Captive Insurance Company Urges Reversal of Tax Court Decision

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
Docket No. 14545-16, Hon. Kathleen Kerrigan

REPLY 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

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Table of Contents

Argument

Conclusion

Certificate of Compliance

Certificate of Digital Submission

Certificate of Service

Addenda

TABLE OF AUTHORITIES

Cases

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

Carnation Co. v. Comm'r, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir. 1981)

Chapman Glen Ltd. v. Comm'r, 140 T.C. 294 (2013)

BrokerTec Holdings, Inc., Comm'r v., 967 F.3d 317 (3d Cir. 2020)

Gulf Oil Corp. v. Comm'r, 914 F.2d 396 (3d Cir. 1990)

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

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

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

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

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

Shellito v. Comm'r, 437 F. App'x 665 (10th Cir. 2011) (unpublished)

State Farm Fire & Cas. Co. v. Griffin, 888 S.W.2d 150 (Tex. App.—1994, no writ)

Tracinda Corp. v. Comm'r, 111 T.C. 315 (1998)

Transco Exploration Co. v. Comm'r, 949 F.2d 837 (5th Cir. 1992)

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

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

Valley Improvement Ass'n v. U.S. Fid. & Guar. Corp., 129 F.3d 1108 (10th Cir. 1997)

Washington Mutual, Inc. v. United States, 856 F.3d 711 (9th Cir. 2017)

Statutes

26 U.S.C.

Other Authorities

Rev. Rul. 69-630, 1969-2 C.B. 112

Rev. Rul. 78-83, 1978-1 C.B. 79

Rev. Rul. 2005-40, 2005-2 C.B. 4

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

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

Captive Insurance Companies Association, Commercial Ins. & Captive Ins. Indus.: Commonly Accepted Practices (Jan. 31, 2019), https://www.cicaworld.com/docs/default-source/default-documentlibrary/cica_commonly_accepted_insurance_practices_risk_pools_jan2019.pdf?sfvrsn=0

Christopher Hanewald, Insight: Denied Business Interruption Claims Could Spur Boom in Captive Insurance, Bloomberg Daily Tax Report, May 15, 2020

Oliver Schofield, Reserve Mechanical: Judge Kerrigan Shows “Limited Knowledge” of Reinsurance Market (June 28, 2018), https://irp-cdn.multiscreensite.com/ea743ce7/files/uploaded/London%20reinsurance%20expert%20criticises%20%E2%80%9Climited%20knowledge%E2%80%9D%20of%20Reserve%20Mechanical%20judge%20-%20article%20-%20Captive%20Review%20Jun%202018.pdf

Leslie Scism, Companies Hit by Covid-19 Want Insurance Payouts. Insurers Say No., Wall St. J., June 30, 2020

Letter from U.S. Senator Cory Gardner to Treasury Secretary Steven T. Mnuchin and IRS Commissioner Charles P. Rettig (Aug. 24, 2020)

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Argument

I. APPELLEE'S EFFORTS TO DEFEND THE TAX COURT'S MISAPPLICATION OF THE LEGAL TEST FOR RISK DISTRIBUTION CANNOT WITHSTAND SCRUTINY.

The parties agree that a captive insurer can achieve risk distribution where a substantial part of the insurer's business comes from unrelated sources. See Appellee's Brief (“Gov.Br.”) 26-27; Reserve's Opening Brief (“Op.Br.”) 35-36. They further agree that where, as here, a captive insurer seeks to achieve risk distribution based on the percentage of premiums that it receives from a pool of unrelated insureds, 30% of gross premiums is judicially recognized as demonstrating that the insurer has a sufficient pool of insureds for risk distribution. Id. They even agree that at least 30% of Reserve's gross premiums derived from unrelated sources (i.e., not from Reserve's Direct Insureds).¹ Gov.Br.27-28; Op.Br.24, 35-36. That should have put an end to the issue — Reserve distributed risk, and the tax court's risk-distribution approach that focused on whether PoolRe was a bona fide insurance company, instead of on whether a sufficient portion of Reserve's gross premiums derived from unrelated sources, was wrong.

Appellee's brief fails to address the threshold issue of the error of the court's risk-distribution approach, an issue reviewed de novo. See, e.g., Shellito v. Comm'r, 437 F. App'x 665, 669 (10th Cir. 2011) (unpublished). Instead, Appellee spends several pages rehashing the court's findings underlying its conclusion that PoolRe was not a bona fide insurance company. Gov.Br.28-39. Appellee then urges this Court to find Reserve waived its challenge to that conclusion by not disputing it in Reserve's opening brief or by not moving to reopen the record to offer additional evidence when the court requested briefing regarding Avrahami v. Commissioner, 149 T.C. 144 (2017). Gov.Br.39-42.

