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Captive Insurance Company Seeks Reversal of Tax Court Decision

FEB. 21, 2020

Reserve Mechanical Corp. v. Commissioner

DATED FEB. 21, 2020
DOCUMENT ATTRIBUTES

Reserve Mechanical Corp. v. Commissioner

[Editor's Note:

The attachments can be viewed in the PDF version of the document.

]

RESERVE MECHANICAL CORP.,
Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.

In The United States Court Of Appeals
For The Tenth Circuit

On Appeal from the Decision of the United States Tax Court
Hon. Kathleen Kerrigan

OPENING BRIEF OF PETITIONER-APPELLANT
RESERVE MECHANICAL CORP.

Val J. Albright
Michelle Y. Ku
Foley & Lardner, LLP
2021 McKinney Avenue
Suite 1600
Dallas, Texas 75201
Tel: 214.999.3000

E. John Gorman
Logan R. Gremillion
Coby M. Hyman
The Feldman Law Firm LLP
Two Post Oak Central
1980 Post Oak Blvd., Suite 1900
Houston, Texas 77056
Tel: 713.850.0700

ORAL ARGUMENT REQUESTED

Corporat` Disclosure Statement

Pursuant to Federal Rule of Appellate Procedure 26.1(a), Petitioner-Appellant Reserve Mechanical Corp. states that (1) no publicly-held corporation owns 10% or more of its stock, and (2) its parent company is Peak Casualty Holdings, LLC, a Nevada limited liability company.


Table of Contents

Corporate Disclosure Statement

Table of Authorities

Statement of Prior or Related Cases

Glossary of Acronyms

Glossary of Insurance Terms

Introduction and Overview

Jurisdictional Statement

Statement of the Issues Presented for Review

Statement of the Case

I. Factual Background

A. Description of Insurance, Reinsurance and Captive Insurance.

B. Peak's Need for Captive Insurance Arises.

C. Reserve Issues Policies, Collects Premiums, and Distributes Risk.

D. Reserve Pays Losses for Covered Claims.

II. Procedural History

III. Rulings Presented for Review

Summary of Argument

Argument

I. Standard of Review

II. The Tax Court Erred in Holding that Reserve's Transactions Did Not Constitute Insurance for Tax Purposes.

A. The Tax Court Erroneously Held that Reserve Did Not Distribute Risk.

1. How Courts Define Risk Distribution.

2. The Tax Court Misapplied the Legal Test for Risk Distribution, Relying on Avrahami Instead.

i. Risk distribution does not require the existence of a bona fide insurance company.

ii. The tax court erroneously focused its risk distribution analysis on PoolRe, instead of Reserve.

3. When analyzed under the correct legal test, the undisputed facts show that Reserve distributed risk as a matter of law.

B. The Tax Court Erroneously Held that Reserve's Transactions Were Not Insurance in the Commonly Accepted Sense.

1. The Tax Court Misread Reserve's Direct-Written Policies as Providing Only Excess Coverage.

2. Relying on its Misreading of Reserve's Direct-Written Policies, the Tax Court Erroneously Determined that Reserve's Premiums Were Unreasonable and Not Negotiated at Arm's Length.

3. Relying on Unfounded Assumptions, the Tax Court Erroneously Determined that Reserve Was Not Operated Like an Insurance Company Because It Was Managed by Hired Professionals.

III. Alternatively, if the Tax Court Is Correct that Amounts Received as Premiums Were Not for Insurance, the Tax Court Erred in Holding that Such Amounts Constituted Taxable Income to Reserve, Instead of Nontaxable Capital Contributions.

Conclusion

Statement Regarding Oral Argument

Certificate of Compliance

Certificate of Digital Submission

Certificate of Service

Attachments

Attachment A

Attachment B

Addenda

Addendum A

Addendum B

Table of Authorities

Cases

AMERCO, Inc. v. Comm'r, 979 F.2d 162 (9th Cir. 1992)

Avrahami v. Comm'r, 149 T.C. 144 (2017)

Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. 1986)

Board of Trade v. Comm'r, 106 T.C. 369 (1996)

Carnation Co. v. Comm'r, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir.)

Cigna Lloyds Ins. Co. v. Kamins, 924 S.W.2d 206 (Tex. App. - Eastland 1996, no writ)

Clougherty Packing Co. v. Comm'r, 811 F.2d 1297 (9th Cir. 1987)

Crawford Fitting Co. v. United States, 606 F. Supp. 136 (N.D. Ohio 1985)

Delta Holdings, Inc. v. Nat'l Distillers & Chem. Corp., 945 F.2d 1226 (2d Cir. 1991)

Emp'rs Reinsurance Corp. v. Mid-Continent Cas. Co., 358 F.3d 757 (10th Cir. 2004)

Epmeier v. United States, 199 F.2d 508 (7th Cir. 1952)

Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

Greenspun, Comm'r v., 156 F.2d 917 (5th Cir. 1946)

Gulf Oil Corp. v. Comm'r, 89 T.C. 1010 (1987), aff'd, 914 F.2d 396 (3d Cir. 1990)

Hanover Bank v. Comm'r, 369 U.S. 672 (1962)

Harper Group v. Comm'r, 96 T.C. 45 (1991), aff'd, 979 F.2d 1341 (9th Cir. 1992)

Hartford Cas. Ins. Co. v. Exec. Risk Specialty Ins. Co., No. 05-03-00546-CV, 2004 WL 2404382 (Tex. App. - Dallas Oct. 28, 2004, pet. denied) (mem. op.)

Haynes v. United States, 353 U.S. 81 (1957)

Helvering v. Le Gierse, 312 U.S. 531 (1941)

Holl, Estate of v. Comm'r, 967 F.2d 1437 (10th Cir. 1992)

Humana, Inc. v. Comm'r, 881 F.2d 247 (6th Cir. 1989)

James v. Comm'r, 899 F.2d 905 (10th Cir. 1990)

Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42 (1997)

Level 3 Commc'ns, LLC v. Liebert Corp., 535 F.3d 1146 (10th Cir. 2008)

Malone & Hyde v. Comm'r, 62 F.3d 835 (6th Cir. 1995)

Moline Props., Inc. v. Comm'r, 319 U.S. 436 (1943)

N. River Ins. Co. v. CIGNA Reinsurance Co., 52 F.3d 1194 (3d Cir. 1995)

Nat'l Union Fire Ins. Co. v. Ins. Co. of N. Am., 955 S.W.2d 120 (Tex. App. - Houston [14th Dist.] 1997, pet. denied), aff'd sub nom. Keck, Mahin & Cate v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., 20 S.W.3d 692 (Tex. 2000)

Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135 (Fed. Cir. 1993)

R.V.I. Guar. Co. v. Comm'r, 145 T.C. 209 (2015)

Reich v. Lancaster, 55 F.3d 1034 (5th Cir. 1995)

Reliance Ins. Co. v. Shriver, Inc., 224 F.3d 641 (7th Cir. 2000)

Rent-A-Center, Inc. v. Comm'r, 142 T.C. 1 (2014)

Ross v. Odom, 401 F.2d 464 (5th Cir. 1968)

Royal Indem. Co. v. Marshall, 388 S.W.2d 176 (Tex. 1965)

RSUI Indem. Co. v. The Lynd Co., 466 S.W.3d 113 (Tex. 2015)

Sammons v. Comm'r, 472 F.2d 449 (5th Cir. 1972)

Scanlon White, Inc. v. Comm'r, 472 F.3d 1173 (10th Cir. 2006)

Sears, Roebuck & Co. v. Comm'r, 972 F.2d 858 (7th Cir. 1992)

Securitas Holdings, Inc. v. Comm'r, 108 T.C.M. (CCH) 490 (2014)

Shellito v. Comm'r, 437 F. App'x 665 (10th Cir. 2011) (unpublished)

Soc'y of Prof'ls in Dispute Resolution, Inc. v. Mt. Airy Ins. Co., Civ. Action No. 3:97–CV–0071–D, 1997 WL 711446 (N.D. Tex. Nov. 7, 1997) (unpublished)

State Farm Fire & Cas. Co. v. Griffin, 888 S.W.2d 150 (Tex. App. - Houston [1st Dist.] 1994, no writ)

Stearns-Roger Corp. v. United States, 774 F.2d 414 (10th Cir. 1985)

Trans City Life Ins. Co. v. Comm'r, 106 T.C. 274 (1996)

Treganowan, Comm'r v., 183 F.2d 288 (2d Cir. 1950)

Twenty Mile Joint Venture, PND, Ltd., v. Comm'r, 200 F.3d 1268 (10th Cir. 1999)

Unigard Sec. Ins. Co., Inc. v. N. River Ins. Co., 4 F.3d 1049 (2d Cir. 1993)

United Nat'l Ins. Co. v. Mundell Terminal Servs., Inc., 740 F.3d 1022 (5th Cir. 2014)

United Parcel Serv. of Am., Inc. v. Comm'r, 254 F.3d 1014 (11th Cir. 2001)

United States v. Lequire, 672 F.3d 724 (9th Cir. 2012)

Valley Improvement Ass'n v. U.S. Fid. & Guar. Corp., 29 F.3d 1108 (10th Cir. 1997)

Weber Paper v. United States, 204 F. Supp. 394 (W.D. Mo. 1962), aff'd, 320 F.2d 199 (8th Cir. 1963)

Weinert’s Estate v. Comm’r, 294 F.2d 750 (5th Cir. 1961)

Statutes

26 U.S.C.

§ 101(a)(1) 

§ 118(a) 

§ 501(c)(15) 

§ 816(a)

§ 881 

§ 881(a) 

§ 953(d)

§ 6110(k)(3) 

§ 6213 

§ 6214 

§ 7442 

§ 7482(a)(1) 

§ 7483 

42 U.S.C.

§ 9601 

§ 9607

10th Cir. R. 14

Fed. R. App. P. 13 

Fed. R. App. P. 14 

Rev. Rul. 69-630, 1969-2 C.B. 112 

Rev. Rul. 78-83, 1978-1 C.B. 9

Rev. Rul. 2002-89, 2002-2 C.B. 984 

Rev. Rul. 2005-40, 2005-2 C.B. 4 

Rev. Rul. 2008-8, 2008-1 C.B. 340 

Revenue Ruling 2005-40

Rev. Rul. 2009-26, 2009-38 I.R.B. 366 

Tax Ct. R. 190

Other Authorities

Boris I. Bittker & James S. Eustice, Fed. Income Tax’n of Corps. & Shareholders ¶¶ 8.06[10] (2020 ed.) 

Commercial Ins. & Captive Ins. Indus.: Commonly Accepted Practices (Jan. 31, 2019),
https://www.cicaworld.com/docs/default-source/default-document-library/cica_commonly_accepted_
insurance_practices_risk _pools_jan2019.pdf?sfvrsn= 

Graydon S. Staring & Hon. Dean Hansell, Law of Reinsurance (2019 ed.)

§ 1:1 

§ 2.10 

I.R.S. P.L.R. 200907006 (Feb. 13, 2009) 

I.R.S. P.L.R. 200950016 (Dec. 11, 2009) 

I.R.S. P.L.R. 201030014 (Jul. 30, 2010)

I.R.S. P.L.R. 201219009 (May 11, 2012) 

I.R.S. P.L.R. 201219011 (May 11, 2012) 

I.R.S. P.L.R. 201224018 (Jun. 15, 2012)

James R. Browne, “Reserve Mechanical and Syzygy: Income from Nothing,” 163 Tax Notes 1665 (June 10, 2019)

1 Robert L. Carter, Carter on Reinsurance 4 (5th ed. 2013)


Statement of Prior or Related Cases

Pursuant to Tenth Circuit Rule 28.2(C)(1), Petitioner-Appellant states that there are no prior or related cases.

