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T.C. Memo. 2024-13

BERNARD T. SWIFT, JR. AND KATHY L. SWIFT,

Petitioners

COMMISSIONER OF INTERNAL REVENUE,

Respondent

__________

Docket Nos. 13705-16, 5354-18,

11261-19.

__________

Filed February 1, 2024.

Jaime Vasquez, A. Leonides Unzeitig, Charles J. Muller III, and Stuart

H. Clements, for petitioners in docket Nos. 13705-16 and 5354-18.

Jaime Vasquez, A. Leonides Unzeitig, and Charles J. Muller III, for

petitioners in docket No. 11261-19.

Sharmeen Ladhani, David W. Sorensen, Alexander R. Roche, Vivian

Bodey, and John Robert Gordon, for respondent in docket No. 13705-16.

Sharmeen Ladhani, Sheila R. Pattinson, Alexander R. Roche, Vivian

Bodey, and John Robert Gordon, for respondent in docket Nos. 5354-18

and 11261-19.

MEMORANDUM FINDINGS OF FACT AND OPINION

URDA, Judge: Bernard T. Swift, Jr., is the founder of more than

a dozen urgent care centers and physical rehabilitation facilities in and

around San Antonio, Texas. From 2004 through 2015 Dr. Swift’s

businesses supplemented their traditional insurance by purchasing

assorted policies from microcaptive insurance companies that Dr. Swift

Served 02/01/24

[*2] also controlled. 1 The premiums paid to the microcaptives dwarfed

more traditional insurance premiums, making for healthy deductions

for petitioners, Dr. Swift and his wife, Kathy L. Swift. Relying on

section 831(b), 2 the microcaptives themselves paid no tax on the

premium income received from their sister entities, investing the money

as directed by Dr. Swift.

On each of their joint federal income tax returns for 2012 through

2015, the years at issue, the Swifts deducted, inter alia, more than

$1 million in premiums paid to the microcaptives and miscellaneous

legal fees.

The Internal Revenue Service (IRS) examined this

arrangement for each of these years and concluded that the

microcaptives used the trappings of insurance for purposes of tax

avoidance and financial planning. It accordingly issued notices of

deficiency that, inter alia, disallowed the claimed deductions and

determined accuracy-related penalties.

Consistent with our decisions in Avrahami, 149 T.C. 144, Reserve

Mechanical Corp. v. Commissioner, T.C. Memo. 2018-86, aff’d, 34 F.4th

881 (10th Cir. 2022), Syzygy Insurance Co. v. Commissioner, T.C. Memo.

2019-34, Caylor Land, T.C. Memo. 2021-30, and Keating v.

Commissioner, T.C. Memo. 2024-2, we will sustain the IRS’s

determinations. 3

FINDINGS OF FACT

We held a remote special trial session in these cases via ZoomGov.

We incorporate by reference the stipulation of facts, including the jointly

1 “A ‘captive insurance company’ is a corporation whose stock is owned by one

or a small number of companies and which handles all or a part of the insurance needs

of its shareholders or their affiliates.” Caylor Land & Dev., Inc. v. Commissioner, T.C.

Memo. 2021-30, at *8 n.4; see also Harper Grp. v. Commissioner, 96 T.C. 45, 46 n.3

(1991), aff’d, 979 F.2d 1341 (9th Cir. 1992). “A ‘microcaptive’ is a small captive

insurance company,” i.e., one that “take[s] in less than $1.2 million in premiums.”

Caylor Land, T.C. Memo. 2021-30, at *8 n.4; see also Avrahami v. Commissioner, 149

T.C. 144, 179 (2017).

2 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all relevant times, regulation

references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all

relevant times, and Rule references are to the Tax Court Rules of Practice and

Procedure. All dollar amounts are rounded to the nearest dollar.

3 The Commissioner argues in the alternative that these insurance

transactions lack economic substance. We need not address this argument in light of

our conclusion that the captive insurance arrangement did not constitute insurance.

[*3] stipulated exhibits contained therein. The Swifts lived in Texas

when they timely filed their petitions in these cases.

Dr. Swift and His Medical Businesses

Dr. Swift received his doctorate in osteopathy from the College of

Osteopathic Medicine in Des Moines, Iowa. He then served in the

U.S. Air Force as a flight surgeon assigned to Randolph Air Force Base

in San Antonio, Texas. Dr. Swift worked as an emergency physician on

the side, ultimately going full time after he left the military in 1980.

Texas MedClinic

In 1982 Dr. Swift decided to open the Texas MedClinic (Clinic),

an urgent care center, rather than continue as an emergency physician.

He operated Clinic as a sole proprietorship during the years at issue

(2012 through 2015), with the Swifts reporting its tax information by

means of Schedules C, Profit or Loss From Business, attached to their

annual returns.

Clinic was successful and grew. It expanded to 13 facilities by

2010. As of 2015, Clinic operated 18 locations in San Antonio, New

Braunfels, and Austin, Texas.

Clinic’s practice focused on urgent care and occupational medicine

services, as well as minor surgical procedures such as the removals of

“lumps and bumps, cysts, . . . [and] skin tags.” The concept of urgent

care refers to “the treatment of urgent but non-life-threatening

problems.” Clinic thus “see[s] less critically ill patients . . . [with] the

usual litany of sprained ankles, sore throats, runny noses, eye injuries,

and whatnot.” Occupational medicine encompasses both “caring for

injured workers” and “deal[ing] with regulatory issues such as drug

testing, regulatory physicals, DOT physicals, [and] asbestos physicals.”

From its founding through 2015, approximately 350 physicians

worked at Clinic as independent contractors. During each of the years

at issue, approximately 75 independent-contractor physicians worked at

Clinic. Clinic averaged gross income of $47,110,423 during the years at

issue.

Other Businesses

Dr. Swift founded two other businesses relating to medical

services. In 2006 he formed an entity focused on sports rehabilitation

[*4] (Rehab). 4 As of the end of 2014, Rehab operated eight physical

rehabilitation centers, all in Clinic locations and facilities.

During 2012 through 2015 the Swifts filed Schedules C for Rehab

as part of their returns. Rehab was a more modest venture with around

12 employees and an average gross income of $1,697,494 during the

years at issue.

Dr. Swift opened a separate dermatology practice, Derm Docs,

PLLC (Derm Docs), in 2007.

Derm Docs had one practicing

dermatologist and did not enjoy the success of the other Swift entities,

closing its doors in 2012. During its last year Derm Docs brought in

$224,073 in gross income.

II.

Traditional Insurance for Swift Entities

During all years relevant to these cases, Clinic purchased,

separate from any captive policies, both medical malpractice insurance

and assorted other lines of general commercial insurance.

Commercial Medical Malpractice Coverage

Coverage

Clinic bought claims-made medical malpractice insurance

policies for all years relevant to these cases. 5 During 2012 through 2015,

these policies each had a one-year term and featured no deductible, a

$500,000 per-claim limit, and an aggregate limit of $1.5 million.

Clinic designated the same date as both the policies’ effective date

and retroactive date, thereby limiting the coverage to those claims that

both occurred and were reported during the one-year policy term. The

nature of an urgent-care practice meant that Clinic would be aware

“fairly quickly” of a catastrophic incident, and during all years relevant

to these cases, Clinic’s policies allowed Dr. Swift to trigger coverage by

reporting potential claims to carriers himself.

4 In 2011 Rehab was converted from a sole proprietorship into a limited liability

company.

5 A claims-made policy is generally “[a]n agreement to indemnify against all

claims made during a specified period, regardless of when the incidents that gave rise

to the claims occurred.” Claims-Made Policy, Black’s Law Dictionary (8th ed. 2004).

Such a policy “can also include a retroactive date that limits how far back the incident

could have happened.” Avrahami, 149 T.C. at 154.

[*5] In 2003 Clinic spent $93,164 on premiums for its commercial

medical malpractice insurance, which declined to $66,639 by 2011. The

downward trend continued during 2012 through 2015, the years at

issue, with Clinic paying $67,059, $34,997, $34,997, and $41,997,

respectively, to cover itself and its sister entities. Dr. Swift attributed

the decrease to Texas’s efforts to limit medical malpractice liability,

which had become law in 2003.

Claims History

From its founding until September 1, 2004, Clinic experienced

four medical malpractice claims (out of approximately 2,150,000 patient

visits), which resulted in settlements ranging from $35,000 to $450,000.

Dr. Swift credited Clinic’s success on this front to his proactive approach

to risk management, comprising (1) identifying potential weaknesses in

doctors, which he would address with “classroom type programs,”

(2) reviewing and providing feedback on each doctor’s medical records

for the first 90 days of employment, and (3) a peer review process for

physician complaints.