Appellee's arguments put the cart before the horse. The threshold issue is whether PoolRe must be a bona fide insurance company for Reserve to distribute risk through its reinsurance arrangements with PoolRe. Obviously, if the answer is “no,” the court misapplied the legal test because whether Reserve distributed risk would not turn on PoolRe being a bona fide insurance company. In that situation, there would be no need to address whether PoolRe was a bona fide insurance company, let alone, whether the court's underlying findings were erroneous.²

But that is precisely the situation here. As shown by the well-settled caselaw recognizing insurance for federal tax purposes even where no insurance company exists, the existence of a bona fide insurance company is not necessary for risk distribution to exist. 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). Notably, citing to Ross and Treganowan, Appellee concedes that Reserve is correct in this regard. Gov.Br.40.

A. Appellee's “Substantive-Functions-of-an-Insurance-Company” Argument Is Unavailing.

Recognizing the fatal nature of the court's error, Appellee does not defend the court's risk-distribution approach on the merits. Instead, Appellee attempts to recast it as an inquiry concerning whether PoolRe performed the substantive functions of an insurance company. Gov.Br.40-41.

Appellee's revisionist portrayal of the court's approach is unavailing. Appellee provides no record citations for this purported “substantive-functions-of-an-insurance-company” inquiry. Nor is there any to be found. The court was clear — it considered the dispositive issue to be “whether PoolRe was a bona fide insurance company,” not whether PoolRe performed the substantive functions of an insurance company. App.Vol.3.p.887.

Furthermore, recasting the court's approach in this way does not save it from conflicting with authorities recognizing that risk distribution is to be analyzed in the same manner regardless of whether the transaction concerns direct insurance or reinsurance. See, e.g., Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 n.25 (Fed. Cir. 1993); Rev. Rul. 2009-26, 2009-38 I.R.B. 366. That means the court should have conducted its analysis from the perspective of Reserve (the reinsurer), not PoolRe (the reinsured), and by solely looking through the reinsurance arrangements to the pool of risks Reserve reinsured, not by looking at whether PoolRe performed the substantive functions of an insurance company. See id.

Appellee cannot identify any authority in which the risk-distribution determination turned on the “substantive-functions-of-an-insurance-company” inquiry. Nor can Appellee reconcile his argument here with his position previously taken in his own guidance. See, e.g., Rev. Rul. 2009-26, 2009-38 I.R.B. 366 (acknowledging that courts have looked through a fronting arrangement to the pool of risks a captive insurer reinsured in analyzing whether risk distribution exists); see also I.R.C. § 831(b)(2)(D) (acknowledging the look-through concept in the context of reinsurance and fronting arrangements).

Nor does recasting the court's approach in this way save it from conflicting with cases recognizing insurance where there was no insurance company, either formally or functionally, such as Ross and Treganowan. The fact that the State of Georgia in Ross and the NYSE in Treganowan were not insurance companies formally or functionally did not affect the conclusions in those cases that the arrangements at issue distributed risk and were insurance for federal tax purposes. Ross, 401 F.2d at 465-70; Treganowan, 183 F.2d at 290-91. In evaluating risk distribution, the courts in those cases focused only on whether the risk of loss was sufficiently diffused by spreading the costs throughout a group. Id.

Appellee nonetheless baldly claims that nothing in the court's analysis undermines cases like Ross and Treganowan because “the relevant inquiry is whether the entity that the captive[ ] reinsure[s] performs the substantive functions of an insurance company, not whether it is licensed and regulated as an insurance company.” Gov.Br.41. In that same breath, however, Appellee acknowledges that very formality — whether PoolRe was licensed and regulated as an insurance company — was one of the factors in the court's purported “substantive-functions-of-an-insurance-company” analysis. Gov.Br.41. It is unclear which, if any, of the remaining five factors considered as part of the court's analysis constitutes a substantive function of an insurance company. What is clear, however, is that the courts in Ross and Treganowan determined that the arrangements at issue distributed risk without regard for any of those five factors.

Circular flow of funds, arm's-length contracts, and actuarially-determined premiums: In evaluating risk distribution, the courts in Ross and Treganowan did not consider whether the arrangements at issue involved a circular flow of funds, were arm's-length contracts, or had actuarially-determined premiums. In fact, whereas the tax court focused on these factors in criticizing the so-called “perfect matching of payments” between stop-loss premium amounts paid to PoolRe and quota-share premium amounts paid to Reserve and the other captive insurers participating in the reinsurance risk pool, and the purported “one-size-fits-all rate” for the stop-loss premiums PoolRe charged, App.Vol.3.p.889-92, the court in Ross rejected the argument that payment of premiums had anything to do with risk distribution as neither good economics nor good law, 401 F.2d at 468-69 (citing Haynes v. United States, 353 U.S. 81, 84 (1957)).

