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Earlier this month, the US Tax Court agreed with an IRS determination against favorable tax treatment of premium and dividend payments using a foreign captive. In the decision, the court ruled that a financial services company could not deduct millions of business expenses for purported insurance coverage through an affiliate captive company or take advantage of preferential rates for dividends paid by the captive to the company’s shareholders. While properly organized and administered captives can take advantage of numerous features not available through the traditional insurance market, the ruling highlights challenges companies may face if a captive is not implemented correctly.


Risk Management Strategies, Inc. (RMS) is an S-corporation that provides employment, administration, and management of service providers for the benefit of trusts. RMS contracted primarily with national banks, specifically wealth management and private banking departments, in their capacities as trustees. Its contracts with those clients required that RMS secure and maintain commercial general liability, professional liability, nonowned automobile liability, workers’ compensation and employer’s liability, employment practices liability, and third-party fidelity coverage.

Tax Advantages Through a Captive

RMS insured some risks through commercial insurance, but it also designed, created, and implemented a captive insurance program. The structure of this Anguillan captive, Risk Retention Ltd., varied over time, but RMS used it in two specific ways at issue in the litigation. First, RMS deducted millions in business expenses paid for what it claimed to be insurance coverage provided by the captive. Second, it treated significant distributions from the captive to RMS’s shareholders as qualified dividends subject to preferential tax treatment. In addition to benefiting the tax status of the two individuals, the business expense deduction had a significant impact on RMS’s taxable income.

The Dispute and Decision

The IRS refused to acknowledge the tax benefits claimed using these practices. When the shareholders challenged that determination, the US Tax Court agreed with the agency. The court found that the payments were not deductible as business expenses because the premiums—which on average were ten times higher than those for average commercial insurance companies—were not reasonable compared to typical industry pricing, were not supported by underwriting, and had not been shown to have been paid for actual insurance coverage.

Instead, the court concluded that the shareholders treated the captive “as if it were a tax-free savings account rather than a bona fide insurance company with which they were dealing at arm’s length.” It also found that because Risk Retention was a foreign (Anguillan) corporation, the dividends it paid were not qualified because Anguilla did not have an income tax treaty with the United States during the time period in question. As a result, RMS was not entitled to its premium deductions and the individual shareholders owed more than $2 million in taxes and accuracy-related penalties.


While the tax practices at issue in this case may seem extreme in some respects, the decision shows the challenges companies may face in implementing captives to take advantage of the many benefits of captives, like increased control, reduced costs, and favorable tax benefits. The US Tax Court opened its substantive analysis of taxation of micro-captive insurance companies and deductibility of payments to them by citing a string of other recent judicial decisions on those topics. Alternative risk transfer, including captives, can be an attractive solution for companies facing difficulties in the traditional insurance market. Retaining experienced professionals to advise on the associated insurance, regulatory, corporate, and tax issues can help avoid disputes and maximize benefits associated with those risk transfer vehicles.