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United States Tax Court
T.C. Memo. 2025-83
CFM INSURANCE, INC.,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
ROBERTINO PRESTA AND ANTONELLA PRESTA,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket Nos. 10703-19, 10704-19.
Filed August 4, 2025.
—————
Jonathan A. Halmi, Tim Alan Tarter, and Kacie N.C. Dillon, for
petitioners.
Elizabeth A. Carlson, Michael T. Shelton, Evan K. Like, and Steven L.
Williams, for respondent.
TABLE OF CONTENTS
MEMORANDUM FINDINGS OF FACT AND OPINION ..................... 4
FINDINGS OF FACT .............................................................................. 5
I.
Background ....................................................................................... 5
II.
Caputo’s Moves to Captive Insurance ............................................. 9
III. Caputo’s Commercial Insurance .................................................... 12
Served 08/04/25
2
[*2]
IV. CFM’s Policies................................................................................. 12
V.
A.
2012 ......................................................................................... 15
B.
2013 ......................................................................................... 17
C.
2014 ......................................................................................... 17
D.
2015 ......................................................................................... 19
Claims ............................................................................................. 21
VI. Insurance Policies in General ........................................................ 21
VII. Calculating CFM’s Premiums ........................................................ 22
VIII. How Things Went .......................................................................... 25
IX. The Returns .................................................................................... 26
X.
A.
CFM’s Returns ........................................................................ 26
B.
The Prestas’ Returns............................................................... 26
Audit, Petitions, and Trial ............................................................. 30
OPINION ............................................. Error! Bookmark not defined.
I.
The Parties’ Arguments ................................................................. 32
II.
McCarran-Ferguson Act ................................................................. 32
III. Whether This Was Insurance ........................................................ 35
A.
Risk Distribution..................................................................... 35
1.
Safe Harbor ...................................................................... 37
2.
Independent Risk Exposures .......................................... 38
a.
Exposure Units......................................................... 38
i.
Customer Transactions .................................... 39
ii.
Products Sold .................................................... 41
3
[*3]
iii. Major Equipment .............................................. 41
iv. Computer Logins .............................................. 42
v.
Employees ......................................................... 42
vi. Key Employees.................................................. 42
vii. Regulatory Changes ......................................... 43
viii. Store Location ................................................... 43
ix. Suppliers ........................................................... 43
x.
Unrelated Tenants............................................ 44
xi. Insured Entities and Policies ........................... 44
b.
Were the Risk Exposures Independent? ................. 44
i.
Number of Entities ........................................... 45
ii.
Geographic Diversity ........................................ 46
iii. Diversity of Industry ........................................ 46
iv. Revenue as a Proxy for Risk ............................ 47
v.
c.
B.
Independence of Policies .................................. 48
Were the Independent Risk Exposures Sufficient? 48
Commonly Accepted as Insurance .......................................... 51
1.
Formal Operation ............................................................ 52
2.
Premium Calculations ..................................................... 52
3.
Valid and Binding Policies .............................................. 56
4.
a.
Untimely Policies ..................................................... 57
b.
Ambiguity ................................................................. 59
Claims Handling .............................................................. 60
4
[*4]
a.
CFM’s Procedure ...................................................... 60
b.
CFM’s Claims Processing in Reality ....................... 60
5.
Absentee Owners ............................................................. 62
6.
Due Diligence ................................................................... 62
IV. Unwinding the Transaction ........................................................... 63
V.
Penalties ......................................................................................... 66
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: Robertino and Antonella Presta own a local
chain of grocery stores in the Chicago area. In 2012 they formed a
microcaptive insurance company, CFM Insurance, Inc. (CFM), under
Utah law and began sending it just shy of $1.2 million in premiums each
year.
We’ve seen this before in Avrahami, 1 Syzygy, 2 Reserve
Mechanical, 3 Caylor, 4 Keating, 5 Swift, 6 and Patel. 7
In each of those cases, we found that the microcaptive insurer
wasn’t really an insurance company. The Prestas argue that CFM is
different.
They may be right.
1 Avrahami v. Commissioner, 149 T.C. 144 (2017).
2 Syzygy Ins. Co. v. Commissioner, 117 T.C.M. (CCH) 1165 (2019).
3 Rsrv. Mech. Corp. v. Commissioner, 115 T.C.M. (CCH) 1475 (2018), aff’d, 34
F.4th 881 (10th Cir. 2022).
4 Caylor Land & Dev., Inc. v. Commissioner, 121 T.C.M. (CCH) 1205 (2021).
5 Keating v. Commissioner, T.C. Memo. 2024-2.
6 Swift v. Commissioner, T.C. Memo. 2024-13, aff’d, No. 24-60270, 2025 WL
1949147 (5th Cir. July 16, 2025).
7 Patel v. Commissioner, T.C. Memo. 2024-34.
5
FINDINGS OF FACT
[*5]
I.