Glossary of Acronyms

Pursuant to Tenth Circuit Rule 28.2(C)(6), the following is a glossary of acronyms used in this brief:

“Capstone” means Capstone Associated Services, Ltd.

“CreditRe” means Credit Reassurance Corporation.

“Commissioner” means the Commissioner of Internal Revenue.

“EPA” means U.S. Environmental Protective Agency.

“FDAP income” means fixed or determinable annual or periodical income.

“Lyndon” means Lyndon Property Insurance Company.

“MEL” means Mining Equipment Ltd.

“Mid-Continent” means Mid-Continent General Agency, Inc.

“Peak” means Peak Mechanical & Components, Inc.

“Peak Casualty” means Peak Casualty Holdings, LLC.

“PoolRe” means PoolRe Insurance Corp.

“Reserve” means Petitioner-Appellant Reserve Mechanical Corp.

“RocQuest” means Rocquest, LLC.

“Willis” means Willis HRH of Houston (n.k.a. Willis Towers Watson).

“ZW” means ZW Enterprises, LLC.

Glossary of Insurance Terms

For the Court's convenience, the following is a glossary of insurance terms used in this brief:

“Direct-written insurance” is insurance issued directly to the insured policyholder describing what kinds of liability will be covered and at what dollar limits.

“Facultative reinsurance” is a type of reinsurance that entails a reinsurer assuming specific risks instead of an entire class of risks under a reinsurance agreement (facultative contract). The facultative reinsurer assesses the unique characteristics of each risk to determine whether to reinsure the risk, and at what price, thus retaining the faculty, or option, to accept or reject any risk.

“Follow the fortunes” is a doctrine of treaty reinsurance, sometimes confirmed in a clause (“follow the fortunes” clause), that the reinsurer accepts the underwriting judgment of the reinsured and shares its underwriting fortunes.

“Fronting arrangement” is an arrangement in which policies are issued by a direct insurer that serves as a “front” or “fronting company” for a reinsurer that reinsures 100% of the risks.

“Quota share reinsurance” is a type of treaty reinsurance in which the ceding insurer transfers, and the reinsurer accepts, a given percentage of both the premium charged for the underlying insurance policy and the exposure thereunder to first-dollar losses such that the ceding insurer and the reinsurer share proportionately in all premiums and losses.

“Reinsurance” is insurance of contractual liabilities to pay claims incurred under contracts of direct-written insurance or reinsurance. Reinsurance occurs when one insurer (the cedent, ceding insurer or reinsured) transfers (cedes) all or part of the risk it underwrites, pursuant to a policy or group of policies, to another insurer (the reinsurer).

“Retrocession agreement” is a reinsurance agreement in which a reinsurer (the retrocedent) transfers (retrocedes) its position on reinsurance to another reinsurer (the retrocessionaire).

“Risk-pooling” is a form of diversification that reduces the dispersion or volatility of losses and is the essence of insurance. Through a joint underwriting operation (the risk pool), insurers or reinsurers accept fixed percentages of all business underwritten, either by one or more of them or by an independent manager.

“Stop loss coverage” is coverage that protects against large claims by reimbursing some portion of losses exceeding a predetermined amount.

“Treaty reinsurance” is a type of reinsurance that entails a reinsurer accepting a percentage participation in all risks of a certain type or class underwritten by the primary insurer (or another reinsurer) during a specified period of time. Once the reinsurance agreement (treaty) is written, the reinsured cedes an entire block of business to the treaty reinsurer who is automatically bound to accept all of the policies under the block of business, including unwritten ones.

Introduction and Overview

This case arises from a company's need for specialized insurance coverage that was not available on the commercial market. Peak Mechanical & Components, Inc. (“Peak”) is in the business of manufacturing, selling, and servicing heavy machinery used in underground mining operations. Peak is located 200 feet from the Coeur d'Alene River in the heavily polluted Bunker Hill Superfund site in the mountains of northern Idaho.

Peak's operations include cleaning used mining equipment, a hazardous process that produces dangerous contaminants. CERCLA (a.k.a. “Superfund”) requires Peak to prevent any release of those toxic substances. See 42 U.S.C. § 9601, et seq. While Peak had never caused an accidental contamination, its owners were concerned that an error in its cleaning operations could leak contaminants into the river, causing massive environmental liability. Peak sought but could not find a commercial insurance policy that would cover either its pollution risk or multiple other risks Peak faced.

Peak's solution was to form its own captive insurance company — Petitioner-Appellant Reserve Mechanical Corp. (“Reserve”) — to provide the needed coverage. With the assistance of consultants, actuaries, and other insurance industry experts, Reserve issued direct-written policies insuring Peak and two affiliates against pollution liability and other risks.

Like Peak, many companies whose operations present unusual or potentially catastrophic risks have formed captive insurers. Recognizing this business necessity and to make such insurers financially viable, Congress exempted from taxation income earned by “insurance companies” whose gross receipts do not exceed $600,000. 26 U.S.C. (“I.R.C.” or the “Code”) § 501(c)(15).

While Reserve was under the income threshold, the tax court held that Reserve did not qualify for the exemption because its transactions did not constitute insurance for tax purposes. Caselaw generally holds that an arrangement constitutes insurance for tax purposes if (1) the arrangement involves insurable risks, (2) the arrangement shifts the risk of loss to the insurer, (3) the insurer distributes the risk among its policyholders, and (4) the arrangement is insurance in the commonly accepted sense. App.Vol.3.p.882.1 The central issue in this appeal is whether the tax court erred in holding that Reserve's transactions did not constitute insurance based on the court's determination that Reserve failed parts (3) and (4) of the four-part test.

As to part (3) of the test — risk distribution — courts have repeatedly recognized that a captive insurer sufficiently spreads risk so as to constitute risk distribution if at least 30% of its gross premiums are derived from covering risks of unrelated insureds. Reserve met this test by receiving more than 30% of its gross premiums from reinsuring pooled and blended risks of more than 150 insureds under more than 500 direct-written policies jointly issued by PoolRe Insurance Corp. (“PoolRe”) and more than fifty captive insurers, and from reinsuring risks relating to a large pool of policies for vehicle service contracts. The tax court, however, rejected this conclusion, holding that Reserve's reinsurance arrangements did not allow Reserve to effectively distribute risk because the arrangements were with PoolRe, an unrelated entity that the court concluded was not a “bona fide insurance company.”

It is apparent from the tax court's opinion that it viewed Reserve, PoolRe, and the insurance arrangements at issue with skepticism, but the court's criticisms are groundless. For example, the court objected that Peak did not have “a genuine need” for pollution liability insurance because Peak had operated continuously for ten years without incurring costs for pollution liability. App.Vol.4.p.906, 909. This flawed reasoning is akin to saying that automobile insurance is unnecessary for drivers who have not yet had an accident.

Reserve's direct-written policies provided real insurance: when Peak suffered a covered loss and made a claim, Reserve paid. Reserve's risk-distributing arrangements imposed real contractual rights and obligations. If Peak suffered a large covered loss, a substantial portion of the loss over a predetermined amount would be borne by the fifty-plus insurers participating in the risk pool. By the same token, if one of those insurers responded to a large loss, Reserve would also be called upon to pay its proportionate share of the loss.

This Court's decision will be the first decision by any circuit court to analyze key issues with respect to a captive insurer's risk distribution through reinsurance arrangements and participation in a risk pool. Instructive caselaw in this area from other jurisdictions is very limited, so this Court's decision is likely to have a major impact on the insurance industry as a whole. Congress enacted the tax exemption for captive insurance companies to encourage their formation, but the tax court's rejection of Reserve's exempt status would frustrate legislative intent by unreasonably restricting the number and kind of captive insurers that could qualify. As shown below, the tax court's holdings were erroneous as a matter of law and should be reversed.

Jurisdictional Statement

The tax court had jurisdiction pursuant to I.R.C. §§ 6213, 6214, and 7442. This is an appeal from the tax court's Memorandum Findings of Fact and Opinion filed on June 18, 2018, and its decision entered on September 28, 2018. App.Vol.3.p.850-Vol.4.p.915, 1003. Reserve timely filed its notice of appeal on December 20, 2018. App.Vol.4.p.1004. See Tax Ct. R. 190; Fed. R. App. P. 13, 14; 10th Cir. R. 14. This Court has jurisdiction pursuant to I.R.C. §§ 7482(a)(1) and 7483.

Statement of the Issues Presented for Review

1. The tax court held that Reserve's transactions did not constitute insurance for tax purposes because they did not allow Reserve to effectively distribute risk and were not insurance in the commonly accepted sense.

(a) Did the court err in concluding that Reserve did not effectively distribute risk through its participation in a reinsurance risk pool and coinsurance arrangement because PoolRe, an unrelated entity that managed the risk pool and ceded risks to Reserve, was not a bona fide insurance company?

(b) In determining that Reserve's transactions were not insurance in the commonly accepted sense, did the court err in relying on a patently incorrect reading of Reserve's direct-written policies as providing only excess coverage and on a series of unfounded assumptions about the nature of the insurance business in general and captive insurance in particular?

2. Having concluded that Reserve's transactions did not constitute insurance for tax purposes and Reserve therefore was not an insurance company exempt from tax under I.R.C. § 501(c)(15), the court held that Reserve was ineligible to make an election under I.R.C. § 953(d) to be treated as a domestic corporation and imposed the 30% withholding tax under I.R.C. § 881(a) on Reserve's gross receipts for the tax years in issue. As an alternative issue:

(a) Did the court err in holding that the payments Reserve received as insurance premiums were taxable income, instead of nontaxable capital contributions to Reserve, where the court's rationale was that there was no legitimate business purpose for the payments?

Statement of the Case

I. Factual Background

A. Description of Insurance, Reinsurance and Captive Insurance.

Insurance is a financial arrangement in which contributions of multiple parties, each exposed to the possibility of loss, are used to compensate those that actually suffer loss. App.Vol.13.p.3704. In the insurance industry, direct-written insurance and reinsurance play different roles. The former is insurance issued directly to the insured policyholder describing what kinds of liability will be covered and at what dollar limits. See N. River Ins. Co. v. CIGNA Reinsurance Co., 52 F.3d 1194, 1198 (3d Cir. 1995). The latter is insurance of contractual liabilities to pay claims incurred under contracts of direct-written insurance or reinsurance. 1 Robert L. Carter, Carter on Reinsurance 4 (5th ed. 2013); see also Graydon S. Staring & Hon. Dean Hansell, Law of Reinsurance § 1:1 (2019 ed.).

Reinsurance occurs when one insurer (the cedent, ceding insurer or reinsured) transfers (cedes) all or part of the risk it underwrites, pursuant to a policy or group of policies, to another insurer (the reinsurer). Unigard Sec. Ins. Co., Inc. v. N. River Ins. Co., 4 F.3d 1049, 1053 (2d Cir. 1993). In typical reinsurance transactions, after a primary insurer first underwrites risks in exchange for premiums from the insureds, the primary insurer transfers (cedes) a portion of its risks to one or more reinsurers, who accept the risks in exchange for premiums from the primary insurer. Delta Holdings, Inc. v. Nat'l Distillers & Chem. Corp., 945 F.2d 1226, 1229 (2d Cir. 1991). In this way, the primary insurer is able to further spread the risks it has underwritten. Id. A reinsurer (the retrocedent), in turn, may transfer (retrocede) its position on reinsurance to another reinsurer (the retrocessionaire) through a “retrocession agreement.” Id.; Trans City Life Ins. Co. v. Comm'r, 106 T.C. 274, 278-79 (1996).

“The purpose of reinsurance is to diversify the risk of loss and to reduce required capital reserves.” Unigard, 4 F.3d at 1053. Reinsured risk is spread in layers with premium dollars allocated in greater amounts to those who have taken larger risks. N. River, 52 F.3d at 1199 n.4. “Spreading part of the risk to the reinsurer can prevent a catastrophic loss from falling upon the insurance company and enable the insurance company to serve more clients.” Emp'rs Reinsurance Corp. v. Mid-Continent Cas. Co., 358 F.3d 757, 761 (10th Cir. 2004).