In considering these three factors, the tax court looked at the stop-loss/quota-share premium structure with a jaundiced eye, despite the evidence proving the premium structure was constructed using actuarial methods and objective criteria purposely to facilitate risk-pooling and risk distribution. App.Vol.2.p.480, Vol.4.p.910, Vol.5.p.1209-10, 1239-42, 1374, Vol.11.p.3250-60, Vol.12.p.3389-400, 3522-33, 3560-69, Vol.13.p.3712, 3770-72. But the assertion that there is something awry about the premium structure is completely unfounded. Rather, it reveals the court's failure to understand that this structure, as explained in the Amicus Brief (“Amicus.Br.”), is typical of such risk-pooling arrangements and necessary for the pool to operate. See Amicus.Br.14-16, 18-19, 23-28; see also Letter from U.S. Senator Cory Gardner to Treasury Secretary Steven T. Mnuchin and IRS Commissioner Charles P. Rettig (Aug. 24, 2020) (Addendum A). “The amount of risk each participant puts into the pool and the amount of risk they take back must be the same in order for the pool to be fair. Premium is merely a proxy for that risk.” Amicus.Br.25. Accordingly, under the quota-share arrangements here, “[b]ecause the quantity of risk ceded to the pool and assumed from the pool were the same, the premiums ceded and assumed were the same.” Amicus.Br.24. Without such an equitable distribution of premium, the pooling arrangement would have been unfair and therefore, untenable among the pool participants, all of whom were unrelated to each other. See Amicus.Br.24; Captive Insurance Companies Association, Commercial Ins. & Captive Ins. Indus.: Commonly Accepted Practices at 5-7 (Jan. 31, 2019), https://www.cicaworld.com/docs/default-source/default-documentlibrary/cica_commonly_accepted_insurance_practices_risk_pools_jan2019.pdf?sfvrsn=0; see also Op.Br.18-22; App.Vol.4.p.1193-94, Vol.5.p.1429, Vol.13.p.3702, 3712-16, 3725, Vol.18.p.5383, Vol.19.p.5441.

The court's skepticism of the stop-loss/quota-share premium structure also reflects its misunderstanding of how risk-pooling facilitates risk distribution. As Dr. Neil A. Doherty explained, “even with heterogeneous exposures, risk can still be effectively reduced by distribution and pooling.” App.Vol.13.p.3759. Distributing risk through a risk pool thus does not depend on the industries, locations, operations, types of risk, and exposure to risk of pool participants being comparable in scale or homogenous. As Appellee's own expert witness conceded, the risk-pooling here distributed risk. App.Vol.6.p.1536, Vol.19.p.5625.

Appellee gloms onto the court's suspect view of the stop-loss/quota-share premium structure, but provides no authority to support invalidating quota-share arrangements. Gov.Br.30-34. Notably, Appellee does not even attempt to reconcile his position here with his own private letter rulings that Reserve cited showing Appellee's approval of quota-share arrangements with this same structure. Op.Br.21-22. Reserve does not contend that these rulings are precedential, but it is beyond dispute that Appellee has routinely approved of such arrangements. Appellee has provided no persuasive reason why this time is any different.³

Instead, Appellee puts forward the novel argument that PoolRe and the pool participants were “effectively under common control” because they delegated their administration, operations, and recordkeeping to Capstone, so that “their relationship cannot fairly be characterized as arm's-length.” Gov.Br.32. But Appellee's newly-invented standard that unrelated entities that share a third-party service-provider of administrative or other back-office services are thereby “under common control” is simply a bridge too far. Were this Court to adopt that standard, it would ignore the economic realities for why companies engage such service-providers and lead to nonsensical results. Indeed, if that is the new standard, companies that hire human resources management companies like ADP or Paychex to handle administrative or other back-office work will all be “under common control,” and any agreements they execute with each other categorically will not be arm's-length agreements. Appellee's argument cannot withstand scrutiny and threatens to upend well-established caselaw recognizing that agreements between unrelated parties are inherently arm's-length agreements. See United Parcel Serv. of Am., Inc. v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001).