Background
Angelo and Romana Caputo grew up in a village on the southeast
coast of Italy. While still a young man, Angelo learned that he was a
dual Italian-American citizen. He joined the United States Army,
completed basic training in Chicago, and shortly after was stationed as
a cook on a military base in Germany. Angelo traveled while on furlough
back to his home village where he quickly courted and married Romana.
He completed his service, and the newlyweds sank roots in Illinois and
opened a 3,750-square-foot store in Elmwood Park called Caputo’s New
Farm Produce (Caputo’s). The store soon became known for fresh
produce and delicious Italian baked goods.
The Caputos also produced a daughter they named Antonella.
Antonella grew up in the store. And as the store prospered Angelo began
hiring outside the family. One of his new employees was Robertino
Presta, who started working at the store when he was only 13 years old.
Like Antonella, Robertino’s parents had also immigrated to the United
States from Italy—his father worked as a tailor and his mother as a
beautician. Smitten by his coworker, Robertino secured Angelo Caputo’s
permission to ask Antonella to the prom. The pair has been together
ever since.
Business was good. In 1979 the Caputos began to expand the
store, and within three years it almost doubled in size. Several years
later, the extended Caputo family mixed business with pleasure when
they toured some old-world manufacturers during a vacation to Italy.
This visit inspired them to create their own line of food products which
they called La Bella Romana. The first La Bella Romana products
included peeled, pureed, and crushed tomatoes, but the line expanded to
olive oils, pastas, and hot-and-ready meals.
Angelo Caputo was looking to retire by 1988 but wanted to keep
the business in the family. He worked out a deal with his daughter and
son-in-law to have them take over. Once they were in charge, the
Prestas expanded the business by buying other stores and opening some
new ones. They set up each new store as a separate Illinois corporation,
each of which they jointly owned. By 2015 the Prestas owned and
operated:
6
[*6]
Name
Year
Formed
Square Footage of Retail
Space as of 2014
Caputo’s New Farm Produce, Inc. (i.e.,
the Elmwood Park store)
1979
50,000
Caputo’s New Farm Produce–Addison,
Inc.
1991
40,000
Caputo’s New Farm Produce–Hanover
Park, Inc.
1996
38,000
Caputo’s New Farm Produce–
Bloomingdale, Inc.
2004
38,000
Caputo’s New Farm Produce–Naperville,
Inc.
2006
70,000
Caputo’s New Farm Produce–South
Elgin, Inc.
2007
65,000
Caputo’s New Farm Produce–Carol
Stream, Inc.
2014
85,000
Caputo’s New Farm Produce–Downers
Grove, Inc.
2014
Unknown
As the number of stores grew, so did what they sold: A full-service
meat department, fish department, café, and bakery were some of the
new features the one-time mom-and-pop produce market began to
provide customers. Each store eventually sprouted a 30-foot-long food
counter to serve La Bella Romana hot meals. La Bella Romana itself
flourished, and by 2012 the company boasted of more than 500 different
products.
As the business grew horizontally, it began to grow vertically.
The Prestas formed LBR Importing & Distributing, Inc., to deal directly
with sellers, and LBR Construction, Inc., to be the general contractor
remodeling Caputo’s stores and obtaining building permits and
construction supplies.
The Prestas also slowly began to increase their storage facilities.
They bought a 20,000-square-foot warehouse in Elmhurst in the 1990s.
In 1999 they upgraded to a 60,000-square-foot warehouse in Addison
equipped with two 6,000-gallon underground fuel tanks for Caputo’s to
use for their trucks. Despite being three times the size of the previous
warehouse, the business again outgrew the space and in 2007 the
Prestas sought to acquire a 300,000-square-foot building on a 30-acre
site in Carol Stream. They planned to expand their production of
7
[*7] prepared foods at that central location, carve out 85,000 square feet
for retail space, and use the rest as a corporate office. They finished this
giant project between late 2012 and early 2013. The warehouse had 20
cooler rooms, a freezer capable of holding 1,000 pallets, and areas
dedicated to sausage making and meat packing.
In 2012 the Prestas incorporated an Illinois limited liability
company to own the warehouse and rent some space in it to the stores.
The Prestas also cultivated a habit of buying shopping centers and
renting out the flagship store to a Caputo’s. They would routinely rent
out the remaining storefronts to other retailers. The result was a
healthy real-estate portfolio, which they planted in R&A Real Estate
Holding, LLC, 8 a holding company for all of their other ventures. It was
jointly owned by the Prestas and the Prestas’ gift trusts.
By 2013 the Prestas held the following real-estate entities:
Name
Year
Formed
RAP
Kennyville,
LLC
2011
Owned real estate and held land for investment.
R&A Real
Estate
Holding, LLC
2012
Holding company for Prestas’ real-estate entities.
2011
60,000-square-foot warehouse rented out to
Caputo’s before the completion of the Carol Stream
warehouse in 2013. After the completion of the
Carol Stream warehouse, this location was rented
out to a third-party liquor vendor.
2011
Owns a six-flat apartment building. The property
included a parking garage that hindered delivery
trucks from getting in and out of the loading dock
on the Elmwood Park store. After the Prestas
purchased the complex, the parking garage was
removed.