There are two basic types of reinsurance contracts — facultative and treaty. N. River, 52 F.3d at 1199. Facultative reinsurance entails a reinsurer assuming specific risks instead of an entire class of risks under a reinsurance agreement (facultative contract). Delta Holdings, 945 F.2d at 1229. The facultative reinsurer assesses the unique characteristics of each risk to determine whether to reinsure the risk, and at what price, thus '“retain[ing] the faculty, or option, to accept or reject any risk.'” N. River, 52 F.3d at 1199 (citation omitted).

In contrast, treaty reinsurance entails a reinsurer accepting “a percentage participation in all risks of a certain type or class underwritten by the primary insurer (or another reinsurer) during a specified period of time.” Delta Holdings, 945 F.2d at 1229; see also Unigard, 4 F.3d at 1054 (“A 'typical treaty reinsurance agreement might reinsure losses incurred on all policies issued by the ceding insurer to a particular insured, while facultative reinsurance would be limited to the insured's losses under a policy or policies specifically identified in the reinsurance agreement.'” (citation omitted)). Once the reinsurance agreement (treaty) is written, the reinsured cedes an entire block of business to the treaty reinsurer who is automatically bound to accept all of the policies under the block of business, including unwritten ones. N. River, 52 F.3d at 1199. Importantly, “[b]ecause a treaty reinsurer accepts an entire block of business, it does not assess the individual risks being reinsured; rather, it evaluates the overall risk pool.” Id. Typically, this type of reinsurance agreement also includes a “follow the fortunes” clause. Id. “Follow the fortunes” refers to a doctrine of treaty reinsurance that the reinsurer accepts the underwriting judgment of the reinsured and shares its underwriting fortunes. Staring & Hansell, supra, § 2.10; N. River, 52 F.3d at 1199. That doctrine is sometimes confirmed in a clause (“follow the fortunes” clause) that obligates the reinsurer to indemnify the reinsured for any good faith payment of an insured loss, thereby preventing the reinsurer from second-guessing good-faith settlements and obtaining de novo review of judgments of the reinsured's liability to its insured. Id.

Captive insurance is a form of alternative risk management financing that can be used to accomplish several objectives including, inter alia, filling-in gaps in coverage and enabling the captive's insured operating business(es) to insure risks that are either too costly or otherwise unavailable in the commercial marketplace. App.Vol.7.p.2036; see also Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1138 (Fed. Cir. 1993); Crawford Fitting Co. v. United States, 606 F. Supp. 136, 147 (N.D. Ohio 1985); Securitas Holdings, Inc. v. Comm'r, 108 T.C.M. (CCH) 490, at *3 (2014); Rent-A-Center, Inc. v. Comm'r, 142 T.C. 1, 3-4 (2014).

B. Peak's Need for Captive Insurance Arises.

Peak manufactures, custom-designs, distributes, sells, repairs, and services equipment used in mining, including in deep underground mines in Idaho's Silver Valley. App.Vol.2.p.370-71, Vol.4.p.1120. Peak's affiliate, RocQuest, LLC (“RocQuest”), owns and leases the real estate and facilities where Peak bases its operations in Silver Valley, within the Bunker Hill Superfund site. App.Vol.4.p.1116-20, Vol.5.p.1386. This site contains toxic mine tailings and other poisons left by unsafe mining practices that yielded silver, lead, and zinc for over 100 years. App.Vol.4.p.1116-21.

Underground mining poses occupational hazards of accidental death and serious injury. App.Vol.4.p.1117-20. Norman Zumbaum and Corey Weikel, Peak's owners, knew many miners who had died on the job, including Weikel's father. App.Vol.4.p.1117-19. Weikel was once buried up to his neck by falling rock, causing such severe injuries that doctors thought he would never walk again. App.Vol.4.p.1119-20. In a separate incident, a large stage winch that Zumbaum's and Weikel's former employer, Mining Equipment Ltd. (“MEL”) — a business similar to Peak — had supplied to a customer, plummeted down a vertical shaft, killing a worker and resulting in a lawsuit against MEL, which settled for $1 to $2 million. App.Vol.4.p.1118.

Peak's equipment was used in mines in Silver Valley, which remains an active Superfund site. App.Vol.4.p.1119-22. Peak's submersible pumps extracted groundwater to prevent flooding. App.Vol.4.p.1121-22. Its large ventilation fans vented noxious gases and cooled underground temperatures that otherwise would have reached 150 degrees. App.Vol.4.p.1119. Its hydraulically-operated steel doors directed the flow of air. App.Vol.4.p.1122. Its specially-designed and custom-built trucks hauled explosives, fuel, and miners in tunnels thousands of feet underground. App.Vol.4.p.1121-22.

Mud lining the mine floor harbors toxic pollutants like lead, zinc and the powerful explosive, ammonium nitrate. App.Vol.4.p.1122. This toxic soup contaminates Peak's equipment, requiring rehabilitation and cleaning at Peak's facility, which lies in a floodplain about 200 feet from the already-contaminated Coeur d'Alene River. App.Vol.4.p.1120-36. Peak also had to control and store this toxic soup at Peak's facility with cleaning bays, pumps and containment areas until it could be treated and hauled off for disposal. App.Vol.4.p.1122. An accident in Peak's cleaning and containment operations could have led to further contamination and possible environmental liability for Peak and its owners and customers. App.Vol.4.p.1122-23; see also 42 U.S.C. § 9607 (regarding CERCLA liability).

As part of its risk-management program, Peak attempted unsuccessfully to acquire commercial pollution liability insurance. App.Vol.4.p.1124. Peak also faced other risks, including possible large financial losses when mines in Silver Valley shut down in the 2000s due to the U.S. Environmental Protective Agency's (“EPA”) accelerated cleanup efforts and when regulatory changes created unforeseen liabilities. App.Vol.4.p.1135-36. Further, Peak's relationship with its commercial insurer soured over the handling of a claim where the insurer took six months before offering an inadequate sum for Peak's loss. App.Vol.4.p.1123-24, 1132-38. In response to these events, and acting on a mentor's recommendation, Peak explored forming a captive insurance company. App.Vol.4.p.1124.

Peak contacted industry expert Capstone Associated Services, Ltd. (“Capstone”) to assess the feasibility of forming a captive insurance company. App.Vol.4.p.1124-25, Vol.5.p.1206-07, 1372-74. Capstone performed a feasibility study, which included, inter alia, an on-site inspection of Peak's facilities, assessment of existing insurance coverages, and evaluation of risks and risk management needs. App.Vol.4.p.1124-25, Vol.5.p.1206-07, 1385-86, 1415. The feasibility study recommended that Peak form a captive because the commercial policies in place left several coverage gaps for risks Peak faced and such coverage was either too costly or otherwise unavailable in the commercial marketplace. App.Vol.7.p.2027-95. One of the world's largest insurance consulting firms, Willis HRH of Houston (n.k.a. Willis Towers Watson) (“Willis”), worked with Capstone to finalize and issue the study. App.Vol.4.p.1077-79, Vol.5.p.1374, 1385-86.

After reviewing a draft of the feasibility study, in 2008, Peak's owners decided to form Reserve as a captive insurer under the laws of the British Overseas Territory of Anguilla, one of the world's largest captive domiciles. App.Vol.4.p.1125, 1133, Vol.5.p.1248, 1254. During the tax years in issue, Anguilla licensed and regulated Reserve as an insurer. App.Vol.5.p.1434-35, Vol.7.p.1885-87. Peak Casualty Holdings, LLC (“Peak Casualty”), a Nevada limited liability company owned by Zumbaum and Weikel, owned 100% of Reserve's stock. App.Vol.2.p.366.

C. Reserve Issues Policies, Collects Premiums, and Distributes Risk.

During the tax years in issue, Reserve issued between eleven and thirteen direct-written policies per year to Peak and its affiliates, ZW Enterprises, LLC (“ZW”), a lending company, and RocQuest (collectively, the “Direct Insureds”). These direct-written policies provided primary coverages (i.e., they did not duplicate the limited commercial insurance coverages the Direct Insureds maintained) that the feasibility study had identified for addressing Peak's risks. App.Vol.7.p.2031-32, 2047-50, Vol.12.p.3570-71, 3586-87. These coverages slightly differed from year-to-year but generally included: (1) pollution liability; (2) product recall; (3) punitive wrap; (4) employment practices liability; (5) loss of services; (6) weather-related business interruption; (7) loss of major customer; (8) legal expense reimbursement; (9) expense  reimbursement; (10) director and officer liability; (11) regulatory changes; (12) intellectual property; (13) tax liability; and (14) cyber risk. App.Vol.11.p.3106-3249, 3283-Vol.12.p.3388, 3421-3521.

Capstone administered Reserve on a day-to-day basis, a standard practice in the captive insurance industry. App.Vol.7.p.1830. Mid-Continent General Agency, Inc. (“Mid-Continent”), an unaffiliated Lloyd's of London underwriter, worked with Capstone to price the risks and set the premiums Reserve charged the Direct Insureds. App.Vol.5.p.1236-37. At trial, two fully-credentialed, independent actuaries testified that they endorsed the premiums Reserve charged as “actuarially sound” and “reasonable.” App.Vol.13.p.3779-865, 3885-Vol.18.p.5327.

During each tax year in issue, for coverage under the direct-written policies, the Direct Insureds paid approximately 80% of the premiums to Reserve and the remainder to another insurer, PoolRe, which jointly  underwrote Reserve's policies pursuant to joint underwriting stop loss endorsements. App.Vol.11.p.3270-77, Vol.12.p.3411-20, 3545-51. These contracts implemented a common insurance practice of layering risk using stop loss coverage. App.Vol.4.p.1194-95, Vol.13.p.3712-13, 3724. “Stop loss coverage” protects against large claims by reimbursing some portion of losses exceeding a predetermined amount. See Reich v. Lancaster, 55 F.3d 1034, 1041 n.4 (5th Cir. 1995). Under these contracts, PoolRe (the stop loss insurer) participated with Reserve (the lead insurer) in an intermediate loss layer above a loss threshold borne solely by Reserve. App.Vol.4.p.1191-95, Vol.13.p.3712-13, 3724; see also Addendum A (Diagram A) (using 2010 as an exemplar year).

PoolRe operated as a licensed insurer in the British Virgin Islands before redomiciling to Anguilla in 2009. App.Vol.4.p.1085, Vol.11.p.3278-82. While PoolRe was administered by Capstone, it was not a captive insurer of Reserve or the Direct Insureds and did not share any common owners, directors, officers, or other key employees with them. App.Vol.5.p.1424. PoolRe was also not related to the other captive insurers that Capstone administered and their affiliated insureds. App.Vol.4.p.1065, Vol.5.p.1424, 1465-66.

As it did with Reserve and for the Direct Insureds, PoolRe jointly underwrote direct-written policies with numerous unrelated captive insurers and provided stop loss coverage for unrelated insureds. App.Vol.4.p.1191, Vol.13.p.3712-3715. In this way, PoolRe assumed a portfolio of higher-layer losses, leaving the smaller losses with the captive insurers. Id.

PoolRe also managed a reinsurance risk pool. App.Vol.11.p.3256, 3276, Vol.12.p.3396, 3527, 3562. A risk pool is a joint underwriting operation in which insurers or reinsurers accept fixed percentages of all business underwritten, either by one or more of them or by an independent manager. Staring & Hansell, supra, § 2.10. “Risk-pooling is a form of diversification that reduces the dispersion or volatility of losses and is the essence of insurance.” Delta Holdings, 945 F.2d at 1229. Risk-pooling is commonly used in the insurance industry to distribute or spread risk. App.Vol.4.p.1081, Vol.13.p.3708. During each tax year in issue, Reserve and more than fifty other captive insurers that Capstone administered participated in the PoolRe risk pool by means of quota share reinsurance arrangements. App.Vol.13.p.3713; see also Addendum B (Diagram B) (using 2010 as an exemplar year). Notably, the Commissioner had reviewed and approved of PoolRe's risk pool as a reinsurance mechanism no less than 39 times before the tax years in issue. App.Vol.19.p.5497-593.