Actual and insurable risk: In Ross and Treganowan, the arrangements at issue were death-benefit funds that insured against the risk of loss from premature death. Ross, 401 F.2d at 465-70; Treganowan, 183 F.2d at 290-91. In evaluating risk distribution, however, the courts' focus was not on the likelihood a loss would materialize or the severity should it occur, but on whether the risk of loss was sufficiently diffused by spreading the costs throughout a group. See id. Notably, as the court recognized in Treganowan, “[f]rom an insurance standpoint, there is no risk unless there is uncertainty or, to use a better term, fortuitousness,” and “[i]t may be uncertain whether the risk will materialize in any particular case.” 183 F.2d at 290.

Here, in contrast, the tax court fixated on the likelihood or severity of a loss on PoolRe and determined that “PoolRe was removed far from any actual risk associated with the business or operations of Reserve's insureds.” App.Vol.3.p.893. This finding, however, is based on a misreading of Reserve's direct-written policies as providing only excess coverage and a fundamental misunderstanding of how stop-loss coverage works.

Appellee does not refute Reserve's argument that the court misread Reserve's direct-written policies as providing only excess coverage. Nor does Appellee address the court's finding that “Reserve's policies covered only losses that were not covered by Peak's third-party policies.” App.Vol.4.p.905. Instead, Appellee argues that the “other insurance” clauses of Reserve's policies “provided an additional barrier between the underlying risks and PoolRe.” Gov.Br.34-36. The only support Appellee cites for his argument is an inconsistent statement in the feasibility study saying Peak had limited pollution liability coverage under its commercial general liability and products liability policies. Gov.Br.36.

As a preliminary matter, Appellee's characterization of the feasibility study as “the post hoc feasibility study” misstates the facts. Gov.Br.36. The evidence unequivocally shows that “the feasibility study was drafted a few weeks after the site visit” in August 2008, App.Vol.5.p.1254 (403:23-404:1); see also App.Vol.4.p.1087, and its conclusions were used in Reserve's application for an Anguillan insurance license in October 2008, App.Vol.7.p.1880-83. And while the feasibility study does contain the inconsistency Appellee cites, any pollution liability coverage under Peak's commercial policies would have been narrow coverage generally available only as exceptions to exclusions. App.Vol.10.p.2810, 2916, 2920, 2978, 2999.

More importantly, however, to the extent that there was any overlap in coverage for a type of loss, Reserve's policies would nonetheless have provided primary, not excess, coverage because Peak's commercial policies and Reserve's policies both contained “other insurance” clauses. App.Vol.10.p.2812, 2863, 2924. The legal effect of such clauses “is to provide that each insurer shall not be liable for any greater proportion of any loss which may occur than the amount named in the policy bears to the entire amount of the insurance coverage available.” State Farm Fire & Cas. Co. v. Griffin, 888 S.W.2d 150, 155 (Tex. App.—1994, no writ). Accordingly, the “other insurance” clauses of Reserve's policies would not provide an additional barrier between the underlying risks and PoolRe.

Furthermore, Appellee's argument that there is something meaningful in the absence of losses affecting the higher layer of stop-loss coverage during the three-year period at issue is misplaced. Gov.Br.33. The purpose of stop-loss coverage is to serve as a layer of coverage to protect against large or catastrophic claims exceeding a predetermined amount. Reich v. Lancaster, 55 F.3d 1034, 1041 n.4 (5th Cir. 1995). Accordingly, “[s]top loss [coverage] should never attach at the 1 in 1 or 1 in 3 year expected loss scenario; it is a protection against a catastrophic deterioration in loss frequency and as such should attach beyond the 1 in 10 year expected loss scenario.” Oliver Schofield, Reserve Mechanical: Judge Kerrigan Shows “Limited Knowledge” of Reinsurance Market (June 28, 2018), https://irp-cdn.multiscreensite.com/ea743ce7/files/uploaded/London%20reinsurance%20expert%20criticises%20%E2%80%9Climited%20knowledge%E2%80%9D%20of%20Reserve%20Mechanical%20judge%20-%20article%20-%20Captive%20Review%20Jun%202018.pdf. To conclude that something is amiss based on just a few years of results is to misunderstand the fundamental purpose behind stop-loss coverage.

Notably, however, while the tax years in issue did not see the type of worldwide turmoil seen today from the coronavirus pandemic, had the pandemic occurred during those years, the stop-loss coverage most assuredly would have been triggered. For example, had the pandemic occurred in 2009, Reserve's regulatory-changes policy would have covered losses from government-mandated shutdowns; Reserve's loss-of-services policy would have covered losses of key employees due to sickness; and Reserve's loss-of-major-customer policy would have covered losses of orders from major customers as a result of business slowdown.