2560 Harlem,
LLC
2011
Rented the building to the Elmwood Park store
until 2009 when it moved location. It then rented
to commercial tenants including Planet Fitness
from 2012–15.
2601 Harlem,
LLC
2011
Owns the parking lot for the 2560 Harlem location.
1811 W.
Fullerton, LLC
2449 N. 72nd,
LLC
Purpose
8 The Prestas formed this holding company in 2012.
8
[*8]
Name
Year
Formed
Purpose
2605 Harlem,
LLC
2011
Commercial real-estate rental to unrelated tenants.
3115 111th
Street, LLC
2011
Rented a building to the Naperville store as well as
unrelated tenants.
2011
Rented part of the shopping center to the Addison
store. The remaining storefronts were leased to
approximately 15 tenants including a dress shop, a
dentist’s office, a gambling venue, and a restaurant.
520 East
North Avenue,
LLC
2011
This building housed the warehouse, corporate
office, and Carol Stream store location. There were
also five or six unrelated tenants including
American Mattress, T-Mobile, a dentist’s office, and
a Sports Clips.
606 Roselle,
LLC
2011
This property was commercial real estate and was
rented to unrelated tenants each year.
7200 Harlem,
LLC
2009
Landlord to the Elmwood Park store; began renting
its building after it moved out from 2560 Harlem
location.
2011
Rented part of a shopping center to the Hanover
Park Store. There were 20 unrelated tenants which
included a cosmetology school, a Polish deli, a cigar
shop, a sports pub, a gym, a camera shop, and a
liquor store.
2001
Rented part of the shopping center to South Elgin
Store. There were approximately 30 tenants,
including an LA Tan, Chili’s, a mobile store, Massage
Envy, a Japanese hibachi restaurant, a gym, and
GNC.
510 Lake Mill
Plaza, LLC
Greenbrook
Plaza, LLC
Lake Street
Plaza, LLC
What started as a local grocery store had grown into an empire.
The average gross revenues for the holding company alone were over
$6 million between 2012 and 2015. As for the Caputo’s stores, the
numbers speak for themselves.
9
[*9]
Average 9 Gross
Revenue
Total Depreciable Assets in 2012 (Other
than Leasehold Improvements)
Elmwood Park
Store
$31,380,471
$6,291,643
Addison Store
19,352,635
2,894,876
Hanover Park
Store
17,580,270
2,853,664
Blooomingdale
Store
17,611,110
1,918,185
Naperville Store
29,218,835
2,289,351
South Elgin Store
19,446,513
2,064,753
Carol Stream
Store 10
13,044,598
4,703,152
Downers Grove
Store 11
13,582,006
1,230,724
Caputo’s Store
II.
Caputo’s Moves to Captive Insurance
The Prestas’ operations contained inherent risk, so naturally they
obtained commercial insurance coverage for the grocery stores,
warehouse, construction company, and some of their real-estate entities.
Starting in 2003, they worked through Steve Gabinski, an insurance
broker at Arthur J. Gallagher Risk Management Services, Inc.
(Gallagher). Gabinski has worked at Gallagher for over thirty years and
holds an insurance license in property casualty, benefits, and major
medical. He specializes in food retailers and is an endorsed broker for
the Illinois Food Retailers Association.
The Prestas came to Gabinski when they were looking to expand
into their 300,000-square-foot space in Carol Stream, to talk about the
potential risks they faced with the expansion and the coverage options
9 All averages are for the years at issue.
10 Amounts listed for total depreciable assets are from its return for the 2014
tax year.
11 Amounts listed for total depreciable assets are from its return for the 2014
tax year.
10
[*10] that were available. These concerns centered on product-recall,
food-contamination, and food-born illness liability. Gabinski attempted
to find coverage for product recall and spoilage in the commercial
market, but that such coverage was limited and prohibitively expensive.
He suggested that the Prestas consider forming a captive insurance
company to provide coverage for product recall and spoilage as well as
to fill in coverage gaps with their existing commercial policies.
There was also undoubtedly an internal marketing opportunity
here for Gabinski. Gallagher had a division called Artex Risk Solutions,
Inc. (Artex), that formed and operated captive insurers. 12 Gabinski set
up an informational meeting to discuss captive insurance for several of
Gallagher’s clients, including the Prestas. He set the meeting for
February 2012, and it was hosted by Artex’s Jeremy Huish.
After the meeting, Robertino Presta reached out to Huish to set
up a call with Huish himself and two of his CPAs. In May 2012, Huish
went to the Carol Stream store where he met with Presta and Caputo’s
CFO Jim Iovino. Presta showed Huish around the facility and
introduced him to the Caputo’s operation. After the meeting, Presta
called Ross Pearlstein, one of his accountants, to see what he thought of
moving forward with the captive. 13
In June 2012 Caputo’s 14 agreed to pay Artex $10,000 to conduct a
feasibility study. In July 2012, before that study was completed, Iovino
signed an Insurance Company Management Agreement whereby Artex
was retained to operate the captive insurance company. The feasibility
study was completed in August 2012. Later that month Gabinski told
Artex that Caputo’s would like to include employment practices liability
coverage as part of the captive since their premiums for commercial
coverage had increased by a factor of five. A few days later, Artex’s
12 For those keeping track of our microcaptive-insurance jurisprudence, Artex
was also involved in Caylor, 121 T.C.M. (CCH) at 1208 n.5, and Keating, T.C. Memo.