From January 1, 2001, through November 1, 2012, Clinic’s

insurers paid $1,352,500 relating to medical malpractice claims. No

such claims were filed from November 1, 2012, through December 1,

2015.

Other Commercial Insurance Coverage

In addition to medical malpractice policies, Clinic bought multiple

other lines of commercial insurance. From 2003 through 2011 Clinic

paid average annual premiums of $50,738 to obtain such coverage.

Clinic paid premiums of $70,030, $80,637, $78,980, and $66,306 during

2012 through 2015, respectively, for these policies.

Clinic purchased a Premier Businessowners Policy to insure

buildings it owned up to their replacement cost (valued between $32

million and $45,545,000 during the years at issue), as well as business

income and equipment damage. It also bought coverage for doctors’

equipment (averaging $6,645,375 during the years at issue), accounts

receivable of $250,000, and fine arts (with an average value of $124,400

during the years at issue). Both of these policies included terrorism

coverage at no charge. Rounding out Clinic’s commercial insurance were

policies for fiduciary liability, crime coverage, workers’ compensation,

and business automobiles, as well as a $10 million umbrella liability

policy (which included excess coverage in 2014 and 2015).

[*6] III.

First Foray into Microcaptive Insurance

Understanding the Arrangement

The year 2004 marked a sea change in Dr. Swift’s insurance

approach. Before 2004, Clinic complemented its commercial medical

malpractice policies with a loss reserve of $500,000 to cover claims

falling outside the policy terms. In 2004 Dr. Swift discontinued the loss

reserve and set up the first of three microcaptive insurance companies,

Castlegate Insurance Co., Ltd. (Castlegate).

Dr. Swift began “explor[ing] the possibility of creating a captive

insurance company” because Clinic’s medical malpractice “premiums

were rising at a rate that was . . . inappropriate given our attentiveness

to managing [its] risks and the insurance company’s risks.” Dr. Swift

claimed a desire to “control these policies and . . . control the[se] claims”

in a way that he could not with his traditional insurance carriers. He

also wanted to pay for “medical malpractice cover[age] with––before tax

dollars.”

Dr. Swift’s interest led to Celia Clark, a New York lawyer who

specialized in the formation and maintenance of small insurance

companies for closely held domestic businesses. Also accompanying

Dr. Swift from the start was Tim Schultz, his certified public accountant

(CPA). These discussions did not begin with specific insurance offerings

that Dr. Swift wanted, but with (1) the financial advantages of operating

a microcaptive insurance company and (2) Ms. Clark’s understanding of

the legal requirements for a captive to be deemed a true insurance

company for tax purposes.

As to the former, the parties discussed section 831(b), which

shields from taxation premium income of an insurer with less than

$1.2 million in annual premiums (i.e., a microcaptive insurance

company). Ms. Clark explained that premiums paid by Clinic to a

microcaptive controlled by Dr. Swift would be untaxed and could be used

“to purchase [additional] clinics or just land, leased to [Clinic.]”

As to the latter, Ms. Clark emphasized the need for the

microcaptive to obtain risk distribution to be considered an insurance

company. Relying on her interpretation of our Court’s caselaw and IRS

actions, Ms. Clark asserted that 30% of the microcaptive’s total

premiums would need to come from unrelated businesses in order for

the arrangement to pass muster. Ms. Clark advised that “[t]he 30%

[*7] unrelated insurance business is usually achieved through the

purchase (subscription) of a piece of reinsurance that relates to a pool.”

During their talks, Ms. Clark explained that if Dr. Swift had “a

firm number in mind that [he] desired to use in payment of captive

premiums, we can work backward from that to determine appropriate

types and levels of coverage.” After deciding to proceed with the

arrangement, Dr. Swift and Ms. Clark decided that “tail” medical

malpractice coverage was appropriate. As Dr. Swift explained in 2004,

this coverage insured claims “that arise from acts committed prior to

[the effective date of Clinic’s commercial malpractice policy], but

reported after that date.”

To price the coverage, Dr. Swift originally turned to his insurance

agent, who reported that “there is no way to obtain an actual quotation

covering back to the hire date of the physicians . . . as no carrier will

write ‘tail’ coverage only.” “Those carriers who are willing to write ‘tail’

coverage charge approximately 200% of the mature premium for an

unlimited extended reporting period.” The insurance agent estimated

$976,704 as the cost of the coverage with a $200,000 per-claim limit and

a $600,000 aggregate limit.

Castlegate

Dr. Swift and Ms. Clark incorporated Castlegate in the British

Virgin Islands in October 2004. Castlegate was owned by a limited

partnership that, in turn, was controlled by the Swifts through a limited

liability company and a family trust in which they were trustees.

Castlegate operated as an insurance company from 2004 through

2009. Each year it reported total premiums just under the $1.2 million

cap of section 831(b), as would allow for its premiums to go untaxed. The

percentage breakdown of premiums reflected Ms. Clark’s view of risk

distribution, with no more than 70% of total premiums attributable to

the tail coverage and no less than 30% attributable to Castlegate’s

participation in one of three risk distribution programs sponsored by

Ms. Clark.

Tail Coverage

Castlegate issued its first tail insurance policy for Clinic on

November 7, 2004, using the same effective date as its commercial

medical malpractice policy. This policy was drafted by Ms. Clark and

Dr. Swift by marking up a preexisting commercial medical malpractice

[*8] policy. In 2004 the tail insurance covered all current and former

Clinic physicians, featuring a $200,000 per-claim limit, a $3 million

aggregate limit, and a $15,000 deductible. The policy reflected a

premium of $976,700, as estimated by the insurance agent.

Dr. Swift thereafter retained Anthony Bustillo of KPMG LLP

(KPMG), to determine premium estimates for the tail coverage. These

estimates included (1) a “pure premium” for the coverage derived from

industry and internal KPMG client data and (2) what is known in the

industry as “expense loads,” which were intended to capture

administrative expenses, profit, and contingencies. Dr. Swift ultimately

based the premium amount on this information.

From the start, KPMG proved itself flexible in conducting this

analysis. KPMG’s first assignment was to provide a premium estimate

for Castlegate’s 2004–05 policy year (even though the policy had been

written and payments had been made). Mr. Bustillo determined an

indicated premium using a 22% load factor to account for expenses. He,

however, had failed to take into account the policy’s $15,000 deductible.

When alerted to that fact, Mr. Bustillo generated a revised report that

incorporated the deductible, raised the load factor to 30%, and produced

the same premium, according to Dr. Swift.

For the next policy year, KPMG computed a premium estimate

for insuring “current [Clinic] physicians and [Clinic] (the entity)” and

not former physicians in the previous year’s policy—because, as

Dr. Swift explained in an email, “the calculated premium was going to

exceed the $840,000 if [they] included this group.”

From 2004 through 2009, Clinic’s premiums for traditional

medical malpractice insurance averaged $100,538 per year, while the

tail coverage premiums averaged $825,830. During this time five claims

were made against the policy, resulting in total liabilities of $615,000.

Risk Distribution Programs

Castlegate participated in three risk distribution programs

affiliated with Ms. Clark during its years as an insurance company. As

most relevant here, in 2009 Castlegate participated in a risk distribution

program involving Pan American Reinsurance Co., Ltd. (Pan American).

Under this program, a business insured by a Clark-affiliated

microcaptive (like Clinic) would buy terrorism insurance directly from

Pan American. Pan American, in turn, would enter into an agreement

with the affiliated microcaptive (think Castlegate) under which the

[*9] microcaptive would reinsure a portion of the blended risk from the

underlying terrorism insurance.

The premium received by the microcaptive for such reinsurance

coverage would match the amount that the affiliated business had paid

to Pan American for the terrorism insurance. This amount would also

represent at least 30% of the microcaptive’s total premiums. We take

judicial notice of our holdings in Avrahami that “Pan American was not

a bona fide insurance company” and that “we cannot find that the

policies it was issuing were insurance.” Avrahami, 149 T.C. at 184–90;

see Fed. R. Evid. 201.

Investments

Castlegate’s healthy premiums coupled with modest expenses

and claims history meant that it had significant resources on hand. By

the end of 2008, Castlegate had invested (1) approximately $2 million in

three real estate partnerships that bought land for the future use of

Clinic and (2) approximately $3 million in mutual funds and equity

securities. In 2009 Castlegate stopped issuing policies, and in 2011 it

was domesticated and turned into an investment company.

IV.

The Second Generation of Swift Microcaptives

Formation

In October 2010 Ms. Clark assisted Dr. Swift with the formation

of two new microcaptives, Castlerock Insurance Co., Ltd. (Castlerock),

and Stonegate Insurance Co., Ltd. (Stonegate) (collectively, Swift

captives). These captives were incorporated in the Federation of St.