App.Vol.11.p.3297-Vol.12.p.3303, Vol.12.p.3320-28, 3368-74. The stop-loss coverage would have been the only insurance available to prevent catastrophic losses from jeopardizing Reserve's ability to respond to such claims.⁴ In fact, because Reserve had already paid a large claim by Peak under Reserve's loss-of-major-customer policy totaling $339,820 in 2009, if Reserve had received one more claim from Peak for at least $110,000, PoolRe's stop-loss coverage would have responded. App.Vol.2.p.377-78, Vol.4.p.1127-29, Vol.12.p.3411-20, 3552-59.

Created for legitimate nontax reasons: In evaluating risk distribution, the courts in Ross and Treganowan did not consider whether the arrangements at issue were created for legitimate nontax reasons. Ross, 401 F.2d at 465-70; Treganowan, 183 F.2d at 290-91. Rather, their focus was on whether the arrangements — regardless of why they were created — distributed risk. See id. Here, the tax court determined that PoolRe was not created or operated for legitimate nontax reasons. App.Vol.3.p.894. The court's determination, however, was based on its view of the facts and circumstances, which, as discussed above, was riddled with misunderstandings and ignored the incontrovertible fact that PoolRe was an independent entity that executed binding arm's-length agreements imposing genuine obligations with unrelated entities. See United Parcel Serv., 254 F.3d at 1018.

B. Appellee's Coinsurance Arguments Conflict with Well-Established Caselaw and Ignore Limitations on Treaty Reinsurers.

At trial, Reserve met its burden of producing evidence to establish the existence of the coinsurance arrangements through documentary evidence, including the coinsurance contracts between PoolRe and Reserve, audited financial statements and general ledgers showing the premiums earned and claims paid by Reserve under the arrangements, and testimony of witnesses. App.Vol.5.p.1283-86, 1416-25, Vol.9.p.2463-508, Vol.11.p.3261-69, Vol.12.p.3401-10, 3534-44, Vol.18.p.5376-87. Neither the court nor Appellee has articulated any persuasive reason why Reserve's evidence establishing the existence of the coinsurance arrangements was insufficient.

Appellee's brief argues without any legal support that Reserve could not prove that the coinsurance arrangements distributed risk without “first establishing the existence of the vehicle service contracts, ceding agreements, and claims paid.” Gov.Br.45. Appellee's argument, however, fares no better than his arguments attacking the quota-share arrangements because it likewise undermines the well-established caselaw recognizing risk distribution and insurance for federal tax purposes in the absence of an insurance contract.

Ross is particularly illustrative. In that case, the Fifth Circuit recognized that the insurance arrangement did not need to be in the form of “a traditional bilateral agreement, or for that matter, even a unilateral one signed by one party and accepted by the other.” 401 F.2d at 467. Instead, for insurance to exist, the critical factors were “the presence in a binding arrangement of risk-shifting and risk distribution.” Id. In evaluating risk distribution, the court was thus unconcerned with whether it had before it documentary evidence establishing the arrangement's existence. Rather, the court focused on whether the risk of loss was sufficiently diffused by spreading the costs throughout a group and determined that the arrangement met the risk-distribution requirement. Id. at 468. Having found both risk shifting and risk distribution existed, the court turned to and disposed of a number of arguments made by “[t]he Government . . . in the hopes of overcoming, probably more accurately, of escaping from this undeniable risk shifting and risk distribution,” all of which followed “a persistent theme that there must be a traditional 'contract,' a contract for insurance, and therefore necessarily executed by one qualified to write insurance as such.” Id.

No reason appears in Appellee's response or the court's opinion explaining why it would be necessary for Reserve to submit the underlying contracts into evidence to prove that the coinsurance arrangements distributed risk. Where, as here, the terms of the coinsurance arrangements are undisputed, it is pedantic to insist on the production of the underlying contracts and other documents evidencing such collateral matters, especially when Appellee should know that Reserve, as a treaty reinsurer, would not have the right to access them.

As Reserve explained, unlike a facultative reinsurer who underwrites each risk prior to determining whether to reinsure the risk, a treaty reinsurer does not engage in such underwriting of its own of the reinsured risks. Op.Br.9-11, 44-45. Accordingly, once a reinsurance treaty is written, considerations such as whether the underlying policies have been written, whether the reinsured correctly underwrote the reinsured risks, and whether claims on the underlying policies are accurately paid, are of no significance to a treaty reinsurer — the treaty reinsurer is bound to indemnify the reinsured for any good faith payment regardless. See id.