2024-2.
13 The Commissioner claims that the agreement to form the captive had been
struck right after the meeting. He cites an email Iovino sent to Gabinski where he
wrote: “I THOUGHT WHEN WE ENDED THAT THE CREATION OF A CAPTIVE
WAS A GO” after the meeting with Huish. We do not find that there were any binding
agreements in place at that time. Gabinski sent an email to Iovino later on to confirm
that Artex should move forward with putting together a feasibility study.
14 The agreement identifies “Angelo Caputo’s Fresh Markets” as the company
contracting with Artex.
11
[*11] director of underwriting, Debbie Inman, revised the coverage
proposal to add the employment practice liability coverage. 15
With the updates in place, Artex began setting up the captive
insurance company on behalf of Caputo’s and named it CFM. The
feasibility study cited Utah as the best place to incorporate CFM because
it was an onshore domicile, had a low capital requirement, and had
Utah also offered maximum
favorable regulatory guidelines. 16
flexibility in paying dividends for its captives. 17
Utah also requires a member of the captive insurer’s board be a
full-time Utah resident. Artex recommended appointing Ted Lewis, a
Utah lawyer, to CFM’s board. The Prestas agreed and, together with
Lewis and their own son, Giancarlo, they made up CFM’s four-person
board. In addition to being directors, the Prestas each owned a
50-percent interest in CFM, and Robertino Presta was its president.
The Utah Insurance Department issued a certificate of public
good for CFM effective October 2012, and the Utah Department of
Commerce issued a certificate of registration to CFM in November 2012.
Artex submitted to the Utah Insurance Department CFM’s articles of
incorporation, bylaws, and articles of organization in that same month.
Inman accomplished this by decreasing the administrative and crisismanagement coverage policy limits. See infra p. 16.
15
16 The report identified Utah as a preferred place to set up CFM since it was a
“state government friendly to business development, no premium taxes, easy access to
regulators and legislators, online application process, commitment to technological
advancements, reasonable and effective regulatory environment, favorable statutes,
access to quality service providers, Salt Lake City is home to an international airline
hub and is a central location for western states.”
Domestic incorporation makes CFM different from many of the microcaptives
that have come before our Court. See Avrahami, 149 T.C. at 149 (insurer incorporated
in St. Kitts); Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1 (2014) (insurer
incorporated in Bermuda); Rsrv. Mech. Corp., 115 T.C.M. (CCH) at 1475 (insurer
incorporated in Anguilla); Caylor, 121 T.C.M. (CCH) at 1208 (insurer incorporated in
Anguilla). But see Securitas Holdings, Inc. & Subs. v. Commissioner, 108 T.C.M.
(CCH) 490 (2014) (insurers incorporated in Ireland and Vermont); Syzygy, 117 T.C.M.
(CCH) 1165 (insurer incorporated in Delaware); Jones v. Commissioner, T.C. Memo.
2025-25 (insurer incorporated in Montana).
17 The maximum flexibility of dividends was a reason for incorporating in Utah
in the first draft of the feasibility study drafted by Artex but wasn’t listed as a reason
in the final draft.
12
[*12] III.
Caputo’s Commercial Insurance
By the end of 2012, the various Caputo’s in conjunction with the
Prestas’ other companies had the following commercial insurance
coverage: 18
Type of Coverage
Premium
Plus Fees
Aggregate
Policy Limits
Deductible
Auto
$40,380
$1,000,000
$1,000
Executive Risk
Employment
Practice Liability
18,100
1,000,000
10,000
Argonaut
Crime/General
Liability/Inland
Marine/Property
185,666
5,000,000
2,500
Argonaut
Commercial
Umbrella
26,537
10,000,000
10,000
Argonaut
WC/ER Liability
344,852
500,000
-0-
Indiana/American
Fire
Property/General
Liability
3,982
2,000,000
1,000
Commercial
Umbrella
2,523
5,000,000
10,000
Maxum
General Liability
18,000
2,000,000
5,000
Hanover/Citizens
Businessowner’s
Unknown
4,000,000
1,000
Phoenix/Travelers
Equipment
Breakdown
4,210
52,821,948
2,500
General Liability
18,000
2,000,000
5,000
$662,250
$85,321,948
$48,000
Provider
Argonaut
Indiana/Ohio
Casualty
Maxum
Total
Though the policies and premiums varied from year to year, the
Commissioner does not contest deductibility of any of the premiums that
Caputo paid for any of these commercial insurance policies.
IV.