Christopher and Nevis (St. Kitts) and licensed to operate as insurance

companies from the St. Kitts Financial Services Regulatory

Commission. 6

Preliminaries

The record contains no feasibility study verifying the need for two

captives. Dr. Swift focused on premiums by stating:

6 In 2006 Ms. Clark assisted in drafting captive insurance legislation for the

island of St. Kitts, which was reviewed and revised by legislators and attorneys from

St. Kitts.

[*10] The only policies that have been issued to date for

Castlegate . . . are medical malpractice, terrorism, and

Credit Re policies. . . . In order to get closer to maxing out

the premiums, I will be looking for other risks to insure,

both from related entities, and also unrelated. Celia has

indicated that a reasonable limit for the terrorism

insurance . . . is probably not more than $400,000.

Actually, we’re thinking in terms of having the captives

write a stop loss policy for [Clinic’s] self insured health

insurance plan. That premium might come in at $150,000200,000 for example. And then there might be others as

well. Whatever might come up, and whatever you and Celia

can come up with for unrelated party premiums.

A few months later he reaffirmed that “the number of other policies [the

Swift captives] write will depend on the total premiums,” estimating

that “about $1.5-1.6M in total premiums . . . will probably be all [Dr.

Swift] can come up with through [Clinic] this year.” For her part, Ms.

Clark verified that “[Clinic] will not be limited to $1,200,000 for the

group.”

The business plans of Castlerock and Stonegate set forth concerns

about the ability to obtain medical malpractice coverage at a reasonable

cost, risks presented by government regulation of the healthcare

industry, and threats presented by competition. The plans also

indicated that the Swift captives would participate in a “pool with other

captive insurance companies . . . [that] will cover business risks relating

to terrorist attacks and other hazards . . . [because,] [i]n the United

States, it is difficult and expensive to obtain appropriate levels of

terrorism risk insurance.”

Execution

The Swift captives were incorporated in October 2010, with each

owned by a trust for one of the Swifts’ two children. Dr. and Mrs. Swift

were the trustees of both trusts, and neither of the children had any role

in the operation of the Swift captives. Dr. and Mrs. Swift also served as

treasurer and assistant treasurer, respectively, for each of the Swift

captives, which gave them authority to open any bank, brokerage, or

investment accounts required by the captives.

The directors of the Swift captives were two Kittian companies,

Corporate Solutions, Ltd., and Heritor Management Ltd. (Heritor). The

[*11] former supplied the principal office, registered office, and

registered agent for the captives. The latter provided services including

claims management and processing, obtaining insurance licenses,

monitoring St. Kitts regulatory compliance, maintaining statutory

insurance records, executing insurance policies, and invoicing. Under

Heritor’s service agreement with the Swift captives, claims were to be

approved and paid out unless Heritor believed coverage was unclear or

if the claimed losses were over $50,000, at which point the claim was

referred for a second opinion.

Both Swift captives elected to be treated as domestic corporations

for United States tax purposes under section 953(d) and elected under

section 831(b)(2)(A)(ii) to be taxed solely on investment income. Each of

the Swift captives was initially capitalized for $36,500, and no

additional capital contributions were made to either captive through the

end of 2015.

Direct Insurance Offerings

The Swift captives sold multiple lines of insurance to Clinic

(covering Clinic, Rehab, and Derm Docs), with each policy featuring the

same pricing and an agreement between the two to share any liability.

In total the captives received the following premiums between 2010 and

2015:

[*12] Policy

2010

2011

2012

2013

2014

2015

Medical

Malpractice

$910,562

$946,134

$812,860

$741,644

649,396

$593,522

Administrative

Actions

101,000

155,936

170,000

102,000

52,000

55,000

Business

Income

116,000

286,136

435,000

134,000

—

Business Risk

Indemnity

60,000

73,674

68,000

44,000

—

Computer

Operations &

Data

14,000

22,869

50,000

33,000

—

Employment

Practices

Liability

31,000

43,256

70,000

37,000

29,000

22,000

Litigation

Expense

77,000

150,364

225,000

43,000

18,000

10,000

Cost of

Defense

—

14,000

7,000

Terrorism

360,000

719,300

540,000

—

Political

Violence

—

231,000

384,000

TOTAL

$1,669,562

$2,397,669

$2,384,860

$1,379,644

$1,139,396

$1,071,522

As the years at issue are 2012 through 2015, we will provide an overview

of the policies as in effect those years.

Malpractice Tail Coverage

Policy Terms

The tail coverage hewed closely to the model developed by

Castlegate, with a $15,000 deductible, $300,000 per-claim limit, and a

$6 million annual aggregate limit. The policy covered claims relating to

professional services rendered at a Clinic facility between the date the

respective physician began work at Clinic and the first day of the policy

period. The policy provided coverage “only if” the claim was reported

within ten days of receipt of written notice by the insured.

Endorsements to the policies included lists of former and current

physicians who were covered, including approximately 140 physicians

who had left Clinic between 1983 and 2000.

[*13]

Pricing

Like Castlegate, the Swift captives engaged KPMG (again,

Mr. Bustillo) to prepare annual actuarial pricing analyses. To provide

its estimates, KPMG received information including copies of the

commercial medical malpractice policies, a report showing all medical

malpractice claims and payments since Clinic’s inception, and a list of

all currently employed and formerly contracted physicians and their

length of time with Clinic. KPMG’s pricing analyses relied on internal

KPMG and industry sources on the ground that the Swift captives’ loss

experience was “too sparse to be fully credible on its own.”

To determine the premium for each physician, KPMG stated that

it looked to (1) mature claims-made premiums for the policy limits of

$300,000 per claim and $6 million in the aggregate, (2) reporting lag

factors, (3) physician specialties and (4) the period of exposure. KPMG

then offered a range of loads “to contemplate administrative expenses,

profit and contingencies,” which would be added to the pure premium to

determine the premium. Dr. Swift ultimately chose the load percentage,

determined the deductible amount, and drafted the medical malpractice

policies.

Nonmedical Coverage

Policy Terms

At various times during 2012 through 2015 the Swift captives

offered nine other lines of insurance:

•

Administrative Actions: These policies covered legal expenses,

fines, and assessments arising from an administrative action or

disciplinary proceeding instituted against the Swift entities.

These policies had a per-event limit of $1 million and an

aggregate limit of $3 million.

•

Business Income: These policies covered business income that the

Swift entities lost as the result of reputational damage, new

competition, or a legislative or regulatory change. The policies

had a per-event limit of $2 million and an aggregate limit of

$5 million. These policies were not purchased in 2014 and 2015.

•

Business Risk Indemnity: These policies offered excess coverage

for business liabilities caused by “construction defects” or events

excluded under the policyholder’s commercial policies—for

[*14] example, losses from asbestos, climate change, or fungi. The

policies did not extend to cover professional liability and had a

per-event limit of $1 million in 2012, and $500,000 in 2013, and

an aggregate limit of $3 million in 2012, and $500,000 in 2013.

These policies were not purchased in 2014 and 2015.

•

Computer Operations and Data: These policies indemnified the

Swift entities against increased cost of working and

reinstatement of data arising out of computer-related

malfunctions at covered Clinic locations. The policies had a perevent limit of $1 million and an aggregate limit of $1.5 million.

These policies were not purchased in 2014 and 2015.

•

Employment Practices Liability: These policies were excess

coverage, insuring against expenses incurred in defending

against employee claims, including discrimination, sexual

harassment, and retaliation. The policies had a per-event and

aggregate limit of $2 million.

•

Litigation Expense: These policies were excess coverage, insuring

any expenses incurred in defending a legal proceeding related to

business activities, prosecuting a third party over a matter

pertaining to the business, or obtaining any legal consultation

pertaining to the business. The policies had a per-event limit and

an aggregate limit of $2.5 million in 2012, $250,000 in 2013, and

$100,000 in 2014 and 2015.

•

Cost of Defense: These policies were excess coverage, offering

insurance for “1) the defense [of ] any Claim instituted against an

Insured [or its officers and directors] . . . ; 2) any private or

governmental Administrative Action . . . ; and 3) any arbitration,

mediation, or other alternative dispute resolution.” The policies

had a per-event and aggregate limit of $10,000.

•

Terrorism: The policy insured against acts of terrorism, as

defined in the Terrorism Risk Insurance Act, as well as assorted

acts (such as the dispersion of biological and chemical agents)

that result in losses exceeding $100 million, which were

committed with the intent to influence or coerce the

U.S. government. The policy did “not apply to loss recoverable . . .

under other insurance or indemnity,” nor did it cover a loss

resulting from acts “occurring in a city with a resident population

greater than two million (2,000,000).” The policy had a per-event

[*15] and aggregate limit of $6,750,000. This policy was discontinued

after 2012.