Despite the foregoing, Appellee insists that Reserve should or could have done more to submit into evidence the vehicle service contracts Lyndon issued, earlier ceding agreements, or documents regarding claims Lyndon paid on the contracts. Gov.Br.43-45. To that end, Appellee points to Reserve's contractual right to obtain coinsurance-related documents PoolRe maintained. Gov.Br.43. Appellee's point, however, is rather unremarkable because he ignores the fact that PoolRe, like Reserve, is also a treaty reinsurer under a treaty with CreditRe and thus would likewise not have had access to such coinsurance documents. App.Vol.13.p.3867-68.

Finally, as with the quota-share arrangements, the court incorrectly determined that the coinsurance arrangements did not involve actual risk by focusing on the amount of risk of the overall pool of vehicle service contracts PoolRe and, in turn, Reserve, assumed. App.Vol.3.p.896. As the caselaw shows, however, the court should have analyzed whether Reserve distributed risk by spreading the risk of loss among the policyholders of the vehicle service contracts. E.g., Ross, 401 F.2d at 465-70; see also I.R.C. § 831(b)(2)(D). It is unknown what, if any, relevance the amount of the overall pooled risk assumed has on risk distribution, and no explanation can be found in the court's opinion or Appellee's brief. It is also unknown how the court could reasonably conclude that the amount of risk involved was “de minimis” when, over the three-year period at issue, Reserve paid almost $190,000 in losses under the coinsurance arrangements, and received coinsurance premiums comprising a material portion of its gross premiums. App.Vol.9.p.2478, 2490-91, 2504, Vol.19.p.5416. The caselaw is clear that circumstances less compelling than those here nonetheless give rise to actual risk. See United Parcel Serv., 254 F.3d at 1018 (holding that the reinsurance treaty between the captive insurer and its reinsured should be respected even though such treaty significantly reduced the odds of loss, since the obligations thereunder were susceptible to default).

For the foregoing reasons and those discussed in Reserve's opening brief, this Court should reverse the tax court's determination that Reserve did not distribute risk through its reinsurance arrangements.

II. RESERVE'S TRANSACTIONS WERE INSURANCE IN THE COMMONLY ACCEPTED SENSE.

Appellee concedes that the tax court, in analyzing whether Reserve's transactions were insurance in the commonly accepted sense, acknowledged that (1) Reserve had adequate capitalization; (2) Reserve's “direct-written policies 'contained the necessary terms to make them valid and binding insurance' and . . . were properly executed”; and (3) Reserve paid claims. Gov.Br.53, 62. Despite expending pages rehashing those settled factors, Appellee does not contend that any were wrongly decided. Accordingly, only two factors remain in dispute — whether Reserve was operated like an insurance company and whether Reserve's premiums were reasonable and negotiated at arm's length. Reserve satisfied both factors, and Appellee's arguments to the contrary are wrong on both accounts.

A. Reserve Was Operated as an Insurance Company.

The crucial question here is whether a captive insurer that has no employees, and whose owners delegate operational functions, financial reporting, regulatory compliance, and day-to-day tasks to hired professionals instead of handling such responsibilities firsthand, can operate as an insurance company. If the answer is “yes,” Appellee's argument should be rejected and the tax court's determination that Reserve was not operated as an insurance company should be reversed.

Appellee's brief argues that Reserve was not operated as an insurance company because Reserve operated without any employees and engaged Capstone and other professionals for operations and oversight of Reserve, but provides no citation to any authority suggesting that this state of affairs is inconsistent with operating as an insurance company. Gov.Br.47-48. That is because it is not. As discussed in Reserve's opening brief, the caselaw shows that most captive insurers operate without employees and routinely delegate such matters to captive managers and other professionals. Op.Br.57-61. It would neither be good economics nor good law if the situation were otherwise. This Court should reject Appellee's invitation to go down that path.

Appellee does not address Reserve's authorities or the merits of Reserve's argument that such state of affairs is entirely reasonable and consistent with operating as an insurance company, especially where, as here, Reserve's owners were new to the insurance business. Reserve operated through a team of insurance professionals, including attorneys, underwriters, insurance accountants, claims processors, and actuaries, all engaged to handle Reserve's day-to-day operations. App.Vol.5.p.1372-74. On Reserve's behalf, those professionals handled, among other responsibilities, underwriting, premium calculations, processing and payment of claims, and due diligence prior to Reserve issuing direct-written policies and entering into the quota-share and coinsurance reinsurance arrangements here.⁵ Id. It is not apparent and Appellee provides no persuasive reason why Reserve operating through its hired team of insurance professionals is any less consistent with operating as an insurance company than Reserve's owners handling such responsibilities firsthand. The tax court's conclusion that Reserve was not operated as an insurance company should be reversed.