CFM’s Policies
CFM’s policies with Caputo’s were somewhat different. In
general they had a coverage period of January 1 of one year through
until January 1 of the next, and were evergreen. This meant that they
18 The policies listed in the chart had named insured extensions which included
several of the Caputo’s stores, real-estate holdings, and support entities related to the
grocery store’s operation.
13
[*13] stayed in effect until they were canceled and they were
automatically renewed each year. They identified the insured as
Caputo’s New Farm Produce, Inc. (Caputo’s New Farm). The Prestas’
other companies (Caputo’s entities) were also covered by the policies. 19
For each year, CFM provided Caputo’s New Farm with either a policy
summary or renewal which outlined the provisions of the policies. As
Artex was contracted to operate the company, its underwriters would
annually gather information from the insured entities including
exposure and gaps in commercial coverage. Gabinski acted as a
consultant to Caputo’s during the captive renewal process. He annually
reviewed the policies and discussed them with Presta and Iovino. They
considered the adequacy of the coverage limits and decided whether
specific policies were necessary.
During the years at issue Caputo’s New Farm had various
combinations of the following policies with CFM:
•
Administrative Actions: Covered losses resulting from
investigations, hearings, proceedings, or appeals held or initiated
by local, county, state, or federal governmental agencies or
programs.
Covered losses included professional fees and
expenses, assessments, fines, penalties, and sanctions.
•
Business Interruption Difference in Conditions (DIC): Covered
expenses incurred or reduction of net income due to a covered
cause of loss, which included, but not limited to, weather
conditions, dishonest acts of employees, strikes, riots, disruptions
of computer systems, pollution events, and government-ordered
shutdowns.
19 The following entities were covered by the 2012 and 2013 policies: Caputo’s
New Farm Produce, Inc.; 1811 W. Fullerton, LLC; 2449 N. 72nd, LLC; 2560 Harlem,
LLC; 2601 Harlem, LLC; 2605 Harlem, LLC; 3115 111th Street, LLC; 510 Lake Mill
Plaza, LLC; 520 East North Avenue, LLC; 606 Roselle, LLC; 7200 Harlem, LLC;
Caputo’s New Farm Produce–Addison, Inc.; Caputo’s New Farm Produce–
Bloomingdale, Inc.; Caputo’s New Farm Produce–Carol Stream, Inc.; Caputo’s New
Farm Produce–Hanover Park, Inc.; Caputo’s New Farm Produce–Naperville, Inc.;
Caputo’s New Farm Produce–South Elgin, Inc.; Greenbrook Plaza, LLC; Lake Street
Plaza, LLC; LBR Construction, Inc.; LBR Importing & Distributing; and RAP
Kennyville, LLC.
The 2014 and 2015 policies added both R&A Real Estate Holdings, LLC, and
Caputo’s New Farm Produce–Downers Grove, Inc., to the list.
14
[*14]
•
Collection Risk: Covered losses from outstanding accounts
receivable that could not be collected.
•
Crisis Management/Reputation Risk: Covered expenses arising
from, or relating to, defending the reputation of the insured,
included expenses incurred to defend the reputation of a grocery
store if it sold bad product.
•
Employment Practices Liability: Covered losses incurred as a
result of a claim by an employee for wrongful termination,
negligent supervision, harassment, and discrimination, among
other reasons.
•
General Liability DIC: Covered gaps or exclusions in the
commercial policy, such as damage to product, nonemployee
related discrimination, and mold.
•
Legal/Litigation Expenses: 20 Covered professional fees and
expenses resulting from a legal process against, or claims brought
on behalf of, the insured entities.
•
Loss of Key Customer: Covered losses resulting from the
termination or suspension of a business relationship between the
insured entities and a customer. 21
•
Loss of Key Employee: Covered the loss of a key employee if he
were to resign, die, become disabled, breach his employment
contract, be dismissed for cause, or lose his license to conduct
business on an insured’s behalf. 22
20 This policy was changed from a legal-expense policy to a litigation-expense
policy effective January 1, 2013.
For 2013 the policy was amended to include only those customer
relationships that represented 5% or more of any insured entity’s annual gross and net
income.
21
22 In 2013 the policy was amended to include only loss of those employees which
would result in the loss of net income or increased expense of at least 5% of annual
gross income of the applicable insured.
15
[*15]
•
Loss of Key Supplier: Covered losses due to the termination of a
business relationship between an insured entity and a third party
providing goods or services under a written agreement. 23
•
Mechanical Breakdown DIC: Covered losses, not covered under a
commercial insurance policy, resulting from the failure, cracking,
malfunction, or breakdown of mechanical equipment. 24
•
Product Recall: Covered losses resulting from the recall or
withdrawal from the market or use by any person of the products
prepared or sold by the grocery stores.
•
Network Security & Privacy Liability: Covered replacement or
restoration of electronic data, losses from extortion threats, and
loss of business income or extra expense from an “E-commerce
incident.”
•
Regulatory Change: Covered losses resulting from any changes
made by governmental agencies or regulatory bodies affecting the
insured’s business and increasing operating expenses, reducing
production capacity, or requiring the withdrawal of a product
from the market.
