacturing, and its fronting carriers were not insurance transactions. This rendered Syzygy’s Section 831(b) election invalid, and the insureds were denied deductions for the premium payments.

In the decision, Judge Rowe ruled that Syzygy’s fronting carriers were not actually insurance companies, and therefore the captive did not distribute risk sufficiently to be treated as insurance for federal income tax purposes.  The ruling also stated that though Syzygy was organized and regulated as an insurance company, it failed to meet the federal income tax requirements to be respected as such. In reaching this conclusion, the judge took exception to the pricing differential between the policies issued by the captive and those in the commercial marketplace, the “circular flow of funds,” the short reporting period at the end of the policy year and the fact that the insureds submitted no claims during the years in question.

This is the third such ruling in favor of the IRS. In August 2017, the Tax Court released its decision in the Avrahami case, which was  the first case that involved a captive that made the election to be taxed solely on investment income under Section 831(b), also referred to as the micro captive strategy. In June 2018, the Tax Court rendered a similar ruling in the Reserve Mechanical case. Both cases were referenced in the Syzygy ruling.

Key Takeaways

Considering these rulings, many continue to question if using the micro captive strategy is still a viable business option. If there is a legitimate, non-tax business reason for utilizing a captive and it is properly operated, there is no reason to change course.

However, doing the due diligence on captive service providers and their underlying programs is more important than ever. While captives are still a great tool for assisting companies with risk management, it is critical that business purposes are substantially documented to withstand IRS scrutiny and that the relationship between a captive and its insureds remain on an arm’s length basis.

 For more information on Section 831(b) or captive formation, please contact Alan Fine, Tax Partner and Insurance Industry Group Leader, at afine@bswllc.com or 314.983.1292.

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