“Quota share reinsurance” is treaty reinsurance under which the ceding insurer transfers, and the reinsurer accepts, a given percentage of both the premium charged for the underlying insurance policy and the exposure thereunder to first-dollar losses such that the ceding insurer and the reinsurer share proportionately in all premiums and losses. Carter, supra, at 147. For example, in the case of a 20% quota share, the insurer transfers 20% of its liability and premiums on every risk to the reinsurer, who must pay 20% of any loss sustained, whether total or partial. Id. The percentage is constant throughout and applies to premiums and losses alike. Id.

Under these arrangements, PoolRe ceded out from the risk pool all of the risks it underwrote pursuant to the joint underwriting stop loss endorsements, thereby reinsuring the pooled risks with all of the pool participants on a proportional (quota share) basis, and those participants agreed to pay their respective proportionate share of the PoolRe losses. App.Vol.13.p.3712-15. All of the participating captive insurers thus shared a percentage of the risks PoolRe underwrote, and in return, received an equivalent share of the stop loss premiums. Vol.4.p.1191-94, Vol.5.p.1427-29, 1467-68, Vol.11.p.3258-59, Vol.12.p.3398-99, 3527, 3530-31, Vol.13.p.3712-15. All of the participating captive insurers also had to “follow the fortunes” of PoolRe and thus were bound by any payments PoolRe made to the insureds on the direct-written policies in the risk pool. App.Vol.11.p.3253, Vol.12.p.3392, 3525.

As Diagram B in the addendum depicts (using 2010 as an exemplar year), Reserve participated in the risk pool by reinsuring its quota share of the blended risks that PoolRe pooled. See App.Vol.9.p.2470, Vol.18.p.5383. Because the risks in the pool originated from risks of more than 150 insureds under more than 500 direct-written policies jointly issued by PoolRe and more than fifty captive insurers, the pool of blended risks was highly diversified. App.Vol.4.p.1193-95, Vol.5.p.1416-29, Vol.13.p.3712-15, 3741-57. Thus, although the amount of pooled and blended risks each pool participant assumed under the quota share arrangements equaled the amount of risks PoolRe assumed from providing stop loss coverage to each participant's respective affiliated insureds, the nature of those risks differed. App.Vol.4.p.1193-94, Vol.5.p.1427-29, 1467-68. Instead of insuring only affiliated insureds, each participating captive insurer was able to distribute its overall risk among hundreds of unrelated policyholders. App.Vol.5.1416, Vol. 13. p.3712-17.

Likewise, although the amount of quota share premiums that each participating captive insurer received under the quota share arrangements equaled the amount of stop loss premiums PoolRe received from each participant's respective affiliated insureds, the nature of the funds differed. App.Vol.5.p.1429. Once the risk pool received the stop loss premiums, those commingled funds lost their identities and the original insureds lost their right to control the use of those fungible funds. App.Vol.5.p.1467; Weber Paper v. United States, 204 F. Supp. 394, 399-400 (W.D. Mo. 1962), aff'd, 320 F.2d 199 (8th Cir. 1963). Thus, although their amounts were the same, the makeup of the stop loss premiums that PoolRe received and the makeup of the quota share premiums that PoolRe paid did not match. App.Vol.4.p.1193-94. Notably, the Commissioner has issued numerous private letter rulings approving of similar arrangements where the quota share premiums from the reinsurance pool were equivalent in dollar terms to the amount ceded to the pool by the insurer in the first instance.2 E.g., I.R.S. P.L.R. 200907006 (Feb. 13, 2009); I.R.S. P.L.R. 200950016 (Dec. 11, 2009); I.R.S. P.L.R. 201030014 (July 30, 2010); I.R.S. P.L.R. 201219009 (May 11, 2012); I.R.S. P.L.R. 201219011 (May 11, 2012); I.R.S. P.L.R. 201224018 (June 15, 2012).

During the tax years in issue, Capstone and Mid-Continent calculated the stop loss premiums that the insureds paid to PoolRe and the quota share premiums that PoolRe paid to the captive insurers participating in the risk pool using actuarial methods and objective criteria. App.Vol.5.p.1239-42, Vol.11.p.2350-60, 3250-60, Vol.12.p.3389-3400, 3522-33, 3560-69. In addition, the premium allocations under the quota share arrangements were based on, inter alia, the input and advice of Myron Steves & Co. (for 2008 and 2009), a large insurance brokerage, and Glicksman Consulting, LLC (for 2010), an accredited actuarial consulting firm. App.Vol.12.p.3562-69.

In addition to reinsuring unrelated risks that PoolRe ceded from its risk pool, Reserve and PoolRe executed retrocession agreements under which Reserve reinsured on a coinsurance basis unrelated risks from insurance policies that PoolRe itself had reinsured under a treaty dated June 1, 2000 between PoolRe and Credit Reassurance Corporation, Ltd. (“CreditRe”),3 a Nevis Island corporation that was merged into Credit Reassurance, Ltd. on January 1, 2009. App.Vol.11.p.3261-69, Vol.12.p.3401-10, 3534-44, 3713. The risks that Reserve reinsured each year under this arrangement were the insurance exposures for that year on all policies of vehicle service contracts directly written by Lyndon Property Insurance Company (“Lyndon”) in force on January 1, 2006 and subsequently issued, and assumed by CreditRe from Aria (SAC) Ltd., under its treaty dated January 1, 2006. Id. Thus, during each tax year in issue, the risks that Reserve reinsured under this arrangement and the coinsurance premiums Reserve received originated from thousands of individual policyholders to whom Lyndon, a U.S.-based insurance company, had issued policies, and were ceded from Lyndon to intervening unrelated reinsurers, including CreditRe and PoolRe, before ultimately being reinsured by Reserve. Id.

During each tax year, the quota share and coinsurance premiums Reserve received totaled more than 30% of Reserve's gross premiums. App.Vol.9.p.2467, Vol.13.p.3713-14, Vol.18.p.5380. Because more than 30% of Reserve's gross premiums was derived from Reserve's unrelated insurance business (i.e., insurance outside Reserve's captive insurance arrangement with its sister companies, the Direct Insureds), one of Reserve's experts, Dr. Neil A. Doherty, an accomplished recognized insurance expert who also testified in Harper Group v. Commissioner, 96 T.C. 45 (1991), aff'd, 979 F.2d 1341 (9th Cir. 1992), opined that Reserve had achieved a very considerable degree of risk distribution that exceeded the 30% threshold recognized by the tax court in Harper. App.Vol.13.p.3716-17, 3725. Dr. Doherty further opined that, during each of the tax years in issue, based on his review of the quota share and coinsurance arrangements, Reserve's direct-written policies, and the policies underwritten by the other captive insurers participating in the PoolRe risk pool,4 (1) the policies insured insurable risks, (2) the risks were shifted, (3) the risks were distributed, (4) the arrangements were insurance as it is commonly understood, and (5) Reserve was an insurance company. App.Vol.4.p.1190-94, Vol.13.p.3713-26.

D. Reserve Pays Losses for Covered Claims.

During each tax year in issue, Reserve paid covered claims, including one large claim by Peak in 2009 under Reserve's loss-of-major-customer policy totaling $339,820. App.Vol.2.p.377-78, Vol.4.p.1127-29, Vol.12.p.3552-59. Reserve also paid $186,892 in losses under the coinsurance program ($61,160, $70,332, and $56,400 in 2008, 2009, and 2010, respectively). App.Vol.9.p.2478, 2490-91, 2504, Vol.19.p.5416.

II. Procedural History

For the tax years in issue, Reserve met the gross-receipts requirement of $600,000 set by I.R.C. § 501(c)(15), filed federal income tax returns on Form 990 under I.R.C. § 501(c)(15), and elected to be taxed as a domestic taxpayer under I.R.C. § 953(d). App.Vol.1.p.42, 78.

In a notice of deficiency, the Commissioner determined that Reserve owed income taxes totaling $144,538, $164,418, and $168,305 for 2008, 2009, and 2010, respectively. App.Vol.6.p.1589-95. The Commissioner determined that Reserve did not qualify as an insurance company for tax purposes under I.R.C. § 501(c)(15) and alleged that Reserve's insurance and reinsurance arrangements lacked economic substance. App.Vol.6.p.1592. Reserve petitioned the tax court to redetermine the deficiencies. App.Vol.1.p.1-21.

After trial and briefing, the tax court issued its opinion in favor of the Commissioner, holding that Reserve was not an insurance company for tax purposes and imposing a 30% tax on Reserve's gross receipts. App.Vol.3.p.850-Vol.4.p.915. This appeal followed. App.Vol.4.p.1003-04. The Commissioner did not cross-appeal.

III. Rulings Presented for Review

Reserve challenges the following rulings of the tax court:

1. That Reserve was not an insurance company for tax purposes.

2. That the payments Reserve received as insurance premiums were taxable income, instead of nontaxable capital contributions. App.Vol.3.p.896, Vol.4.p.911, 915.

Summary of Argument

As to both rulings, the tax court misapplied controlling legal principles.

Risk distribution: The tax court erred in holding that, despite the uncontroverted fact that over 30% of Reserve's gross premiums for each of the tax years in issue was derived from providing insurance to unrelated parties through its reinsurance arrangements, Reserve did not distribute risk through these arrangements. The court based its holding that Reserve did not distribute risk on its legal conclusion that PoolRe was not a “bona fide insurance company.” The existence of a bona fide insurance company, however, is not necessary for risk distribution to exist. Indeed, tax law recognizes “insurance” even where no insurance company exists. Moreover, the court misapplied the legal test for risk distribution by focusing on PoolRe, instead of Reserve, and requiring PoolRe be a bona fide insurance company for Reserve to be able to distribute risk through its arrangements with PoolRe. Had the court correctly applied the legal test for risk distribution, the only reasonable conclusion it could have reached under the undisputed facts is that Reserve distributed risk as a matter of law.

Insurance in the Commonly Accepted Sense: The tax court further erred in holding that Reserve's transactions were not insurance in the commonly accepted sense. The court's holding is premised on a patently incorrect reading of Reserve's direct-written policies as providing only excess coverage, and a series of unfounded assumptions about the nature of the insurance business in general and captive insurance in particular. These errors led the court to erroneously hold that Reserve's transactions did not constitute insurance in the commonly accepted sense.

Contributions to Capital: Alternatively, if the tax court correctly determined that Reserve was not an insurance company for tax purposes, the court erred in holding that the payments Reserve received as insurance premiums were taxable income, instead of nontaxable capital contributions to Reserve. Where, as here, the court's rationale for its decision was that there was no legitimate business purpose for the payments, the only viable alternative tax characterization of the payments Reserve received is that they were nontaxable capital contributions.

Argument

I. Standard of Review

This Court reviews the tax court's findings of fact for clear error and conclusions of law de novo. Estate of Holl v. Comm'r, 967 F.2d 1437, 1438 (10th Cir. 1992). This Court also reviews de novo “the standards and tests governing the factual analysis, and the application of the law to the facts,” Shellito v. Comm'r, 437 F. App'x 665, 669 (10th Cir. 2011) (unpublished), and “is not bound by the clearly erroneous standard when the trial court has based its findings on an erroneous view of the law,” Valley Improvement Ass'n v. U.S. Fid. & Guar. Corp., 129 F.3d 1108, 1123 (10th Cir. 1997). The general characterization of a transaction for tax purposes is a question of law. Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978).