A.
2012
CFM sent Caputo’s New Farm a list of prospective coverages in
August 2012, and Robertino Presta signed it in October 2012,
completing the deal. Though the proposal did not specify what risks
each policy covered, the Prestas contend that it acted as a “binder”, by
which they mean that the proposal was confirmation that the policies
were in place before the policy documents were drafted and sent to them.
2012:
These were twelve policies that were supposedly in place in late
23 In 2013 the policy was amended to include only loss of those suppliers which
would result in loss of net income or increased expense of at least 5% of annual gross
income.
24 In 2013 the policy was amended to include business interruption and extra
expense resulting from equipment inoperable due to utility interruption.
16
[*16]
Premium
Limit
Rate on
Line 25
Percent of
Total
Premiums
Administrative Actions
$84,127
$250,000
33.65%
7.02%
Collection Risk
30,560
300,000
10.19
2.55
Crisis
Management/Reputation
Risk
86,955
750,000
11.59
7.25
Employment Practices
Liability
42,500
300,000
14.17
3.45
General Liability DIC
74,347
500,000
14.87
6.20
Legal Expense
90,739
1,000,000
9.07
7.57
Loss of Key Customer
40,306
200,000
20.15
3.36
Loss of Key Employee
130,607
1,000,000
13.06
10.89
Loss of Key Supplier
254,528
1,000,000
25.45
21.23
Mechanical Breakdown
DIC
57,987
500,000
11.60
4.84
Product Recall
196,953
1,000,000
19.70
16.42
Regulatory Change
109,527
1,000,000
10.95
9.13
$1,199,136
$7,800,000
—
—
Policy Name
Total
The Prestas’ stated understanding may be important because
CFM didn’t issue the actual policies listed in the coverage proposal until
January 2013—several weeks after the coverage period had ended.
Endorsements and declarations in the policies outlined the policyspecific provisions, as well as general terms and conditions.
The payment of premiums was a bit odd as well. PRS Insurance
(PRS), a company controlled by Artex, issued an invoice to Caputo’s New
Farm dated November 12, 2012, for $1,199,136. Even though the invoice
did not identify a specific due date, it provided for semiannual,
quarterly, and monthly payment plans and set forth the amount due
under each plan. Caputo’s New Farm did not wire PRS the $1,199,136
payment until December 2012.
25 The rate on line is the premium divided by the occurrence limit.
17
[*17] B.
2013
Since the 2012 policies contained an evergreen provision, they
were automatically renewed for 2013. The premiums, limits, and rates
for each of the types of policies were identical to those of 2012. The
binder for the 2013 coverage year was sent out on January 23, 2013. But
CFM didn’t issue the renewal endorsements for the 2013 captive policies
until December 27, 2013, a mere four days before the end of the coverage
period. As with the 2012 endorsement, this document identified the
general terms and conditions that governed the captive policies. The
legal-expense, loss-of-key-customer, loss-of-key-employee, loss-of-keysupplier, and mechanical-breakdown DIC policies for 2013 also had a
revised endorsement with new provisions specific to those policies.
PRS issued to Caputo’s New Farm an invoice for $1,199,136 on
January 23, 2013, and like the 2012 invoice, it had no specified due date;
but the same semiannual, quarterly, and monthly payment options were
listed. Caputo’s New Farm paid the premium only in December 2013,
shortly before the end of the policy year.
C.
2014
While the evergreen provision meant that the policies from 2013
were automatically renewed, the binder for 2014 was sent only in May.
But Caputo’s New Farm rejiggered the policies. CFM canceled the lossof-key customer and loss-of-key employee policies in July 2014, albeit
with a supposed retroactive cancellation date of January 1, 2014. That
same day, CFM issued the 2014 renewal endorsements for the
remaining policies containing their terms and conditions, as well as an
unnumbered endorsement that changed the policy numbers. It even
revised policy-specific provisions of the administrative actions, collection
risks, general-liability DIC, litigation-expenses, loss-of-key-employee,
mechanical-breakdown DIC, product-recall, and regulatory-change
policies. CFM also issued a new policy—the business-interruption DIC
policy—which it had not issued for 2012 and 2013.
We summarize:
18
[*18]
Premium
Limit
Rate on
Line
Percent of
Total
Premiums
Administrative Actions
$60,680
$500,000
10.14%
5.07%
Business Interruption DIC
198,612
1,000,000
19.86
16.60
Collection Risk
47,186
300,000
15.73
3.94
Crisis
Management/Reputation
Risk
75,397
500,000
15.08
6.30
Employment Practices
Liability
42,500
750,000
5.67
3.55
General Liability DIC
85,779
500,000
17.16
7.17
Litigation Expense
141,398
1,000,000
14.14
11.82
Loss of Key Employee
98,394
500,000
19.68
8.23
Mechanical Breakdown
DIC
82,125
500,000
16.43
6.87
Product Recall
190,934
1,000,000
19.09
15.96
Regulatory Change
173,143
1,000,000
17.31
14.48
$1,196,148
$7,550,000
—
—
Policy Name
Total
Billing was again somewhat odd. PRS issued an invoice dated
April 9, 2014 to Caputo’s New Farm for $1,204,478 in premiums that
would be owed under the 2014 policies that had not yet been written.