•

Political Violence: The policy insured Clinic for losses to its

buildings (including the removal of debris) and its net income

against assorted events including acts of terrorism, sabotage,

riots, mutiny, civil war, and the use of biological chemical, or

nuclear weapons (causing more than $100 million in damage and

which were committed with the intent to influence or coerce the

United States government). The policy did not apply “to loss

recoverable . . . under other insurance or indemnity.” It had a

per-event and aggregate limit of $3.3 million and was in effect

from 2013 through 2015.

Between 1982 and December 2010 Dr. Swift had not purchased

similar coverage for his medical entities from commercial insurance

companies. Dr. Swift’s commercial insurance provider was not aware of

the existence of the Swift captives, much less these specific lines of

coverage, during the years at issue.

These policies featured some unusual terms. Several of the

policies identified a claims notification period “as a condition precedent

to payment of any benefit.” The policies also provided for payment by

promissory note if Clinic “suffers a series of catastrophic loss

occurrences that may impair [Clinic’s] solvency.” And the policies each

provided for termination “upon the insolvency or bankruptcy of the

insured.”

Pricing

To price the Swift captives’ nonmedical malpractice policies,

Ms. Clark turned to Allen Rosenbach, an actuary for ACR Solutions

Group, Inc. Ms. Clark (or someone working for her) would send

Dr. Swift’s annual selections and supporting materials to

Mr. Rosenbach. This material included information about business

metrics, including prior year revenue and expenses, average number of

patients, average revenue per patient, payroll, number of employees,

prior claims, and changes in business practices.

Mr. Rosenbach prepared a report with premium estimates for

each desired line of coverage. The report for each year (and each Swift

captive) used stock terms on such estimates:

[*16] [T]he base rates and rating factors developed in this report

were based on a survey of rating plans obtained from

regulatory filings submitted by commercial insurance

carriers in the United States of America. . . . Where

comparable coverages were unavailable, we used

professional judgment to develop reasonable rating

guidelines to reflect the expected loss potentials. The

Company and/or its representatives supplied key

information, both qualitative and quantitative, to help

develop the underlying frequency and severity parameters

in the base rates. Indicated rates were also reviewed and

tempered to reflect historical consistency and rate-on-line

ranges.

The reports also included boilerplate regarding coverage

comparisons. Specifically, the reports stated that “many of the

coverages provided by the Company are either unavailable or

unaffordable in the commercial insurance market” and thus

“adjustments were made to modify the commercial rates and rating

factors to reflect our interpretations of the differences in the captive

insurance policies.”

During most of the years at issue Ms. Clark (or one of her

employees) provided Mr. Rosenbach with a target for the Swift captives’

premiums. In November 2012, for example, an attorney working with

Ms. Clark sent Mr. Rosenbach a memorandum indicating that the

captives wished to renew six policies then in effect, which had a

$366,118 premium for each Swift captive. The attorney further stated

that “the client’s total maximum premium is $1,587,140 to be divided

evenly between Castlerock and Stonegate,” including general cost of

defense and terrorism risk insurance. Mr. Rosenbach ultimately

reached an estimated premium of $1,572,000 for the Swift captives’ 2012

nonmedical policies.

Mr. Rosenbach incorporated feedback from Ms. Clark and her

team into his analyses. In November 2013 an attorney working with

Ms. Clark wrote Mr. Rosenbach a memorandum detailing the policies

selected for 2013, which reflected a premium of $786,000 for each of the

Swift captives. The attorney further stated that the “client’s total

maximum premium target is $458,356 to be divided evenly between [the

Swift captives.]” After Mr. Rosenbach provided his initial calculations,

the attorney responded that the Swift captives’ “requested level is

extremely low this year” and asked if he would “mind seeing if limits

[*17] could be lowered to meet the lower premiums?” Mr. Rosenbach

complied. He also worked with the attorney to adjust the premium

numbers to hit 30% risk distribution rather than 29.7%.

This collaborative approach to premium pricing was repeated in

2014 and 2015. During those years Mr. Rosenbach made premiums

higher or lower as Ms. Clark’s employees instructed, with an eye on 30%

risk distribution. In 2015 one of Ms. Clark’s employees noted that the

premiums were “very lopsided” and asked whether it would be “possible

to adjust the limits upwards and allocate more premium to policies other

than [political violence]?” In a later email the lawyer further requested

Mr. Rosenbach to “raise the limits on Administrative Actions to a level

over $200,000,” noting that the “limit should be raised further if needed

to achieve the 30+% risk distributions on the cessions.”

Claims

Clinic paid the Swift captives a total of $5,975,422 during 2012

through 2015 (following more than $4 million in 2010 and 2011) to

obtain the various lines of insurance coverage. In contrast, Clinic

submitted three claims to the Swift captives during the years at issue,

resulting in total payments of $339,224 (as of the end of September

2015).

The first of the three claims was made under the 2011–12 medical

malpractice tail coverage policies, relating to a Texas state court

lawsuit. Clinic received service of this suit on February 1, 2012,

although it previously had been sent letters dated November 23, 2010,

and July 21, 2011, complaining to Clinic about treatment received on

November 22, 2010, and threatening legal action. Although the policy

required reporting of the claim “within ten (10) days of receipt by [Clinic]

of a written notice of a Claim,” a lawyer working for Ms. Clark sought

and received an extension after notifying the Swift captives of the

lawsuit on November 6, 2012. Heritor ultimately authorized payment

of $13,212 with respect to this claim, which was closed in 2015.

The second claim was made on August 29, 2013, under the

Litigation Expense and Administrative Action policies in effect for 2011

through 2012. Clinic sought the payment of legal expenses incurred in

defending a wrongful termination lawsuit stemming from a dismissal on

October 26, 2012. Although the policies provided that a “Claims

Notification Period of 30 days from the date of occurrence of an Insured

[*18] Event shall exist as a condition precedent to payment of any

benefit hereunder,” Heritor granted Clinic’s extension request.

During the pendency of this claim, the “Cost of Defense policies

with both Captives [were] exhausted,” so a member of Ms. Clark’s team

requested that excess expenses “be applied instead to the Litigation

Expenses policies.” Before mediation in that case, another member of

Ms. Clark’s team represented that the fact that the policy requires the

Swift captives to consent in writing to a settlement “doesn’t necessarily

mean that Dr. Swift has to consult with the [Swift] captive[s] before

finalizing the settlement.” According to the lawyer, she suspected that

Heritor would provide “a letter approving coverage for the future

settlement.”

The Swift captives paid a combined total of $108,012, net a

contribution of $3,439 from the risk distribution pool in which they were

participating at the time (which will be discussed below). Even after

closing, Heritor reopened the claim to approve additional expenses.

Clinic provided notice of the final claim on October 16, 2014,

under the Administrative Actions policy issued on December 1, 2013.

This notice followed a memorandum from Ms. Clark dated September

12, 2014, in which she stated to her “Clients” that their businesses “may

have coverage under an Administrative Actions Insurance Policy issued

by your captive for legal and administrative fees relating to a pending

IRS audit.” Ms. Clark’s firm reported on Clinic’s behalf that the

Department of the Treasury had initiated an audit on February 20,

2014. Again, Heritor approved the untimely claim and ultimately

authorized payments totaling $275,793 by the end of 2015.

Investment of Premiums

During 2010 through 2015 the Swift captives received just over

$10 million in premiums. With the relatively small claims and

expenses, the Swift captives had considerable ready money, which

Dr. Swift invested in (1) real estate, buying and developing property for

three urgent care facilities later leased to Clinic, and (2) the stock

market, through investment accounts with Fidelity and the ownership

of two limited liability companies organized in 2013. In total the Swift

captives invested more than $8 million of the premiums received from

2010 through 2015.

Given the illiquid nature of a large portion of the Swift captives’

investment portfolio, Ms. Clark advised Dr. Swift in April 2013 to

[*19] indemnify the Swift captives and protect them “against future

capital calls they may be unable to meet because of insurance claims.”

In June 2013 Dr. Swift issued a put option to both Swift captives that,

if needed, required him to purchase either or both Swift captives’ entire

interest in the real estate partnership at a price determined by an

appraisal process. The agreements then provided that Dr. Swift could

pay via a promissory note to be paid in three equal installments, with

the first payment to occur about 30 days after the closing date. Later

that year, Ms. Clark’s firm recommended that, going forward “the

captive[s] keep[] 30% of the annual premium in cash or cash

equivalents.”