II. The Tax Court Erred in Holding that Reserve's Transactions Did Not Constitute Insurance for Tax Purposes.

An “insurance company” is tax-exempt if its gross receipts for the taxable year do not exceed $600,000, and more than half of those receipts consist of insurance premiums. I.R.C. § 501(c)(15). An entity is an “insurance company” if more than half of its business during the taxable year is the issuing of insurance or reinsurance contracts. Id. § 816(a). Reserve's gross receipts did not exceed $600,000 for any tax year in issue, and substantially all of those receipts came from the kinds of transactions at issue here. The central issue in this appeal is whether those transactions constituted “insurance.” If so, Reserve was an insurance company for tax purposes and tax-exempt under I.R.C. § 501(c)(15).

Whether a transaction constitutes insurance is a question of law reviewed de novo. E.g., AMERCO, Inc. v. Comm'r, 979 F.2d 162, 164 (9th Cir. 1992). While the Code does not define “insurance” or “insurance company,” caselaw generally looks to four criteria in deciding whether an arrangement constitutes insurance for tax purposes: (1) the arrangement involves insurable risks; (2) the arrangement shifts the risk of loss to the insurer; (3) the insurer distributes the risks among its policyholders; and (4) the arrangement is insurance in the commonly accepted sense. Helvering v. Le Gierse, 312 U.S. 531, 539-40 (1941); Rent-A-Center, 142 T.C. at 13.

For captive insurers like Reserve, before proceeding to the four-part test to analyze whether the captive insurer's transactions constituted insurance, courts conduct a threshold inquiry to determine whether the captive insurer is a sham. Malone & Hyde v. Comm'r, 62 F.3d 835, 840 (6th Cir. 1995) (“We believe the tax court put the cart before the horse in this case. It should have determined first whether Malone & Hyde [the parent] created Eastland [the captive insurance subsidiary] for a legitimate business purpose or whether the captive was in fact a sham corporation.”). If the captive insurer is a sham, i.e., it was not created for a legitimate business purpose, its separate taxable treatment is disregarded. Moline Props., Inc. v. Comm'r, 319 U.S. 436, 438-39 (1943); Ocean Drilling, 988 F.2d at 1144, 1150. A captive insurer that is a sham cannot be a bona fide insurance company. Rent-A-Center, 142 T.C. at 10 (“[O]ur initial inquiry is whether Legacy was a bona fide insurance company. We respect the separate taxable treatment of a captive unless there is a finding of sham or lack of business purpose.”).

Here, the tax court did not undertake this threshold sham analysis to determine whether Reserve was created for a legitimate business purpose or was in fact a sham. This analytical decision became centrally important later in the court's analysis because it did perform a sham analysis — but of the wrong entity — PoolRe. Instead of proceeding with the threshold sham analysis, the court proceeded directly to the four-part test to analyze whether Reserve's transactions constitute insurance. The court ultimately held that those transactions did not constitute insurance for tax purposes because they did not pass muster under parts (3) and (4) — risk distribution and insurance in the commonly accepted sense. See App.Vol.3.p.896, Vol.4.p.911. The court's analysis of both factors, however, misapplied controlling legal principles, thereby leading to reversible error.

A. The Tax Court Erroneously Held that Reserve Did Not Distribute Risk.

1. How Courts Define Risk Distribution.

In Le Gierse, the Supreme Court, addressing the meaning of the term “insurance” under the federal estate tax laws, stated that historically and commonly insurance involves risk-distributing, 312 U.S. at 539-40, but did not define “risk-distributing,” leaving lower courts to develop their own interpretations of the term, Ocean Drilling, 988 F.2d at 1144. For its part, this Court has defined “risk-distributing” as follows: “'risk distributing' means that the party assuming the risk distributes his potential liability, in part, among others.” Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986). This Court, however, has not squarely discussed the issue of risk distribution in the captive insurance context. Rather, in the two occasions that captive insurance issues have come before this Court, both were disposed of on other grounds, without analyzing risk distribution. Id. at 922-23 (disposing of case based on risk-shifting); Stearns-Roger Corp. v. United States, 774 F.2d 414, 415 (10th Cir. 1985) (same). Those cases are thus not instructive here, and this Court must look to decisions of other courts for guidance.

Like this Court, other courts have defined risk distribution as “spreading the risk of loss among policyholders.” E.g., Ocean Drilling, 988 F.2d at 1153. Courts have held that “[r]isk 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).” Rent-A-Center, 142 T.C. at 24. “[A]s the size of the pool increases the law of large numbers takes over, and the ratio of actual to expected loss converges on one. The absolute size of the expected variance increases, but the ratio decreases.” Sears, Roebuck & Co. v. Comm'r, 972 F.2d 858, 863 (7th Cir. 1992). The pooling transforms and diminishes risk. Id. The pooling of exposures thus brings about the risk distribution. Securitas, 108 T.C.M. (CCH) 490, at *10. “Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as a premium and set aside for the payment of the claim.” R.V.I. Guar. Co. v. Comm'r, 145 T.C. 209, 228 (2015).

Here, the tax court held that Reserve's transactions did not constitute insurance because they did not allow Reserve to effectively distribute risk. The court's holding was premised on its legal conclusion that PoolRe was not a bona fide insurance company. This Court reviews de novo the tax court's legal conclusions and the legal standard the tax court applied in reaching its conclusions. See Shellito, 437 F. App'x at 669; AMERCO, 979 F.2d at 164; James v. Comm'r, 899 F.2d 905, 909 (10th Cir. 1990).

In evaluating risk distribution, courts look at the actions of the insurer — not the insured — because it is the insurer's risk that is reduced by risk distribution. Rent-A-Center, 142 T.C. at 24. Because “risk-distribution looks at the transaction from the standpoint of the insurer,” AMERCO, 979 F.2d at 169, “[t]he focus is broader and looks more to the insurer as to whether the risk insured against can be distributed over a larger group rather than the relationship between the insurer and any single insured.” Humana, Inc. v. Comm'r, 881 F.2d 247, 256 (6th Cir. 1989).

While the arrangements at issue here concern reinsurance rather than direct insurance, the focus of the risk distribution analysis remains the same. See, e.g., Ocean Drilling, 988 F.2d at 1153 n.25 (“Direct insurance and reinsurance are both considered insurance.”). Even the Commissioner agrees that “[c]ourts have generally analogized reinsurance to insurance.” Rev. Rul. 2009-26, 2009-38 I.R.B. 366. Thus, risk distribution, in either context, is analyzed in the same manner, i.e., from the insurer's perspective and by looking solely to the pool of risks assumed by the insurer. See Humana, 881 F.2d at 256-57; Sears, 972 F.2d at 861. Accordingly, as the Commissioner himself acknowledges, in the context of captive insurance, courts have looked through a fronting arrangement to the pool of risks a captive reinsured in analyzing whether risk distribution exists. Rev. Rul. 2009-26, 2009-38 I.R.B. 366. A “fronting arrangement” is a well-established and accepted arrangement in which policies are issued by a direct insurer that serves as a “front” or “fronting company” for a reinsurer that reinsures 100% of the risks. Staring & Hansell, supra, § 2.10 (defining “fronting contract” as “a reinsurance of 100 percent, in which the direct insurer is a 'front' for the reinsurer.”); see also Reliance Ins. Co. v. Shriver, Inc., 224 F.3d 641, 643 (7th Cir. 2000).

In Harper, the tax court considered the percentage of the captive insurer's gross premiums that was derived from unrelated insurance business for purposes of analyzing risk distribution and determined that the captive insurer had “a sufficient pool of insureds to provide risk distribution” when approximately 30% of its business came from insuring unrelated parties. 96 T.C. at 59-60. Reserve exceeded the Harper threshold for risk distribution, receiving more than 30% of its gross premiums was derived from Reserve's unrelated insurance business through its quota share and coinsurance arrangements. App.Vol.3.p.885-87, Vol.13.p.3716-18, 3725-26.

2. The Tax Court Misapplied the Legal Test for Risk Distribution, Relying on Avrahami Instead.

In analyzing whether Reserve distributed risk, the tax court failed to apply the well-established precedents set forth just above. Relying instead on Avrahami v. Commissioner, 149 T.C. 144 (2017), the court stated that “[i]n cases where we held that the captive insurer achieved risk distribution by insuring a sufficient number of unrelated parties, we also determined that the transactions with the unrelated parties were insurance transactions for Federal income tax purposes.” App.Vol.3.p.887. According to the court, this meant that “before we can determine whether Reserve effectively distributed risk through these agreements, we must determine whether PoolRe was a bona fide insurance company.” Id. (emphasis added). The court then set out Avrahami's multi-part test for a bona fide insurance company, concluded that PoolRe did not qualify, and held that Reserve's reinsurance arrangements with PoolRe did not allow Reserve to effectively distribute risk. App.Vol.3.p.887-97.

In relying on Avrahami, the tax court misapplied the legal test for analyzing risk distribution and committed error, which this Court reviews de novo. See Shellito, 437 F. App'x at 669; AMERCO, 979 F.2d at 164.

i. Risk distribution does not require the existence of a bona fide insurance company.

Before Avrahami, no court had held that a captive insurer can achieve risk distribution by reinsuring an unrelated party only if the unrelated party itself is a bona fide insurance company. Even the authorities on which Avrahami relied in fashioning this novel approach lend no support. Harper based risk distribution on the percentage of gross premiums paid by unrelated insureds versus the percentage paid by related companies; risk distribution occurred where the unrelated premiums ranged from 29% to 33% of the captive insurer's total business. 979 F.2d at 1342. In AMERCO, 52% to 74% sufficed to achieve risk distribution. 979 F.2d at 164. And in Rent-A-Center, the captive insurer assumed and pooled only premiums of affiliates for “a sufficient number of statistically independent risks” and achieved risk distribution because it issued policies for its affiliates that covered more than 14,000 employees, 7,100 vehicles and 2,600 stores in all 50 States. 142 T.C. at 24. None of the foregoing cases involved a captive insurer that acted as a reinsurer.

The reason why Avrahami stands alone is apparent: the existence of a bona fide insurance company is not necessary for risk distribution to exist. To the contrary, Avrahami's approach to risk distribution conflicts with well-established caselaw recognizing insurance for federal tax purposes even where no insurance company exists.5 E.g., Ross v. Odom, 401 F.2d 464, 465-70 (5th Cir. 1968); Comm'r v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950).

Treganowan is particularly illustrative. In that case, pursuant to the New York Stock Exchange's (“NYSE”) constitution, NYSE members made an initial payment to a death-benefit fund and again contributed that same amount when any member died. 183 F.2d at 289-90. In addition to these pooled payments, the NYSE allocated one-half its profits over $10,000 to the fund. Id. These two sums, along with excess payments and accumulated interest, made up the NYSE's “gratuity fund,” from which the fund's trustees paid a member's estate a substantial death benefit. Id.

The Second Circuit held that the arrangement at issue not only shifted “the risk of loss from premature death” to the other members of the NYSE, but it also manifestly distributed risk. Id. at 291. According to the court, “[r]isk distribution . . . emphasizes the broader, social aspect of insurance as a method of dispelling the danger of a potential loss by spreading its costs throughout a group,” and because of this arrangement, “the risk of premature death is borne by the 1373 other members of the [NYSE], rather than by the individual.” Id. “By diffusing the risks through a mass of separate risk shifting contracts, the insurer cast his lot with the law of averages. The process of risk distribution, therefore, is the very essence of insurance.” Id. (citation and internal quotation marks omitted). Given its substance, the arrangement qualified as insurance. The fact that the NYSE was not an insurance company did not affect the court's conclusion that the arrangement was insurance, let alone the court's analysis of whether the arrangement distributed risk.6

Similarly, in Ross, the Fifth Circuit, citing Treganowan, recognized that insurance can arise in the absence of an insurance company in holding that a death benefit paid by the State of Georgia to a state employee's beneficiary “constituted proceeds of 'a life insurance contract' under [I.R.C.] § 101(a)(1) and were thus wholly tax exempt.” 401 F.2d at 465-67. The Fifth Circuit further recognized that insurance can arise even in the absence of an insurance contract. Id. at 467-68 (stating that the insurance agreement need not be in the form of the standard life insurance contract or in the form of a contract at all). Rather, according to the Fifth Circuit, insurance “historically” turns on “the presence in a binding arrangement of risk-shifting and risk distribution,” both of which existed in Ross, even though no insurance company or insurance contract existed. Id.