The first 2014 invoice stated: “[P]ayment in full is due by expiration of
the billing period shown above.” The “billing period shown above” was
January 1, 2014, through January 1, 2015. This continued to provide
for semiannual, quarterly, and monthly payment options.
PRS then voided that invoice and sent Caputo’s New Farm a
second invoice in May 2014, for $1,196,148, a small but critical change
in the total amount owed. See infra p. 26. This second invoice had the
same payment terms as the first 2014 invoice, but listed different
policies and premiums for the same 2014 coverage period:
19
[*19]
Premium Shown on
April 4, 2014, Invoice
Premium Shown on
May 19, 2014, Invoice
$131,935
$60,680
n/a
198,612
Collection Risks
44,939
47,186
Crisis
Management/Reputation
Risk
78,006
75,397
Employment Practices
Liability
42,500
42,500
General Liability DIC
96,111
85,779
Litigation Expense
224,442
141,398
Loss of Key Employee
165,947
98,394
Mechanical Breakdown DIC
65,179
82,125
Product Recall
181,842
190,934
Regulatory Change
173,577
173,143
$1,204,478
$1,196,148
Policy
Administrative Actions
Business Interruption DIC
Total
In addition to the payment schedule on the invoice, the general
terms and conditions applicable to the 2014 policies stated that the
insured was “responsible for the payment of all premiums quarterly but
in no event later than the expiration of the Coverage Period.” Caputo’s
New Farm wired PRS $299,037 in July 2014 and the remaining
$897,111 on December 29, 2014.
D.
2015
In January 2015, CFM canceled all of the existing policies
effective January 1, 2015. This was not, however, because CFM had
gone out of business. Instead, in May 2015, Inman issued a policy
certificate which the Prestas assert acted as a binder for the new
policies. But it was 2012 all over again. CFM did not issue the
declarations for new captive policies until January 2016, with a
purported effective date of January 2015. These declarations identified
the general terms and conditions governing the policies, and they had
20
[*20] new endorsements since they were not renewal documents. This
resulted in the following policies and coverage for 2015:
Policy Name
Premium
Limit
Rate on
Line
Percent of
Total
Premiums
Administrative Actions
$49,330
$200,000
24.67%
4.11%
Business Interruption
DIC
172,544
500,000
34.51
14.39
Collection Risk
47,186
300,000
15.73
3.94
Crisis
Management/Reputation
Risk
75,397
500,000
15.08
6.29
Employment Practices
Liability
42,500
750,000
5.67
3.54
General Liability DIC
85,779
500,000
17.16
7.15
Litigation Expense
141,398
1,000,000
14.14
11.79
Loss of Key Employee
98,394
500,000
19.68
8.21
Mechanical Breakdown
Deductible
Reimbursement (DR)
3,496
10,000
3.50
0.29
Mechanical Breakdown
DIC
82,125
500,000
16.43
6.85
Network Security &
Privacy Liability
42,339
500,000
8.47
3.53
Product Recall
190,934
1,000,000
19.09
15.92
Property DR
2,033
5,000
8.13
0.17
Regulatory Change
165,568
750,000
22.08
13.81
$1,199,023
$7,015,000
—
—
Total
Cooper Mountain Assurance, Inc., a company controlled by Artex,
issued Caputo’s New Farm the 2015 invoice for $1,199,023 on May 22,
2015. The 2015 invoice provided for semiannual, quarterly, and
monthly payment plans. CFM then modified the 2015 captive policies
to remove the quarterly payment requirement that had been established
in the 2014 captive policies. Caputo’s New Farm wired CFM $1,199,023
just before the end of the policy year on December 28, 2015.
21
[*21] V.
Claims
Artex was CFM’s third-party administrator for claims, although
it had no written guidelines for processing claims until late 2013 or early
2014. Even then, what procedures it did have focused on how to
physically process a claim rather than how to evaluate a claim’s merits.
Artex also didn’t have a claims department or any licensed claims
adjusters for its various captive insurance companies until Chris Leavitt
joined the company in 2014. Leavitt was a licensed claims adjuster who
worked on captive claims. In 2015, Kevin Christy joined the team as
another claims adjuster. After that, Leavitt served as a claims manager.
VI.
Insurance Policies in General
A valid insurance policy must insure an insurable risk, shift the
risk from the insured, and distribute risk. See Helvering v. Le Gierse,
312 U.S. 531, 539–40 (1941). As the Prestas’ expert Professor Michael
Angelina explained, an insurable risk is one that is fortuitous, that is
limited to indemnification, and that covers an insurable interest.
Fortuitous loss means that the loss must be accidental. Indemnification
means the insurer not paying more than the actual loss suffered by the
insured. And an insurable interest is one in which the insured may
suffer financial loss due to the occurrence of a fortuitous event.