Risk Distribution and Reinsurance Program

Structure

During 2012 through 2015 the Swift captives participated in two

risk distribution pools affiliated with Ms. Clark: Jade Reinsurance

Group, Inc. (Jade), in 2012 and 2013, followed by Emerald International

Reinsurance, Inc. (Emerald), in 2014 and 2015. Jade and Emerald were

both Alabama captive insurers, formed to “function as . . . vehicle[s] to

pool diverse risks ceded to [them] by” Clark-related microcaptive

insurance companies.

As Ms. Clark explained to Mr. Rosenbach when requesting help

on “the actuarial end,” “[a]fter three years of using terrorism risk

through a reinsurance structure to accomplish risk distribution, [her

team was] re-designing the pool to include more types of coverage.” The

pools thus represented the next links in the evolutionary chain following

the Pan American risk distribution program, in which the Swift captives

had participated in 2010 and 2011.

At a high level, Jade (and then Emerald) agreed to reinsure a

portion of the risks written by participating Clark-affiliated captive

insurance companies, with all of the participating captives, including

the Swift captives, paying premiums to the pool for such coverage. In

turn, the self-same captives each contracted with the respective pool to

reinsure a quota share portion of the pool’s blended liability, with the

pool paying for this coverage by releasing a percentage of the total

premiums that had been paid to it by all the captives. In Ms. Clark’s

view the premium amounts retroceded to the captives pursuant to this

arrangement constituted unrelated business premiums for risk

distribution purposes. She touted in 2014 that both pools were

[*20] “independently managed and have been designed and organized

to be in compliance with IRS rulings issued in 2012, and to result, in

most cases, in risk distribution well above 30%.”

Turning to specifics, Jade and Emerald both grouped the various

insurance policies that could be reinsured as part of their pool as

Coverage Part A, B, or C. 7 For policies under Coverage Part A, Jade

agreed to insure a net loss above $200,000 in 2012 and $100,000 in 2013,

subject to limits of liability of (1) 51% of $800,000 over the $200,000 for

2012 and (2) 55% of $900,000 over $100,000 for 2013.

For its part, Emerald divided Coverage Part A policies on a peroccurrence limit of $100,000. For the policies below this line, Emerald

agreed to cover (1) 80% of a loss over 50% of the per-occurrence limit in

2014 and (2) 100% of a loss over $50,000 up to the occurrence limit in

2015.

For policies above $100,000 in per-occurrence limits, a

participating captive was liable for the first $100,000 and Emerald was

liable above that amount subject to (1) a maximum of 80% of the

$900,000 over the initial $100,000 for 2014 and (2) 100% of the losses up

to $1 million for 2015. The aggregate limits were $720,000 and $950,000

for 2014 and 2015, respectively.

In return for this coverage, Jade received a percentage of the

original gross policy premium that varied depending on occurrence

limits (with higher occurrence limits being charged a lower percentage).

Emerald, on the other hand, charged a flat 30.3% reinsurance premium

for Coverage Part A policies during 2014 and 2015.

The arrangements with respect to Coverage Parts B and C,

including General Cost of Defense and Terrorism or Political Violence

policies, respectively, had many fewer moving parts. For Coverage

Part B, Jade agreed to pay $10,000 per claim and in the aggregate, while

Emerald agreed to 100% liability of each loss occurrence, capped at

$15,000.

7 Coverage Part A policies included the following types of insurance policies:

(1) Administrative Actions; (2) Administrative Actions (Physicians); (3) Business

Income and Extra Expense; (4) Business Risk Indemnity; (5) Computer Operations and

Data; (6) Contract Cancellation; (7) Cyber Protection; (8) Directors and Officers

Liability; (9) Employee Fidelity; (10) Employment Practices Liability; (11) Kidnap,

Ransom and Extortion; (12) Litigation Expense; (13) Loss of Key Employee; and

(14) Tax Indemnity. Coverage Part B consisted of General Cost of Defense Insurance.

Coverage Part C consisted of Terrorism or Political Violence Insurance.

[*21] For Coverage Part C, both Jade and Emerald agreed to reinsure

a percentage of the underlying premiums, depending on the client’s

preference. This approach was consistent with Ms. Clark’s view in 2012

(when setting up Jade) that terrorism and political violence policies

could be used as necessary to assure the desired risk distribution.

Despite the multitude of steps under each program, Ms. Clark

assured participants that “[i]n all cases, the total premiums ceded to

Jade [or Emerald] by a [captive] will be at least 30% and will usually be

substantially above that.”

The reinsurance by Jade and Emerald was only one side of the

coin, however. Jade and later Emerald also entered into quota share

retrocession agreements with the participating captives to retrocede a

quota share of the pool’s blended risk from each Coverage Part to each

participating captive.

In return for effectively reinsuring its reinsurer, each

participating captive, including the Swift captives, received premiums

corresponding to the quota share of risk retroceded. These amounts

would “not be released to the captives immediately” but held in a trust

account and released to the participating captives in tranches

throughout the year. Pursuant to the Jade pool, “half of the funds

[would] be released” from the trust account after 90 days, with the

remainder released after 180 days, “less a . . . holdback as a continuing

loss reserve until the end of the policy period (one year plus any

extended reporting period).”

Emerald tweaked Jade’s approach somewhat. In 2014 Emerald

built in “a 5% holdback as a continuing loss reserve until all obligations

of the pool [had] been settled and paid,” anticipating that the trustees

might be directed to reserve greater amounts. In 2015 the funds were

to remain in the trust account for 180 days, “at which time half of the

funds not used to pay losses or reserved for expected losses [would] be

released.” After 280 days 25% of the original amount would be released

(less the funds used to pay losses or which were reserved). The

remaining funds would be released “when all obligations of the pool

[had] been settled and paid.” If at any time Emerald held amounts “less

than those required to pay [l]osses,” the participating captives were

required to, “within thirty (30) days of notice[,] provide additional funds

. . . for amounts equal to such difference.”

[*22] If the respective pool did not have enough money in its accounts

to cover a filed claim, each captive in the pool would be asked to pay its

fair share of the claim to the pool. In planning conversations with

Mr. Rosenbach about Jade, Ms. Clark identified “meaningful deterrents

to claims against the pool.” Among other things, she noted that the pool

excluded high severity and high frequency lines of insurance, that each

captive would need to pay up to its retained limit before making a claim,

and that the pool would have the authority to exclude an insured making

excessive claims from future pools.

Despite skin-deep differences between Jade and Emerald, their

general structure was the same and can be seen from a diagram included

in Ms. Clark’s 2015 memorandum overviewing Emerald:

To participate in the programs, a captive was required to submit

an application for reinsurance to the relevant pool, which requested a

limited range of information: entity name, business organization (e.g.,

sole proprietorship), location, business activity, gross revenue, value of

property insured, and whether the reinsurance company had previously

received any claims. Ms. Clark then circulated the applications to all

other pool participants, who had less than a week to determine whether

to exclude fellow participants from their respective pool. Dr. Swift, for

example, chose to exclude three applications in 2015 because of different

property value and revenue. The captive thereafter would enter into a

trust agreement, a reinsurance agreement, and a quota share

retrocession agreement, as necessary to participate in both risk

distribution programs.

[*23] The fees for participation in Jade and Emerald were $5,000 in

2012, $6,000 in 2013, and $6,325 in 2014 and 2015. All told, 94 captives

participated in Jade with a total gross volume of $22,700,000 in 2012

and $33,100,000 in 2013. With respect to Emerald, 150 captives

participated with total gross volume of $36,600,000 in 2014, and

159 captives with total gross volume of $36,200,000 in 2015.

The Swift Captives’ Participation in Jade and

Emerald

2012 and 2013

The Swift captives participated in the Jade reinsurance pool in

2012 and 2013. In the first year each of the Swift captives had premiums

of $1,192,430, and Jade reinsured $360,050, which represented 30.2% of

the total. The amounts retroceded to the Swift captives under the quota

share agreement matched the amount paid to it. The pattern of

matching premiums was repeated in 2013, with Jade receiving

reinsurance premiums of $207,450 (30.1% of total premiums of

$689,822) from each of the Swift captives, and the Swift captives

receiving the same amounts in their roles as retrocessionaires. All told,

the Swift captives received back 99.59% and 98.74% of the reinsurance

premiums they paid to Jade in 2012 and 2013, respectively. 8

2014 and 2015

The Swift captives’ experience with Emerald was more of the

same. Specifically in 2014 each captive had total premiums of $569,698,

resulting in $171,450 in premiums reinsured by Emerald (30.1% of the

whole) and retroceded from Emerald to each captive. Likewise, in 2015,

each captive had total premiums of $535,761 and reinsurance premiums

and premiums retroceded of $170,800, which constituted 31.9% of the

whole. Ultimately, the Swift captives each received back 94.98% and

98.99% (before the final distribution) of the reinsurance premiums paid

to Emerald in 2014 and 2015, respectively.