B. Appellee Ignores the Tax Court's Misreading of Reserve's Direct-Written Policies as Providing Only Excess Coverage.

Reserve demonstrated in its opening brief that the tax court misinterpreted Reserve's direct-written policies as providing only excess coverage based on its misreading of the “other insurance” clauses of Reserve's policies. Op.Br.48-52. By misreading Reserve's policies in this way, the court inevitably and erroneously 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.” Op.Br.53-57.

As noted above, Appellee does not defend the court's misreading of Reserve's policies. Instead of directly addressing the court's error on the merits, Appellee simply ignores it, and argues that the record supports the court's determination that Reserve's premiums were unreasonable and not negotiated at arm's length. Gov.Br.55-61.

Appellee's argument, which effectively consists of a rehashing of the tax court's analysis, is unavailing because Appellee fails to account for the fact that the court's analysis of Reserve's premiums, its determination that they were unreasonable and not negotiated at arm's length, and its ultimate conclusion that Reserve's transactions were not insurance in the commonly accepted sense, were all built on the flawed premise that Reserve's policies provided only excess coverage. Appellee's own words show this to be true. On brief, Appellee writes that “[a]s the starting point of its analysis [of whether premiums were reasonable and the result of arm's-length dealing], the court noted that Peak's insurance expenses dramatically increased as a result of the captive arrangement,” and that “Peak continued to maintain all of its commercial insurance plus supplemental coverage[.]” Gov.Br.55 (second emphasis added). The court's misapprehension of the increase in Peak's insurance expenses flowed directly from its misreading of Reserve's policies as providing only supplemental coverage (i.e., excess coverage). Similarly, the court's criticism of Peak for maintaining all its commercial insurance even after paying for additional coverage from Reserve incorrectly presumes that Peak should have discontinued its commercial insurance after purchasing coverage from Reserve because of the court's misunderstanding that both sets of policies covered the same risks.

The tax court's undisputed misreading of Reserve's direct-written policies infects its entire analysis of Reserve's premium pricing. This Court should reverse the tax court's determination that Reserve's premiums were unreasonable and not negotiated at arm's length.

III. If Amounts Received as Premiums Were Not for Insurance, Such Amounts Were Capital Contributions.

On brief, Appellee misstates Reserve's position on this issue.⁶ Reserve has never claimed that Revenue Ruling 2005-40, 2005-2 C.B. 4, contains an exhaustive list of possible characterizations for a failed insurance arrangement. Reserve's point has always been that any characterization of the amounts as income to Reserve, including the characterizations described therein or otherwise, would have a business purpose, and because the tax court determined that there was no such purpose here for Reserve's receipt of the payments, the payments Reserve received could only be characterized as nontaxable capital contributions. Op.Br.63-68.

Nor has Reserve claimed that distinguishing between the alternative characterizations does not require consideration of all the facts and circumstances. Rather, that is precisely what Reserve argues should have occurred here. The difference between the parties lies in what those facts and circumstances are from each party's perspective. Appellee insists only “the intent or motive of the transferor matters.” Gov.Br.64 n.16, 67; see also Appellee's Rule 28(j) Letter (dated September 3, 2020) (discussing Commissioner v. BrokerTec Holdings, Inc., 967 F.3d 317 (3d Cir. 2020)). But the caselaw Appellee relies on is distinguishable because his cited cases concern non-shareholder payments between unrelated entities and thus are not analogous to the situation here, which involves shareholder payments between commonly controlled entities.

For its part, Reserve believes this Court should consider the tax court's determination that there was no legitimate nontax reason for Reserve's receipt of the payments and the underlying analysis. In doing so, this Court should hold, pursuant to the two-part test under Sammons v. Commissioner, 472 F.2d 449 (5th Cir. 1972), that the payments Reserve received could only be characterized as nontaxable capital contributions. Id. at 451-54 (providing that a payment is recharacterized as a deemed dividend to the common shareholders and a capital contribution by such shareholders to the recipient corporation when (1) the common shareholder is able to exercise control over the payment through control of the payee corporation, and (2) the payment primarily benefited the common shareholder and the payor corporation obtained no substantial nontax business benefit from the payment); see also James R. Browne, “Reserve Mechanical and Syzygy: Income from Nothing,” 163 Tax Notes 1665, 1668 (June 10, 2019). In Sammons, the court's focus was on whether the recipient of the payment received a substantial nontax business benefit from its commonly controlled entity in exchange for the payment at issue regardless of the payor's intent. 472 F.2d at 451-54.⁷

No additional evidence of the payor's intent is necessary in these circumstances. The court determined Reserve's transactions did not constitute insurance and that there was no business purpose for the payments Reserve received. App.Vol.4.p.911. Whether a payment is taxable income turns on the substance of the transaction based on the facts and circumstances found by the court, and a payment between commonly controlled entities with no business purpose simply cannot be income to the recipient.⁸ Sammons, 472 F.2d at 452-54; Rev. Rul. 69-630, 1969-2 C.B. 112; Rev. Rul. 78-83, 1978-1 C.B. 79.

