Sunil S. Patel and Laurie McAnally- Patel v. Comm., TCM 2024-34
This post is part of our series on recent important tax cases that may be of interest to accounting, tax, and finance professionals. For more like this, see our Federal Tax Update and California Federal Tax Update, which offer a comprehensive analysis of the year’s most pivotal tax developments.
Circular Flow of Funds Flushes Claim of Insurance Expense (Sunil S. Patel and Laurie McAnally- Patel v. Comm., TCM 2024-34)
The Patels owned an eye surgery practice, Ophthalmology Specialists of Texas (OST) and two companies used to conduct clinical research trials on experimental drugs for retina diseases: Integrated Clinical Research, LLC (ICR) and Strategic Clinical Research Group, LLC (SCR). The Patels also formed West Texas Hospital with other doctors, in part, so Dr. Patel (Sunil) would not have to wait for operating rooms for his patients. After suffering substantial losses related to a patient death at the hospital, the Patels investigated the formation of a micro-captive insurance company.
Eventually, the Patels formed two micro-captives: Magellan Insurance Co. and Plymouth Insurance Co. Premiums paid from 2013 through 2016 to Magellan and Plymouth were slightly under the §831(b) limits each year. In an attempt to meet the safe harbor provisions of Rev. Rul. 2002-89, 51% of all premiums received by the micro-captives were used to purchase reinsurance through a pooling arrangement. The reinsurance premiums were paid to Capstone Reinsurance Co. The micro-captives then participated in a reinsurance from an entity related to Capstone in which they received most of their 51% back. For the years 2012 through 2016, Magellan received over 94% of its premiums paid to Capstone back.
The Tax Court generally looks at nine factors to determine whether an entity is performing the functions of an insurance company:
- Whether it was created for legitimate nontax reasons;
- Whether there was a circular flow of funds;
- Whether the entity faced actual and insurable risk;
- Whether the policies were arm’s-length contracts;
- Whether the entity charged actuarially determined premiums;
- Whether comparable coverage was more expensive or even available;
- Whether it was subject to regulatory control and met minimum statutory requirements;
- Whether it was adequately capitalized; and
- Whether it paid claims from a separately maintained account.
The court found that there was a circular flow of funds, no arm’s length negotiations occurred (rate-on-line was 12 times higher than commercial policies), and premiums were not actuarily determined. All deductions for insurance expense paid to the micro-captives were disallowed.
Case update. The Patels’ attempt to not have accuracy-related penalty assessed for transactions that lacked economic substance. The court ordered briefs on whether there was a relevance threshold for the economic substance doctrine. Nearly a dozen different parties filed amicus briefs on the issue.
Tax Practitioner Planning. Micro-captives can offer significant tax benefits, but those must be secondary to the insurance benefits the taxpayer is seeking. Be cautious of insurance and financial plans touting only tax benefits of micro-captive insurance companies.