8 Under the 2013 pool, two claims to captive insurance companies reinsured by

Jade were approved, and Jade was responsible for $360,853 of loss, payable from trust

funds. In January 2014 Jade also paid the Swift captives $1,719 for a claim payment

related to pool coverage under Coverage B.

[*24] V.

IRS Examination and Notices of Deficiency

The Swifts’ tax returns were prepared by their CPA, Mr. Schultz,

who had done so since 2004. For tax years 2012 through 2015, the Swifts

reported gross income, total expenses, and insurance expense (other

than health insurance) as follows:

Year

Gross Income

Total Expenses

Insurance Expense

2012

$51,939,335

$50,037,253

$2,518,374

2013

45,778,832

45,194,057

1,495,278

2014

45,214,460

43,535,206

1,253,373

2015

45,509,064

44,273,720

1,181,184

Clinic was the only Swift entity that claimed insurance deductions for

the captive insurance premiums.

Examination

The IRS conducted an examination into the Swifts’ tax returns

for each of the years at issue. Revenue Agent Allen Sohrt conducted the

examination with respect to the Swifts’ 2012 through 2014 tax years and

Revenue Agent Elia Maglaya conducted the examination into their 2015

tax year.

2012 and 2013

On December 31, 2015, Revenue Agent Sohrt notified the Swifts

via letter that he had completed his review for their 2012 and 2013 tax

years and recommended disallowance of the applicable captive premium

payments, although the final decision rested with IRS District Counsel.

In his letter he also pointed out that he recommended the imposition of

20% accuracy-related penalties in his revenue agent report. About a

week later, on January 4, 2016, Group Manager Cynthia Tam signed a

Civil Penalty Approval Form approving the assertion of 20% accuracyrelated penalties under section 6662(c) and (d) for the Swifts’ 2012 and

2013 tax years.

2014

Two years later, Revenue Agent Sohrt completed his examination

for the Swifts’ 2014 tax year and, on October 2, 2017, sent the Swifts

Form 4549, Report of Income Tax Examination Changes, for that year.

The report reflected a 40% accuracy-related penalty but did not include

[*25] the 20% penalty. On October 19, 2017, Group Manager Tam

signed Civil Penalty Approval Forms for the Swifts’ 2014 tax year. In

addition to the 40% penalty shown on the revenue agent’s report, Group

Manager Tam approved, in the alternative, a 20% accuracy-related

penalty for both negligence and substantial understatement.

2015

As to 2015, Revenue Agent Maglaya likewise recommended the

accuracy-related

penalty

for

negligence

and

substantial

understatement. Group Manager Arturo Velasquez signed a Civil

Penalty Approval form on April 9, 2019, approving the penalty. By letter

dated April 9, 2019, Group Manager Velasquez sent to the Swifts an

examination report that, inter alia, took the position that the 20%

accuracy-related penalty applied.

Notices of Deficiency

The IRS issued three notices of deficiency to the Swifts,

disallowing the amounts deducted as insurance premiums and related

legal expenses. 9 The IRS first issued to the Swifts a notice of deficiency

that determined for 2012 and 2013 deficiencies of $893,809 and

$596,855 (stemming from the disallowance of deductions for the

insurance premiums and related legal and professional expenses), as

well as alternative 20% accuracy-related penalties under section

6662(a). The IRS later issued a notice of deficiency determining a

deficiency of $494,259 for their 2014 tax year, as well as an alternative

20% accuracy-related penalty. The IRS finally issued to the Swifts a

notice of deficiency for their 2015 tax year determining a deficiency of

$461,524 and a 20% accuracy-related penalty as an alternative position.

OPINION

Burden of Proof

In general the Commissioner’s determinations in a notice of

deficiency are presumed correct, and the taxpayer bears the burden of

proving that the determinations are in error. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). The taxpayer bears the burden of

proving entitlement to any deduction claimed. INDOPCO, Inc. v.

9 The notice of deficiency for each year at issue also determined a 40% accuracyrelated penalty. The Commissioner has since conceded that penalty, and we

accordingly will not address it.

[*26] Commissioner, 503 U.S. 79, 84 (1992). Thus, a taxpayer claiming

a deduction on a federal income tax return must demonstrate that the

deduction is provided for by statute and must maintain records

sufficient to enable the Commissioner to determine the correct tax

liability. See I.R.C. § 6001; Hradesky v. Commissioner, 65 T.C. 87, 89–90

(1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Treas. Reg.

§ 1.6001-1(a).

If, in any court proceeding, the taxpayer puts forth credible

evidence with respect to any factual issue relevant to ascertaining the

liability of the taxpayer and meets certain other requirements, the

burden of proof shifts to the Commissioner. I.R.C. § 7491(a)(1) and (2). 10

When each party has satisfied its burden of production, then the party

supported by the weight of the evidence will prevail, and thus a shift in

the burden of proof has real significance only in the event of an

evidentiary tie. See Knudsen v. Commissioner, 131 T.C. 185, 189 (2008),

supplementing T.C. Memo. 2007-340.

We do not perceive an evidentiary tie in these cases and are able

to decide the issues on the preponderance of the evidence. See, e.g.,

Bordelon v. Commissioner, T.C. Memo. 2020-26, at *11.

II.

Insurance

General Principles

Section 162(a) allows the deduction of “all the ordinary and

necessary expenses paid or incurred during the taxable year in carrying

on any trade or business.” Insurance premiums are typically deductible

under section 162(a) as ordinary and necessary expenses if paid or

incurred in connection with a trade or business. Treas. Reg. § 1.1621(a).

Insurance companies are generally taxed on taxable income,

including premium income and investment income, in the same manner

as other corporations. See I.R.C. § 831(a); see also Syzygy, T.C. Memo.

2019-34, at *27. Section 831(b), however, provides an alternative taxing

structure for certain small insurance companies. See Avrahami,

10 The U.S. Court of Appeals for the Fifth Circuit, to which an appeal in these

cases would ordinarily lie, see I.R.C. § 7482(b)(1), has likewise held that, if an

“assessment is arbitrary and erroneous, the burden shifts to the government to prove

the correct amount of any taxes owed,” Portillo v. Commissioner, 932 F.2d 1128, 1133

(5th Cir. 1991), aff’g in part, rev’g and remanding in part T.C. Memo. 1990-68.

[*27] 149 T.C. at 175. Specifically, an insurance company with written

premiums not over $1.2 million in its tax year that makes a valid section

831(b) election is subject to tax only on its investment income (and thus

not its premium income). See I.R.C. § 831(b)(1) and (2). 11 To make a

valid section 831(b) election, a captive must be an insurance company,

however. See I.R.C. § 831(c); Syzygy, T.C. Memo. 2019-34, at *28.

Neither the Code nor the Treasury Regulations define insurance.

See R.V.I. Guar. Co., Ltd. & Subs. v. Commissioner, 145 T.C. 209, 224

(2015); Securitas Holdings, Inc., & Subs. v. Commissioner, T.C. Memo.

2014-225, at *18. The categorization nonetheless has profound effects:

“[W]hile insurance is deductible, amounts set aside in a loss reserve as

a form of self-insurance are not.” Caylor Land, T.C. Memo. 2021-30,

at *31; see also Harper Grp., 96 T.C. at 46. When the insurer and the

insured are related (including in the case of captive or microcaptive

insurers), the line between insurance and self-insurance blurs. See

Avrahami, 149 T.C. at 176–77.

Given the lack of a statutory definition, the meaning of insurance

“has thus been developed chiefly through a process of common-law

adjudication.” R.V.I., 145 T.C. at 224–25; see also, e.g., Caylor Land,

T.C. Memo. 2021-30, at *31. The U.S. Supreme Court long ago explained

that “[h]istorically and commonly insurance involves risk-shifting and

risk-distributing.” Helvering v. Le Gierse, 312 U.S. 531, 539 (1941).

Building on this foundation, to determine whether an arrangement

constitutes insurance, we “look[] to four nonexclusive but rarely

supplemented criteria: [1] risk-shifting; [2] risk-distribution;

[3] insurance risk; and [4] whether an arrangement looks like commonly

accepted notions of insurance.” Caylor Land, T.C. Memo. 2021-30,

at *32; see also Avrahami, 149 T.C. at 181; Rent-A-Center, Inc. v.

Commissioner, 142 T.C. 1, 13 (2014); Rsrv. Mech., T.C. Memo. 2018-86,

at *33.