Appellee's argument that Reserve is attempting to “turn the purpose of the substance-over-form doctrine on its head” is also misplaced. Gov.Br.70. Contrary to Appellee's assertion, Reserve is not “attempting to recast the payments from its perspective (i.e., as capital contributions from its indirect owners, Zumbaum and Weikel) without a symmetrical recasting of those same payments from the affiliated insureds' perspective (i.e., as nondeductible distributions to their owners, Zumbaum and Weikel, for contribution to taxpayer).” Gov.Br.69-70. Rather, Reserve maintains that this Court should determine the proper tax consequences of the payments to Reserve as the only party before it.

Nor is Reserve attempting to disavow the form of its transactions. Gov.Br.69-70. Reserve continues to maintain that its transactions are insurance. Both the payors (the Direct Insureds) and the payee (Reserve) undeniably intended the payments to be insurance premiums, App.Vol.4.p.1237-38, Vol.13.p.3701-26, but the court rejected the evidence demonstrating this fact. Having done so and having determined that such payments had no business purpose, the court should have determined that such payments did not constitute income to Reserve. Appellee's own authorities confirm that would have been the proper outcome. E.g., Rev. Rul. 69-630, 1969-2 C.B. 112; Rev. Rul. 78-83, 1978-1 C.B. 79.

The “substance-over-form” doctrine taxes a transaction based on its economic substance if the economic substance varies from its legal form. See Tracinda Corp. v. Comm'r, 111 T.C. 315, 326 (1998). In this case, the tax court held that the “substance” of the transaction was not insurance and that there was no business purpose for the payments that Reserve received. If this Court affirms the tax court in this regard, the substance-over-form doctrine mandates that the payments be characterized as capital contributions.

A. Appellee's Attempt to Distinguish Reserve's Cited Authorities Fails.

Appellee argues that Reserve's reliance on Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir. 1981), is misplaced, by arguing that, in Carnation, (1) the insured did not “advance an alternative characterization of the purported insurance premiums if the court found otherwise”; (2) the tax court affirmed Appellee's determination that the premiums should be recharacterized as capital contributions based on the “presumption of correctness” that attached thereto; and (3) the tax court had no occasion to elucidate the “facts and circumstances” under which purported insurance premiums should be recharacterized as capital contributions. Gov.Br.70-71.

Appellee's attempt to distinguish Carnation on each of these grounds fails. Contrary to Appellee's assertion, even where Appellee contended that amounts paid as premiums to a putative insurance company were nevertheless income to the recipient (i.e., the opposite of what occurred in Carnation), the tax court has followed Carnation. E.g., Chapman Glen Ltd. v. Comm'r, 140 T.C. 294, 350 (2013). For example, applying Carnation, the tax court in Chapman Glen held that such amounts were capital contributions where the tax court had determined that amounts paid as premiums were not for insurance premiums because there was no insurance company for tax purposes. 140 T.C. at 350.

Appellee cites Gulf Oil Corp. v. Commissioner, 914 F.2d 396 (3d Cir. 1990), as a situation where the court found the “arrangements did not constitute insurance contracts for tax purposes but declin[ed] . . . to recharacterize payments made thereunder as capital contributions.” Gov.Br.71. That case, however, does not support Appellee's position here because Appellee fails to recognize that the court in Gulf Oil properly applied the two-part Sammons test where the payments at issue were determined to have a business purpose. Gulf Oil, 914 F.2d at 413. Unlike in Gulf Oil, the tax court here specifically determined that the payments to Reserve had no valid nontax business purpose. Properly applying the Sammons test to the facts and circumstances here mandates the payments Reserve received be recharacterized as deemed distributions by Peak and capital contributions to Reserve.⁹

Appellee's attempt to distinguish Revenue Ruling 78-83, 1978-1 C.B. 79, is also unavailing.¹⁰ Gov.Br.71-72. The ruling is clear that the excess over the correct amount (even if the amount is zero) is the amount that is treated as a distribution to the parent and a contribution to the recipient of the payment. In the present context, this means that the total premium amount received by Reserve would be a capital contribution.

Under the facts and circumstances here, this Court should determine that Reserve had no taxable income.

Conclusion

Reserve renews its prayer at page 68 in its opening brief.

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.