In recognizing insurance, Treganowan and Ross focused not on a transaction's form, but on its economic realities because, as the Fifth Circuit noted, looking through form to substance is the cornerstone of sound taxation, for tax law deals in economic realities, not legal abstractions. Ross, 401 F.2d at 468; see also Haynes v. United States, 353 U.S. 81, 83-85 (1957); Weinert's Estate v. Comm'r, 294 F.2d 750, 755 (5th Cir. 1961); cf. Epmeier v. United States, 199 F.2d 508, 511 (7th Cir. 1952) (“[T]here is no legal magic in form; the essence of the arrangement must determine its legal character.”).

Unlike the well-established caselaw emphasizing the importance of adhering to this fundamental principle, Avrahami ignored it. Even more troubling, however, is that Avrahami's approach to risk distribution would produce contradictory and untenable results depending on whether the insurance recognized in these cases was reinsured by a captive insurer, like Reserve. For example, if Reserve reinsured the insurance recognized in Treganowan and more than 30% of Reserve's gross premiums were from such unrelated business, the risk distribution analysis would not end there. Rather, according to Avrahami, before the Court could determine whether Reserve distributed risk through such reinsurance, the Court must first decide if the NYSE itself is a bona fide insurance company because, if it is not, the insurance recognized in Treganowan would no longer be insurance for tax purposes and Reserve's reinsurance of same would not distribute risk. As such, because the NYSE is not a bona fide insurance company, Reserve's reinsurance of the insurance recognized in Treganowan would not be recognized as insurance for tax purposes. Avrahami's approach to risk distribution is fundamentally flawed, and the tax court erred as a matter of law by adopting and applying that approach here.

ii. The tax court erroneously focused its risk distribution analysis on PoolRe, instead of Reserve.

Because risk distribution is analyzed from the perspective of the insurer, the tax court should have focused on Reserve, as “the party assuming the risk.” See Humana, 881 F.2d at 256; Rent-A-Center, 142 T.C. at 24. Instead, relying on Avrahami, the court focused on PoolRe and thereby misapplied the legal test for risk distribution and disregarded the rationale for the risk distribution test itself. App.Vol.3.p.887-88. Compounding this error, the tax court, again relying on Avrahami, subjected PoolRe to a multi-part test to determine whether PoolRe was a bona fide insurance company. Id.

Neither here nor in Avrahami did the tax court explain its approach. Nor can any explanation be found in Rent-A-Center, from which Avrahami purportedly adopted this novel approach, including the “bona fide insurance company” nomenclature. In fact, Rent-A-Center did not discuss this test in connection with risk distribution or a reinsurance arrangement at all. Rather, Rent-A-Center considered it while conducting the ordinary threshold inquiry in captive insurance tax cases: whether the separate corporate existence of the captive insurance company should be respected for tax purposes or should be disregarded as a sham. 142 T.C. at 10. Rent-A-Center described this threshold issue as whether Legacy, the captive insurer involved in that case, was a “bona fide insurance company.” Id. The tax court conducted no such inquiry here as to Reserve.

It is beyond dispute that PoolRe was owned and controlled by an unrelated individual and thus was not a captive insurer with respect to Reserve or the Direct Insureds. App.Vol.5.p.1424. Rather, PoolRe was an independent entity that entered into binding agreements imposing genuine obligations with, at minimum, Reserve and the Direct Insureds, the other captive insurers participating in the risk pool and their affiliated insureds, and CreditRe. App.Vol.11.p.3250-77, Vol.12.p.3389-410, 3522-51, 3713. These agreements were inherently arm's-length agreements because the contracting parties were unrelated. See United Parcel Serv. of Am., Inc. v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001) (“The kind of “economic effects” required to entitle a transaction to respect in taxation include the creation of genuine obligations enforceable by an unrelated party.”).

It is also beyond dispute that, as part of Reserve's reinsurance arrangements, both of which were treaty arrangements, Reserve was bound to automatically accept all of the policies and losses covered thereby and thus would not have examined risks, investigated claims, or even received notices of losses from the original insureds. App.Vol.5.p.1428-29, Vol.11.p.3250-60, Vol.12.p.3389-400, 3522-33. The tax court's criticism of Reserve for not providing evidence of the existence of the thousands of vehicle service contracts reinsured under the coinsurance arrangements and the “industries, locations, operations, types of risks and exposure to risk” of all the “other Capstone entities” in the quota share arrangements, App.Vol.3.p.891, is thus misplaced and ignores not only the evidence in the record but also the rationale behind treaty reinsurance. App.Vol.4.1190-94, Vol. 9. p. 2470, Vol. 13. p. 3713-26. Indeed, if a reinsurer were required to duplicate the costly but necessary efforts of a primary insurer in evaluating risks and handling claims, reinsurance simply would not work because it would not be economical to place and administer. Unigard, 4 F.3d at 1054.

There is no precedent for focusing on PoolRe, instead of Reserve, let alone for focusing on whether PoolRe, instead of Reserve, is a bona fide insurance company in evaluating whether Reserve achieved risk distribution by insuring a sufficient number of unrelated parties.7 To the contrary, the caselaw dictates that, in evaluating whether a transaction between two companies resulted in risk shifting and risk distributing, the entities must be considered as separate entities. E.g., Ocean Drilling, 988 F.2d at 1151 (“This court must adhere to the principles of Le Gierse and Moline Properties in reaching a decision. Plaintiff and Mentor must be considered as separate entities in evaluating whether the transactions between the two companies resulted in risk shifting and risk distributing.”).

3. When analyzed under the correct legal test, the undisputed facts show that Reserve distributed risk as a matter of law.

Due to the quota share and coinsurance premiums that Reserve received under its reinsurance arrangements, more than 30% of its gross premiums received during each tax year in issue was derived from Reserve's unrelated insurance business (i.e., insurance outside Reserve's captive insurance arrangement with its sister companies, the Direct Insureds). App.Vol.9.p.2467, Vol.13.p.3713-14, Vol.18.p.5380. Reserve thus exceeded the Harper threshold for risk distribution. Had the tax court here correctly applied the legal test for risk distribution, the only reasonable conclusion it could have reached under the undisputed facts is that Reserve distributed risk as a matter of law.

B. The Tax Court Erroneously Held that Reserve's Transactions Were Not Insurance in the Commonly Accepted Sense.

As an alternative ground for its holding that Reserve's transactions did not constitute insurance for tax purposes, the tax court determined that Reserve's transactions were not insurance in the commonly accepted sense after analyzing whether (1) Reserve was organized, regulated and operated as an insurance company, (2) Reserve was adequately capitalized, (3) Reserve's policies were valid and binding, (4) Reserve's premiums were reasonable and negotiated at arm's length, and (5) Reserve paid claims. See, e.g., Rent-A-Center, 142 T.C. at 24. While the court found parts (2) and (5) in Reserve's favor and part (3) as a neutral factor, the tax court held that Reserve failed parts (1) and (4) of this test, concluding that Reserve charged unreasonable premiums and was not operated like an insurance company.

In concluding that Reserve failed parts (1) and (4), the tax court relied on a patently incorrect reading of Reserve's direct-written policies. Reserve's policies provided primary coverage whenever no other policy covered the loss, which, for Reserve's Direct Insureds, was always the case. The court misread the policies, however, as providing only excess insurance — i.e., insurance that applies only after coverage afforded by one or more primary policies is exhausted. The court also relied on a series of unfounded assumptions about the nature of the insurance business in general and captive insurance in particular. As shown below, these errors led the tax court to erroneously hold that Reserve's transactions did not constitute insurance in the commonly accepted sense.

1. The Tax Court Misread Reserve's Direct-Written Policies as Providing Only Excess Coverage.

The interpretation of the terms of insurance policies, like other contracts, is a question of law that this Court reviews de novo, under applicable law. Level 3 Commc'ns, LLC v. Liebert Corp., 535 F.3d 1146, 1154 (10th Cir. 2008); Valley Improvement, 129 F.3d at 1115. Reserve's direct-written policies designated Texas law as the law governing their interpretation. App.Vol.19.p.5681, 5696.

The tax court misinterpreted Reserve's insurance policies as providing excess insurance coverage rather than primary coverage based on its reading of the “other insurance” clauses of Reserve's direct-written policies. App.Vol.3.p.863, Vol.4.p.909, Vol.20.p.5703-04, 5730. Under a primary policy, Reserve's liability as an insurer attaches as soon as a covered loss occurs. Nat'l Union Fire Ins. Co. v. Ins. Co. of N. Am., 955 S.W.2d 120, 138 (Tex. App. - Houston [14th Dist.] 1997, pet. denied), aff'd sub nom. Keck, Mahin & Cate v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., 20 S.W.3d 692 (Tex. 2000). An excess policy, on the other hand, makes the excess carrier liable for amounts above and beyond that which an insured may collect on primary insurance. Id. Given this layered coverage, an insured must exhaust the primary policy's coverage to trigger the excess policy. Id.

The tax court based this misunderstanding on its reading of the first paragraph of a two-paragraph “other insurance” clause, specifically:

THE COVERAGES AFFORDED BY THIS POLICY ARE EXCESS OVER ANY OTHER VALID AND COLLECTIBLE INSURANCE POLICY ISSUED BY ANY OTHER INSURER * * *. THE LIMITS AND DEDUCTIBLES STATED HEREIN ONLY APPLY AFTER COVERAGE IS EXHAUSTED FROM ANY AND ALL OTHER VALID INSURANCE POLICIES ISSUED BY ANY OTHER INSURER. 

App.Vol.3.p.863. Making matters worse, the tax court ignored the language in the second paragraph entirely, focusing instead on the first paragraph only. In doing so, the tax court impermissibly isolated a single section of the policy from the whole, thereby taking the “other insurance” clause out of context. See RSUI Indem. Co. v. The Lynd Co., 466 S.W.3d 113, 118 (Tex. 2015). The operative word “collectible” vanishes from the text. Id.

The second paragraph (i.e., the one not cited by the tax court) states: 

THIS EXCESS POLICY DOES NOT REQUIRE THE INSURED TO MAINTAIN ANY SPECIFIC UNDERLYING PRIMARY INSURANCE POLICIES UNLESS SPECIFIED BY ENDORSEMENT TO THIS POLICY. THE COVERAGES AFFORDED HEREIN WILL DROP DOWN AND PROVIDE PRIMARY COVERAGE ONLY IF THERE ARE NO OTHER VALID AND COLLECTIBLE INSURANCE POLICIES IN FORCE TO WHICH A CLAIM WOULD APPLY.

E.g., App.Vol.20.p.5703-04, 5730 (emphasis added). Reading the first paragraph with the second, i.e., taking the “other insurance” clause as a whole, makes the plain meaning of the clause clear. When read as a whole, it is obvious that Reserve's policies provide primary coverage when no other valid and collectible insurance policies cover the same claim.