“In our [five] prior microcaptive cases, we have focused on the

elements of risk distribution and ‘commonly accepted notions of

insurance.’” Caylor Land, T.C. Memo. 2021-30, at *32; see also

Avrahami, 149 T.C. at 181–97; Keating, T.C. Memo. 2024-2, at *51–52;

Syzygy, T.C. Memo. 2019-34, at *29; Rsrv. Mech., T.C. Memo. 2018-86,

11 For tax years after December 31, 2016, Congress raised the premium ceiling

to $2,200,000 and added certain diversification requirements to make a section 831(b)

election. See Consolidated Appropriations Act, 2016, Pub. L. No. 114-113, § 333(b),

129 Stat. 2242, 3108 (2015). These changes do not have any bearing on the years at

issue.

[*28] at *33–34. We will do so again, and we again reach the conclusion

that the microcaptive arrangement before us does not constitute

insurance.

Risk Distribution

Risk distribution occurs when the insurer pools a large enough

collection of unrelated risks, or risks that are “generally unaffected by

the same event or circumstance.” Rent-A-Center, 142 T.C. at 24; see also

Avrahami, 149 T.C. at 181. “The idea is based on the law of large

numbers—a statistical concept that theorizes that the average of a large

number of independent losses will be close to the expected loss.”

Avrahami, 149 T.C. at 181; see also R.V.I., 145 T.C. at 228; Securitas,

T.C. Memo. 2014-225, at *25–26. Thus, “[b]y assuming numerous

relatively small, independent risks that occur randomly over time, the

insurer smoothes out losses to match more closely its receipt of

premiums.” Rent-A-Center, 142 T.C. at 24 (quoting Clougherty Packing

Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987), aff’g 84 T.C.

948 (1985)); see also Securitas, T.C. Memo. 2014-225, at *25–26 (“As the

size of the pool increases, the chance that the loss per policy during any

given period will deviate from the expected loss by a given amount (or

proportion) declines.” (quoting AMERCO v. Commissioner, 96 T.C. 18,

33 n.14 (1991), aff’d, 979 F.2d 162 (9th Cir. 1992))). Distributing risk

also “allows the insurer to reduce the possibility that a single costly

claim will exceed the amount taken in as a premium.” Securitas, T.C.

Memo. 2014-225, at *25 (quoting Clougherty Packing Co. v.

Commissioner, 811 F.2d at 1300).

In analyzing risk distribution, we look to the actions of the insurer

as it is the insurer’s risk, not the insured’s, that is reduced by risk

distribution. See Rent-A-Center, 142 T.C. at 24; see also Humana Inc. v.

Commissioner, 881 F.2d 247, 251 (6th Cir. 1989), aff’g in part, rev’g and

remanding in part 88 T.C. 197 (1987); Clougherty, 811 F.2d at 1300. We

have concluded on two occasions that a captive insurer had established

risk distribution solely by insuring commonly owned brother-sister

entities.

Each involved coverage at an impressive scale. The captive in the

first instance offered workers’ compensation, automobile, and general

liability insurance covering “between 2,623 and 3,081 stores; . . .

between 14,300 and 19,740 employees; and . . . between 7,143 and 8,027

insured vehicles,” with operations in all 50 states, the District of

Columbia, Puerto Rico, and Canada. Rent-A-Center, 142 T.C. at 24. The

[*29] captive in the second case offered workers’ compensation,

automobile, employment practice, general, and fidelity liability

insurance to 25 to 45 separate entities in more than 20 countries with

more than 200,000 employees and 2,250 vehicles. Securitas, T.C. Memo.

2014-225, at *26.

Microcaptive insurers have not fared as well with respect to

showing risk distribution; all of our previous cases have found

compliance with this requirement lacking. See Avrahami, 149 T.C.

at 182–90; see also Caylor Land, T.C. Memo. 2021-30, at *33–39; Syzygy,

T.C. Memo. 2019-34, at *29–37; Rsrv. Mech., T.C. Memo. 2018-86,

at *34–48. In those cases the microcaptives have attempted to

demonstrate risk distribution in two different ways: (1) direct policies to

brother-and-sister entities and (2) participation in a risk pool. See

Avrahami, 149 T.C. at 182–90; see also Caylor Land, T.C. Memo. 202130, at *33–39; Syzygy, T.C. Memo. 2019-34, at *29–37; Rsrv. Mech., T.C.

Memo. 2018-86, at *34–48. The Swifts assay a similar climb and take

the same tumble.

Direct Written Policies

The Swifts first argue that the Swift captives policies themselves

establish risk distribution. This argument appears to have been a

somewhat belated revelation, as the Swift captives’ business plans

indicate that they were participating in Jade and Emerald risk pools

(and the Pan American pool before them) for risk-distribution purposes.

In our previous microcaptive cases, we “have focused on both the

number of insureds and the total number of independent risk exposures”

when assessing risk distribution. Rsrv. Mech., T.C. Memo. 2018-86,

at *34. In each of those cases “we found there wasn’t a large enough

pool of unrelated risk from the policies issued to the related entities.”

Caylor Land, T.C. Memo. 2021-30, at *34.

We reach the same conclusion here. The Swift captives insured,

at most, three entities (in 2012), which dropped to two in 2013 when

Derm Docs closed its doors. 12 The Swift captives issued only nine lines

of coverage in 2012 and 2013 and six lines in 2014 and 2015. These

numbers are comparable to those we have found wanting in several of

our previous microcaptive cases. See Avrahami, 149 T.C. at 184 (finding

12 The Commissioner argues that the Swift captives insured only one entity.

We need not address this argument because even with three insured entities, we agree

with the Commissioner’s contention that the Swift captives failed to distribute risk.

[*30] seven types of policies to four entities fell short); Caylor Land, T.C.

Memo. 2021-30, at *19, *21, *35–37 (finding 11–12 policies concentrated

in two entities fell short); Rsrv. Mech., T.C. Memo. 2018-86, at *35–36

(between 11 and 13 policies for three entities fell short).

Moreover, Clinic and Rehab did not insure “a sufficient number

of unrelated risks to allow the law of large numbers to predict losses.”

See Caylor Land, T.C. Memo. 2021-30, at *36; see also Rsrv. Mech., T.C.

Memo. 2018-86, at *35–36. The Swift captives’ six or nine policies

covered an operation spanning approximately 28 locations (as of 2015)

and a workforce that ranged between 530 (2012) and 341 (2015) workers

during the years at issue, including its independent-contractor

physicians. The Swift captives’ risk exposure pales in comparison with

that we have deemed satisfactory for the law of large numbers to apply.

See R.V.I., 145 T.C. at 214 (finding insurance company issued 951

policies covering 714 different insured parties with 754,532 passenger

vehicles, 2,097 real properties, and 1,387,281 commercial-equipment

assets); Rent-A-Center, 142 T.C. at 2 (finding over time, captive insured

14,300 to 19,740 employees, 7,143 to 8,027 vehicles, and 2,623 to 3,081

stores); Harper Grp., 96 T.C. at 51 (finding captive insured 7,500

customers covering more than 30,000 different shipments and 6,722

policies); cf. Caylor Land, T.C. Memo. 2021-30, at *36 (“[T]his is called

the law of large numbers—not small numbers or some numbers.”).

The Swifts argue, however, that the law of large numbers applies

here considering the millions of doctor-patient interactions covered by

the medical malpractice tail policies. The Swifts are using the wrong

metric to evaluate the risk: Michael Angelina, the more persuasive of

the Swifts’ experts, and the Commissioner’s experts looked to the

number of doctors, which is standard in the industry when evaluating

risk. 13 Consistent with the majority of the experts, KPMG likewise

considered doctors, not patient interactions, when offering its price

estimates. We will follow their lead.

Nor do we think the number of physicians sufficient for riskdistribution purposes. We first disagree with the Swifts that all of the

independent-contractor physicians that worked at a Clinic location

stretching back to 1982 represented live risk exposures. During the

years at issue Texas had a two-year statute of limitations on medical

13 Indeed, it strikes us that using the doctor-patient interaction as the

appropriate unit of measurement for risk exposure would be tantamount to treating

as the correct unit of measurement for risk exposure in the automobile insurance

context every time a car is put into gear.

[*31] malpractice claims and a ten-year statute of repose. See Tex. Civ.

Prac. & Rem. Code Ann. § 74.251 (West 2003). Given this legal regime,

doctors who left Clinic’s service before 2002 should not be considered in

the risk-distribution analysis, leaving approximately 199 current or

former physicians. We do not believe that this is an adequate number

of risk exposures, concentrated in one line of insurance, for the operation

of the law of large numbers. In short, the captives “face[d] a number of

independent risks that are at least a couple orders of magnitude smaller

than the captives in cases where we’ve found sufficient distribution of

risk.” Caylor Land, T.C. Memo. 2021-30, at *37.