To classify Reserve's policies as primary rather than excess accords with Texas law governing “other insurance” clauses. The “type of loss” itself, not the “other insurance” clause, determines whether a policy affords primary or excess coverage. Soc'y of Prof'ls in Dispute Resolution, Inc. v. Mt. Airy Ins. Co., Civ. Action No. 3:97–CV–0071–D, 1997 WL 711446, at *3 (N.D. Tex. Nov. 7, 1997) (unpublished). Moreover, the mere presence of another policy does not trigger the “other insurance” clause in Reserve's policies. United Nat'l Ins. Co. v. Mundell Terminal Servs., Inc., 740 F.3d 1022, 1028-31 (5th Cir. 2014); Mt. Airy Ins., 1997 WL 711446, at *3. “Under Texas law, the provisions of an 'other insurance' clause apply only when the 'other' insurance covers the same property and interest therein against the same risk in favor of the same party.” Mundell Terminal Servs., 740 F.3d at 1028 (omitting quotation).

None of Peak's commercial insurance policies covered the same risk of loss as Reserve's direct-written policies did. App.Vol.12.p.3570-88. Where, as here, Peak's commercial insurance policies and Reserve's policies covered different risks, the “other insurance” clause in Reserve's policies did not apply so that Reserve's policies provided primary, rather than excess, coverage. Cigna Lloyds Ins. Co. v. Kamins, 924 S.W.2d 206, 210 (Tex. App. - Eastland 1996, no writ). For example, if there were a release of pollutants and the EPA sued Peak for violating CERCLA, the loss would not be covered by any of Peak's commercial policies. Peak would present its claim directly to Reserve, which would be the primary insurer under the policy language. Here, Peak submitted and Reserve paid a claim for Peak's loss of a major customer, a loss that Peak's commercial policies undisputedly did not cover. App.Vol.12.p.3552-59.

The tax court recognized that Peak's commercial insurance policies and Reserve's policies did not cover the same risks: “Reserve's policies covered only losses that were not covered by Peak's third-party policies.” App.Vol.4.p.905. The tax court nonetheless erroneously construed the “other insurance” clause in Reserve's policies as requiring Peak to exhaust the limits of its commercial policies before Reserve's policies would pay any covered claim: “All the direct written policies included a provision that the coverage afforded by the policy would be valid only after insurance coverage from other insurers was exhausted. Peak had never come close to exhausting the policy limits of its third-party commercial insurance coverage.” App.Vol.4.p.909. In this way, the tax court effectively converted Peak's commercial insurance policies into “other collectible policies” and Reserve's policies into excess policies without regard for whether the policies provided the same coverage. Royal Indem. Co. v. Marshall, 388 S.W.2d 176, 181 (Tex. 1965) (“Courts cannot make new contracts between the parties, but must enforce the contracts as written.”). The tax court misconstrued and misapplied the “other insurance” clause as a matter of law. See Hartford Cas. Ins. Co. v. Exec. Risk Specialty Ins. Co., No. 05-03-00546-CV, 2004 WL 2404382, at *2 (Tex. App. - Dallas Oct. 28, 2004, pet. denied) (mem. op.); State Farm Fire & Cas. Co. v. Griffin, 888 S.W.2d 150, 155 (Tex. App. - Houston [1st Dist.] 1994, no writ).

2. Relying on its Misreading of Reserve's Direct-Written Policies, the Tax Court Erroneously Determined that Reserve's Premiums Were Unreasonable and Not Negotiated at Arm's Length.

By misinterpreting and mischaracterizing Reserve's policies as excess insurance, the tax court inevitably found that (1) Reserve's premiums were unreasonable and not negotiated at arm's length, (2) there was no “real business purpose” for Reserve's policies, and (3) Peak lacked “a genuine need for acquiring additional insurance.” App.Vol.4.p.909-11. The tax court viewed the economic realities as rendering the coverage illusory: “no unrelated party would reasonably agree to pay Reserve the premiums that Peak and the other insureds did for the coverage provided by the direct written policies.” App.Vol.4.p.910. The tax court's misapprehension of Reserve's premiums flowed directly from its misreading of Reserve's policies, which constitutes an error of law this Court reviews de novo.

Here, Reserve's premiums were calculated using actuarial methods and objective criteria by Capstone and Mid-Continent, a large, well-respected insurance brokerage firm. App.Vol.2.p.480, Vol.5.p.1209-10, 1374, Vol.12.p.3560-61, Vol.13.p.3770-72. At trial, two actuaries provided uncontroverted testimony validating Reserve's premiums as reasonable. App. Vol. 13. p. 3779-865, 3885-Vol. 18. p. 5329; see also Securitas, 108 T.C.M. (CCH) 490, at *10 (holding that premiums were “reviewed by outside actuaries and determined to be within the range of reasonable premiums”); Crawford Fitting, 606 F. Supp. at 139, 147 (holding that premiums charged based on recommendations from experienced actuaries were “proportionate to the risks they covered”).

The tax court, despite recognizing that “Capstone calculated Reserve's premiums using objective criteria and what appear to be actuarial methods,” nonetheless determined that “the absence of a real business purpose for Reserve's policies leads us to conclude that the premiums paid for the polic[i]es were not reasonable and not negotiated at arm's length.” App.Vol.4.p.910. The tax court reached this conclusion only by mistaking Reserve's primary policies for excess policies in derogation of Texas law. Pointing to the absence of a significant history of losses for Peak, the tax court further suggested that this factor somehow undermined the reasonableness of Reserve's premiums. App.Vol.3.p.856, Vol.4.p.909.

The tax court's flawed reasoning however is akin to saying that automobile insurance is unnecessary for drivers who have not yet had an accident, or that fire insurance is unnecessary for homeowners who have never had their homes burned down. From an insurance standpoint, there is no risk unless there is uncertainty or fortuitousness; it may be uncertain whether the risk will materialize in any particular case. Treganowan, 183 F.2d at 290. Accordingly, a history of no losses is no guarantee that Peak will not suffer losses in the future. See United Parcel Serv., 254 F.3d at 1018.

It is undisputed that Reserve's policies provided coverages for which loss data was not readily available to forecast potential losses. App.Vol.3.p.620, Vol.5.p.1256, 1294, Vol.12.p.3560-61. In the insurance industry, policies are regularly written without readily available loss data to forecast losses. App.Vol.5.p.1294, Vol.6.p.1501, 1574-75, Vol.20.p.5712. Furthermore, common insurance practices require no previous loss history for a captive to cover an insurable risk. App.Vol.4.1192-95, Vol.13.p.3763-64; see also Captive Insurance Companies Association (“CICA”), Commercial Ins. & Captive Ins. Indus.: Commonly Accepted Practices at 9-10 (Jan. 31, 2019), https://www.cicaworld.com/docs/default-source/default-document-library/cica_commonly_accepted_insurance_practices_risk_pools_jan2019.pdf?sfvrsn=0. A valid insurance policy only needs to cover risk of loss arising from a random, uncertain, or “fortuitous event.” Treganowan, 183 F.2d at 290-91; R.V.I. Guar., 145 T.C. at 232-33.

Here, Peak's owners explained why Reserve was formed and why Reserve's direct-written policies were needed. App.Vol.4.p.1117-25. Reserve was formed and issued direct-written policies to Peak because the commercial policies Peak had in place left several coverage gaps for risks Peak faced and such coverage was either too costly or otherwise unavailable in the commercial marketplace. App.Vol.7.p.2027-95; see, e.g., Crawford Fitting, 606 F. Supp. at 147 (concluding brother-sister captive insurance arrangement that provided insurance for plaintiff that was unavailable or available only at higher rates had legitimate business purpose).

The tax court criticized Peak for maintaining its full set of third-party commercial coverage even after paying for additional coverage from Reserve. App.Vol.4.p.907. This criticism presumes that Reserve's insureds should have discontinued all third-party commercial coverage after purchasing coverage from Reserve. The tax court's criticism is misplaced because Peak's commercial insurance policies and Reserve's policies did not cover the same risks. App.Vol.7.p.2031-32, 2047-50, Vol.12.p.3570-88. Industry practice, especially for captive insurance, often sees companies that transition to captive insurance keep their commercial insurance coverage in place. App.Vol.4.1194-95; see also CICA, supra, at 8-9. The captive insurance in turn functions as a “risk financing vehicle” for previously self-insured risks. CICA, supra, at 8. Captive insurers fill in coverage gaps and write specialized insurance the market avoids or overprices. Ocean Drilling, 988 F.2d at 1138; Crawford Fitting, 606 F. Supp. at 147; Rent-A-Ctr., 142 T.C. at 3-4; Securitas, 108 T.C.M. (CCH) 490, at *3.

The tax court's erroneous determination that the premiums for Reserve's direct-written policies were unreasonable and not negotiated at arm's length was based on its incorrect reading of Reserve's direct-written policies as providing only excess coverage. As such, this determination should be reversed.

3. Relying on Unfounded Assumptions, the Tax Court Erroneously Determined that Reserve Was Not Operated Like an Insurance Company Because It Was Managed by Hired Professionals.

To support its determination that Reserve not operated like an insurance company, the tax court considered it important that Capstone managed Reserve's planning, incorporation, and operations during the tax years in issue and that Reserve lacked employees of its own who performed those services. App.Vol.3.p.899-Vol.4.p.902. The tax court also criticized Zumbaum's inability to recite chapter and verse concerning Reserve's operations and the policies that it had issued. App.Vol.3.p.899-Vol.4.p.901. Although Reserve was incorporated in Anguilla, the tax court determined that “there is no evidence that any activities were ever performed there.” Id. According to the tax court, Reserve performed little or no due diligence regarding its insurance and reinsurance policies. App.Vol.4.p.900-01. The tax court further faulted the documentation supporting the claim that Reserve paid during the tax years in issue. Id.

None of the foregoing, however, supports the tax court's determination that Reserve was not operated as an insurance company. Rather, they reveal the tax court's unfounded assumptions about the nature of the insurance business in general and captive insurance in particular.

First, the tax court overlooked existing caselaw recognizing that most captive insurance companies operate without any employees and routinely delegate operational functions, financial reporting, regulatory compliance and day-to-day tasks to captive managers. See, e.g., United States v. Lequire, 672 F.3d 724, 726 (9th Cir. 2012); Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42, 51-53 (1997); Rent-A-Center, 142 T.C. at 24-25, 30; Gulf Oil Corp. v. Comm'r, 89 T.C. 1010, 1013-14 (1987) (where Marsh & McLennan provided underwriting, rating, claims, reinsurance, record keeping, banking and checking services for a captive's operations), aff'd, 914 F.2d 396 (3d Cir. 1990); Securitas, 108 T.C.M. (CCH) 490, at *1, 10-11. Even the Commissioner concedes this point in his published rulings. See Rev. Rul. 2002-89, 2002-2 C.B. 984. Third-party “captive management firms” administer nearly all captives, including most captives of Fortune 500 companies. CICA, supra, at 9.

Zumbaum's inability to recite details concerning Reserve's operations and the contents of its insurance policies provides no support for the tax court's conclusion that Reserve was not operated as an insurance company. Reserve retained professional management partly so that Peak's principals would not be burdened with the details of managing a small insurance company. Where, as here, Reserve was new to the insurance business, it is only reasonable that Reserve's principals would retain and rely on hired professionals. See Kidde, 40 Fed. Cl. at 53 (“As to KIC 'contracting out' most typical insurance functions, it would not seem unreasonable for KIC to do so when KIC first entered the insurance business. Through such contracts, a new entrant into the industry could eliminate uncertainty as to the cost of performing certain services and thereby secure greater predictability as to its operational costs.”). It is therefore meaningless that one of Reserve's principals could not recall details about the very subjects that he had hired professionals to handle.

The tax court also seemed to be searching for activities that Reserve conducted in Anguilla. But neither the tax court nor the Commissioner identified any activities that Reserve should have but failed to perform in Anguilla, especially in view of Reserve's having hired industry professionals to handle such activities to Capstone. Notably, the Commissioner's position herein that Reserve's transactions were not insurance in the commonly accepted sense was inconsistent with his position espoused in the 39 private letter rulings issued to 39 similarly situated captive insurance companies that were administered by Capstone. Indeed, the Commissioner had favorably ruled that such companies were insurance companies, specifically noting that the elements of risk distribution and commonly accepted notions of insurance were satisfied.8

Capstone was instrumental in performing the due diligence regarding Reserve's policies and reinsurance policies. App.Vol.4.p.1079-80, 1090, 1125, Vol.5.p.1206-08. The tax court agreed that the feasibility study assessing whether a captive insurance company could be formed addressed many of the due diligence issues. App.Vol.3.p.898. Capstone, together with the assistance of Mid-Continent and independent actuaries, was also involved in setting the premiums under the policies that were issued by the captive insurance companies that Capstone administered and that participated in the PoolRe risk pool. App.Vol.5.p.1209-10, 1236–466. The tax court's opinion does not suggest what additional due diligence should have been conducted by or for Reserve.

The tax court's conclusion that Reserve was not operated as an insurance company was erroneous as a matter of law.

III. Alternatively, if the Tax Court Is Correct that Amounts Received as Premiums Were Not for Insurance, the Tax Court Erred in Holding that Such Amounts Constituted Taxable Income to Reserve, Instead of Nontaxable Capital Contributions.

As an insurance company, Reserve's income would be exempt from taxation because its gross receipts were less than $600,000. I.R.C. § 501(c)(15). The tax court held, however, that Reserve had not emonstrated that the amounts that Reserve received as premiums were not “fixed or determinable annual or periodical” income (“FDAP income”) from sources within the United States that are subject to the 30% tax under I.R.C. § 881.

If this Court affirms the tax court's holding that Reserve was not an insurance company for tax purposes, this Court should reverse the tax court's determination that amounts received as insurance premiums constituted taxable income and render a decision that such amounts constituted nontaxable contributions to capital. This issue of whether the payments Reserve received qualify as taxable income under I.R.C. § 881(a) or nontaxable capital contributions under I.R.C. § 118(a) is subject to de novo review. Twenty Mile Joint Venture, PND, Ltd., v. Comm'r, 200 F.3d 1268, 1275 (10th Cir. 1999); Scanlon White, Inc. v. Comm'r, 472 F.3d 1173, 1175 (10th Cir. 2006).

Although the tax court determined that “Reserve was organized and regulated as an insurance company, and it satisfied the regulatory requirements of the domicile jurisdiction,” the tax court also determined that Reserve “was not operated as a bona fide insurance company”; Reserve's premiums were unreasonable and not negotiated at arm's length because “there was no legitimate business purpose for the policies that Reserve issued for the insureds”; “the only purpose PoolRe served through the quota share arrangement was to shift income from Peak to Reserve”; and “Reserve had not established that PoolRe was created or operated for legitimate nontax reasons.” App.Vol.3.p.894, Vol.4.p.911 (emphasis added).

Zumbaum and Weikel were the ultimate owners of Reserve and the Direct Insureds, which they owned directly or indirectly in equal shares. App.Vol.7.p.2047, Vol.18.p.5373. After concluding that there was no legitimate nontax reason for the policies Reserve issued and the payments Reserve received as premiums, the tax court determined that Reserve had not shown that the payments were otherwise nontaxable to Reserve. App.Vol.4.p.914.

The tax court's determination that there was no legitimate non-tax reason for Reserve's receipt of the payments is dispositive of the issue of the characterization of the amounts received from the perspective of Reserve. As discussed further below, the payments could not constitute payments in return for services provided by Reserve to the Direct Insureds, a loan of funds from them to Reserve or a deposit arrangement between the Direct Insureds and Reserve because these arrangements would have some legitimate non-tax purpose associated with such arrangements. The tax court's determination that there was no legitimate business purpose for such payments negates any such characterizations.

In evaluating whether the payments constituted nontaxable capital contributions to Reserve, the tax court noted that the issue turned on whether the parties to the insurance transactions treated or intended the payments to be contributions to capital. App.Vol.4.p.914. None of the cases the tax court cited, however, concluded the relevant analysis after determining the intent of the taxpayer involved. Indeed, in Board of Trade v. Commissioner, 106 T.C. 369 (1996), the tax court specifically found that none of the persons who contributed funds to the Board of Trade actually testified that the amounts at issue were intended to be contributions to capital, noting that “[d]irect proof of the motive of the payor is rarely available.” Id. at 391. Instead, the analysis evaluated the facts and circumstances surrounding the financial transactions at issue to determine the transaction's proper character. Thus, the court in that case correctly considered the transaction's substance and economic realities.

Here, however, the tax court actually conducted no analysis and did not appear to consider the analysis that it conducted to evaluate whether the payments were insurance premiums. Had the tax court done so, the only conclusion that it could have reached was that the amounts constituted nontaxable contributions to capital to Reserve, not taxable income.

The testimony and other evidence Reserve presented established that the payments made under the policies at issue were insurance premiums. App.Vol.4.p.1237-38, Vol.13.p.3701-26. The tax court rejected this evidence, finding that there was no legitimate nontax reason for the payments to have been made to Reserve. Thus, the tax court determined that the payments made by the insureds were not supported by adequate consideration Reserve provided. Indeed, the tax court's broad determination that there was no legitimate nontax reason for the payments to have been made negates the provision of anything in return from Reserve, as this would be inconsistent with the tax court's conclusion that there was no legitimate nontax reason for the payments. The Commissioner agrees that “[w]here property is transferred from one affiliate” (i.e., the insureds here) “to a sister corporation without adequate consideration therefor, there is a constructive distribution to the common parent whether or not the motive for the transfer was an attempt improperly to allocate income or deductions between the corporations.”

Rev. Rul. 78-83, 1978-1 C.B. 9; see Comm'r v. Greenspun, 156 F.2d 917, 921 (5th Cir. 1946) (finding a constructive distribution from the sister corporation to the common shareholder and contribution to capital of the brother corporation); Rev. Rul. 69-630, 1969-2 C.B. 112. Because the funds in this situation are found in the sister corporation (i.e., Reserve), there is a deemed contribution of the funds from the common parent (i.e., Zumbaum and Weikel through Reserve's parent, Peak Casualty) to the sister corporation. See Boris I. Bittker & James S. Eustice, Fed. Income Tax'n of Corps. & Shareholders ¶¶ 8.06[10] (2020 ed.); Rev. Rul. 2005-40, 2005-2 C.B. 4.9

In Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir.), an unrelated company insured Carnation, which also formed a captive reinsurer in Bermuda. Id. at 1012. The original insurer reinsured 90% of its risk with the offshore captive, retaining 10% of the liability. Id. Carnation paid all premiums to the original insurer, which insisted that Carnation further capitalie the reinsurer by almost $2.9 million on demand. Id. at 1012-13. By agreeing to this condition, the tax court held that Carnation retained the ceded risk, and there was no risk shifting and no insurance. Id.

The Commissioner “determined the 90% premium ceded to [the captive] was not deductible as a business expense” and claimed Carnation owed a deficiency. Id. at 1012. Unlike in this case, the Commissioner “characterized” Carnation's reinsurance premiums as its “capital contribution” to its captive subsidiary. Id. On summary judgment, the tax court concluded as a matter of law that no “insurance” existed, re-characterizing the reinsurance “premium” as a capital contribution Carnation made through the original insurer. Id. at 1013-14.

Each of the alternative arrangements (other than a contribution to capital) described in Revenue Ruling 2005-40 are inconsistent with the tax court's determination that there was no non-tax reason for Reserve to have received the payments at issue. Under these circumstances, the only potentially applicable characterization is a contribution to capital. See James R. Browne, “Reserve Mechanical and Syzygy: Income from Nothing,” 163 Tax Notes 1665 (June 10, 2019).

In the present case, the tax court's finding that there was no legitimate business purpose for the payment of the premiums by the Direct Insureds means that their transfers of funds to Reserve constitute constructive distributions by them to the ultimate common shareholders and contributions to capital to Reserve by said shareholders because, according to the tax court, there was no non-tax reason for the insureds to make such payments. App.Vol.4.p.913-14. Under these circumstances, Reserve had no taxable income.

Conclusion

This Court should reverse the tax court's decision that Reserve was not an insurance company for tax purposes. Alternatively, this Court should reverse the tax court's decision that the payments Reserve received as insurance premiums were taxable income to Reserve and render a decision that such amounts were nontaxable capital contributions to Reserve.

Respectfully submitted,

Val J. Albright
Michelle Y. Ku
Foley & Lardner, LLP
2021 McKinney Avenue
Suite 1600
Dallas, Texas 75201
Tel: 214.999.3000
valbright@foley.com
mku@foley.com

E. John Gorman
Logan R. Gremillion
Coby M. Hyman
The Feldman Law Firm LLP
Two Post Oak Central
1980 Post Oak Blvd., Suite 1900
Houston, Texas 77056
Tel: 713.850.0700
jgorman@feldlaw.com
lgremillion@feldlaw.com
chyman@feldlaw.com

Counsel for Reserve Mechanical Corp.

FOOTNOTES

1“App.” refers to Reserve's Appendix, which is cited herein by volume and page number.

2Although lacking in precedential value, these rulings reflect how the Commissioner interprets, administers and applies the tax laws. I.R.C. § 6110(k)(3); cf. Hanover Bank v. Comm'r, 369 U.S. 672, 686-87 (1962).

3CreditRe shared no common ownership with PoolRe or any of the captive insurers Capstone administered. App.Vol.5.p.1284. Nor was CreditRe a captive insurance company or administered by Capstone. App.Vol.5.p.1424.

4The risk pool consisted of more than 500 policies during each tax year in issue and provided a diverse array of coverages. App.Vol.4.p.1193-94, Vol.5.p.1416, Vol.9.p.2470, Vol.13.p.3714, 3741-57.

5Notably, the Commissioner's lone expert agreed that insurance requires little formality, testifying that an “insurance contract” arises regardless of (1) the premium's amount, (2) actuarially determined premiums, or (3) any premium payment at all. App.Vol.4.p.1492-93.

6Treganowan is a seminal case on insurance for tax purposes and risk distribution in particular and has been approvingly cited as authority by numerous circuit courts, including this Court, see, e.g., Beech Aircraft, 797 F.2d at 922; Ross, 401 F.2d at 467; Clougherty Packing Co. v. Comm'r, 811 F.2d 1297, 1300 (9th Cir. 1987); the tax court, see, e.g., R.V.I. Guar., 145 T.C. at 232; Avrahami, 149 T.C. at 193; and the Commissioner in his rulings addressing risk distribution, see, e.g., Rev. Rul. 2005-40, 2005-2 C.B. 4; Rev. Rul. 2009-26, 2009-38 I.R.B. 366; Rev. Rul. 2008-8, 2008-1 C.B. 340.

7Because Avrahami was issued after the evidence closed, neither party below geared its trial strategy for addressing risk distribution on establishing whether PoolRe was a bona fide insurance company. Avrahami was issued after the parties submitted their simultaneous opening briefs, and while the parties submitted limited briefing to the tax court regarding the impact, if any, of Avrahami, the evidence was not re-opened. In its limited briefing to the tax court, Reserve explained the reasons why Avrahami was factually and legally inapposite. Reserve further argued that evaluating whether Reserve distributed risk through its reinsurance arrangements with PoolRe did not require evaluating whether PoolRe was an insurance company. App.Vol.3.p.813-24.

8See supra text accompanying note 2.

9In Sammons v. Commissioner, 472 F.2d 449 (5th Cir. 1972), the Fifth Circuit described this flow of funds as follows: “In the situation where funds are transferred from one such sibling corporation to another, the theory is that the funds pass from the transferor to the common stockholder as a dividend and then to the transferee as a capital contribution.” Id. at 453.

END FOOTNOTES

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