In addition to failing to show sufficient risk exposures, we hold in

the alternative that the Swifts have not demonstrated that the Swift

captives faced independent risks, also necessary for risk distribution.

Several of the policies insured overlapping risks, as illustrated by the

seamless switch in coverage between the cost of the defense policy and

the litigation expenses policy in connection with the 2013 wrongful

termination claim. This 2013 wrongful termination claim does not

represent an isolated incident, with the Commissioner’s expert David

Russell pointing out that one event might trigger multiple policies,

including Administrative Actions, Business Income, and Litigation

Expenses.

Moreover, “there was no geographic diversity . . . in the entities

that [the Swift captives] insured.” See id. at *38. Clinic’s locations were

concentrated in the San Antonio-Austin area, within a 100-mile radius,

particularly significant given the heavy investment in terrorism and

political violence insurance.

Nor was there industry diversity, with both Clinic and Rehab

operating in well-defined slices of the medical field. The doctors did not

introduce such diversity even in the circumscribed context of the tail

coverage. KPMG grouped in the same risk category all of the physicians

that contracted with Clinic, assigning no value to individual claim

history, specialty, or full-time or part-time status. And Dr. Swift touted

that he tightly controlled physician practice in this setting to achieve

uniformity of performance and desirable outcomes, which belies

diversity.

In summary, we conclude that the Swift captives failed on

multiple levels to establish risk distribution through the direct policies

in effect during the years at issue.

[*32]

Reinsurance Pools

The Swifts argue in the alternative that the Swift captives

distributed risk by their participation in the Jade and Emerald

reinsurance pools. We are thus called to determine “whether [each]

quota-share arrangement was a true insurance arrangement for the

distribution of risk.” Rsrv. Mech. v. Commissioner, 34 F.4th at 912.

In our previous cases we have analyzed this question by reference

to the factors used to determine whether a company is a bona fide

insurer:

(1) whether the company was created for legitimate nontax

reasons;

(2) whether there was a circular flow of funds;

(3) whether the entity faced actual and insurable risk;

(4) whether the policies were arm’s-length contracts;

(5) whether the entity charged actuarially determined

premiums;

(6) whether comparable coverage was more expensive or

even available;

(7) whether it was subject to regulatory control and met

minimum statutory requirements;

(8) whether it was adequately capitalized; and

(9) whether it paid claims from a separately maintained

account.

See, e.g., Reserve, T.C. Memo. 2018-86, at *38–39. To be clear, we do not

consult these factors to determine whether Jade or Emerald “meet the

formal definition of an insurance company” but to decide whether their

products constituted insurance as necessary for Castlerock and

Stonegate to distribute risk. See Rsrv. Mech. v. Commissioner, 34 F.4th

at 912. Several factors convince us that Jade’s and Emerald’s risk pools

did not suffice on this score.

[*33]

Circular Flow of Funds

Under the reinsurance agreements, the Swift captives paid

reinsurance premiums to Jade and to Emerald to reinsure a portion of

their risk. Pursuant to trust agreements and quota share retrocession

agreements, Jade and Emerald returned to the Swift captives 99.59%

and 98.74% of the reinsurance premiums paid to Jade in 2012 and 2013,

respectively, and 94.98% and 98.99% of the reinsurance premiums paid

to Emerald in 2014 and 2015, respectively. “While not quite a complete

loop, this arrangement looks suspiciously like a circular flow of funds.”

Avrahami, 149 T.C. at 186; see also Syzygy, T.C. Memo. 2019-34,

at *30–31; Rsrv. Mech., T.C. Memo. 2018-86, at *40–41.

The Swifts argue that under section 832(b)(4)(A), the Swift

captives never received as income the portion of Clinic’s premium

payments that were later paid to Jade and Emerald for reinsurance.

Ms. Clark refutes this argument, explaining in her annual memoranda

describing the structure of Jade and Emerald: “Your business will pay

all insurance premiums, initially to your [captives.]”

Even assuming that Ms. Clark was incorrect, the end result was

the transfer of nearly all of the reinsurance premium amounts from

Clinic, which was 100% owned by Dr. Swift, to the Swift captives, which

were owned by trusts for the benefit of the Swifts’ adult children, with

the Swifts acting as trustees. Cf. Avrahami, 149 T.C. at 186 (“The end

result of two years in the Pan American program was the transfer of

$720,000 from an entity owned 100% by the Avrahamis to one owned

100% by Mrs. Avrahami.”); Rsrv. Mech., T.C. Memo. 2018-86, at *41.

Arm’s-Length Contracts

Nor do we believe that the Swift captives entered into arm’slength contracts with Jade and Emerald, for the same reasons that we

laid out in Reserve Mechanical, T.C. Memo. 2018-86, at *42, and

Avrahami, 149 T.C. at 188–89. Jade, and later Emerald, agreed to

reinsure a portion of the risks insured under the direct policies written

by the Swift captives, with premiums purportedly related to the specific

risks that the reinsurer assumes. At the same time, the respective

reinsurer retroceded to the Swift captives a share of the total

reinsurance premiums received from approximately 100 captives that

insured diverse companies in various lines of business.

The fact that the premium amounts for the two different types of

insurance agreements matched belies the idea that the parties entered

[*34] into these contracts at arm’s length. It beggars belief that for each

of the four years at issue the premiums paid to Jade and Emerald to

reinsure a portion of the Swift captives’ risk equaled the premiums paid

to the Swift captives for assuming a quota share portion of Jade and

Emerald’s blended risk from approximately 100 different captives.

See Rsrv. Mech., T.C. Memo. 2018-86, at *41–42; see also Rsrv. Mech. v.

Commissioner, 34 F.4th at 906, 912.

Although the Swifts argue that “reinsurance premiums are

normally priced as a percentage of the original premium, this contention

is a red herring. As in Reserve Mechanical, T.C. Memo. 2018-86,

at *41–43, the Swifts failed to show why each percentage was reasonable

and why they perfectly aligned in light of the different risks being

assumed (some of which were wholly subject to client discretion). From

our perspective, it appears that the percentages were reverse engineered

by Ms. Clark and Mr. Rosenbach to ensure that the reinsurance and

retrocessions premiums both equaled at least 30% of a participating

captive’s total premiums as Ms. Clark believed necessary.

The chance that a qualifying loss would not have been paid under

either the Jade or Emerald pool also raises questions whether a

reasonable business would enter into these contracts absent tax

motivations. See Avrahami, 149 T.C. at 188. Both were thinly

capitalized, with Jade ceding 97.5% of its premiums within the first six

months of each year in which the Swift captives participated and

Emerald releasing 95% on the same timeline in 2014. Although

Emerald slowed this cession rate in 2015, this alteration does not change

our view that the Swift captives entered into reinsurance contracts with

companies that would have difficulties making good on claims, precisely

because of the promise, i.e., the premiums would be returned, at the

heart of the arrangement. As in Avrahami, 149 T.C. at 189, Jade and

Emerald would be required to go hat in hand to the participating

captives to cover cash shortfalls, despite their inability to force any of

the participating captives to pay more money into the pool to cover the

claim.

And we cannot ignore that the risk distribution pools actively

sought to block reinsurance coverage. As Ms. Clark explained to

Mr. Rosenbach, she had erected “meaningful deterrents to claims

against the pool.” Specifically, with respect to Coverage Part A, each

captive would need to pay up to a retained limit before making a claim

against the pool, and the pool would have the authority to exclude an

insured making excessive claims from future pools. In short, the

[*35] contracts were set up to dissuade participants from using the pools

as reinsurance.

Actuarially Determined Premiums

Both Jade and Emerald charged premiums as a percentage of the

participating captives’ direct written policies, assigning different

percentages to various types and amounts of coverage. “We have held

that premiums were not actuarially determined where there has been

no evidence to support the calculation of premiums and when the

purpose of premium pricing has been to fit squarely within the limits of

section 831(b).” Syzygy, T.C. Memo. 2019-34, at *34; see also Avrahami,

149 T.C. at 196; Rsrv. Mech., T.C. Memo. 2018-86, at *43.

We begin by observing that the Jade and the Emerald premiums

produced loss ratios that deviated significantly from the industry

standard. The loss ratio generally represents the “[p]ercentage of each

premium dollar an insurer spends on claims.” Loss Ratio, Insurance

Information Institute, https://www.iii.org/resource-center/iii-glossary/L

(last visited Dec. 7, 2023). As we have said before, “[a]s the size of the

pool increases, the chance that the loss per policy during any given

period will deviate from the expected loss by a given amount (or

proportion) declines.” Securitas, T.C. Memo. 2014-225, at *25–26;