Angelina also credibly explained that there are four “ables”
characteristic of insurable risk, though few risks satisfy all four.
Insurable risks are poolable, determinable, calculable, and manageable.
Poolable means the risk entails a sufficiently large number of
independent exposure units in order to make the risk of loss to the
insurance company reasonably predictable. Determinable means the
loss must be of a finite nature that is clearly defined by the insurance
policy so that the amount indemnified is actually known and capable of
measurement. Calculable means the risk is of a nature such that the
insurer is able to estimate an appropriate premium based on the
expected frequency and severity of the loss arising from the exposure.
And manageable means that the risk can’t be catastrophic in nature,
while taking into account risk-management techniques such as risk
diversification and reinsurance.
Angelina also explained the necessary risk shifting and
distribution involved in an insurance transaction. Risk shifting
transfers the financial uncertainty of an adverse event to a third party
in exchange for what is normally a fixed dollar amount. Risk
22
[*22] distribution is based on the law of large numbers. He explained
that “according to the Law of Large Numbers, the greater the number of
independent exposures, the more closely the actual results will approach
the probable results that are expected.” One does not have to have
sufficient risk distribution for each policy; instead, the industry views
risk distribution from the perspective of the entire package of policies
that an insurer writes for an insured. This can be true even if the risks
being insured are correlated because these risks can be exposed to
different forms of loss. By way of analogy, if one doesn’t have enough
apples or enough oranges to insure, one may still have enough fruit.
VII.
Calculating CFM’s Premiums
As we explained in Avrahami, 149 T.C. at 151–52, the
underwriting process determines the terms, conditions, price, and
acceptability of risk that an insurance company will take on in a
competitive market. The goal of an insurer is to price the policy high
enough so that the premiums cover the expected losses and operational
expenses while providing for a profit. Id. at 152. The job of calculating
premiums is divided between actuaries and underwriters. Id. Actuaries
“define the rating scheme,” while underwriters adjust for the given risks
through their individual selections of relevant factors. Id.
An actuary typically determines the rating system by starting
with published rates and large datasets for particular risks and making
adjustments to various factors including “policy limits, estimates of the
frequency and severity of loss, deductibles, the claims history of a
particular customer, and perhaps a dozen or so other factors that can be
combined into equations that he uses to set a premium for a particular
policy.” Id. An actuary is supposed to make sure that his work is
appropriate for its intended use, consider whether his work includes
large enough risk statistics, and check the reasonableness of his results.
Actuarial Standard of Practice No. 12: Risk Classification (for All
Practice Areas) § 3.3 (Actuarial Standards Bd. 2005). 26
To determine the coverage and in turn the premiums of each
policy, Inman—Artex’s director of underwriting—used a rating system
26 “The Actuarial Standards Board (ASB) is vested by the professional actuarial
societies with the responsibility for promulgating Actuarial Standards of Practice
(ASOPs) for actuaries providing professional services in the United States. Actuaries
are required to follow the ASOPs by their actuarial societies.” Avrahami, 149 T.C. at
152 n.9 (quoting Acuity, A Mut. Ins. Co., & Subs. v. Commissioner, T.C. Memo. 2013209, at *13).
23
[*23] set up by an outside actuary. This rating system consisted of an
exposure measure as well as various captive-risk measures.
Inman and her team made adjustments to the base rates to
account for the particulars of the insured entities through selecting the
appropriate values to plug into the equation. A risk factor below 1
lowered the premium, while a risk factor greater than 1 increased it.
The equation along with the factors used in the equation are as follows:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
Abbreviation
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
× 𝑅𝑅 × 𝐿𝐿𝐿𝐿𝐿𝐿 × 𝑆𝑆𝑆𝑆 × 𝐹𝐹𝐹𝐹 × 𝐿𝐿 × AdjPercl × 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
1,000
Factor
Explanation
Rate
This was also known as a “loss factor;” it was a
base rate that was given to each different type of
policy. This was an output from a simulation that
was run.
LCM
Loss Cost
Multiplier
A factor for what the limit is going to be. One
wants something to put in if there’s going to be a
deductible.
SV
Severity
Expected severity of claims under the policy.
FR
Frequency
Expected frequency of claims for the policy.
L
IncLimits
Factor associated with the policy limit.
AdjPercl
Adequacy of
Assets
How adequate the assets are in the captive to pay
the claim.
CRFTotal
Captive Risk
Factor Total
The riskiness of the insured company itself.
R
While Inman did not describe the reasoning behind the policyspecific risk factors in her testimony, she outlined how she determined
the CRFTotal for each of the years. This figure gives the individual
insured a risk grade factor that is plugged into the equation.
Solvency of the
captive
Inman testified that the adequacy of the assets in the
captive were set at 1.25 for 2012 and 2013 because for the
first year, it only had its base capital when it started and
one is not supposed to pay claims out of its base capital, one
is supposed to keep it. Artex felt that it needed to have
higher premiums to get some assets in the captive. After
the second year it went to 1 because CFM had more assets
from the premiums paid in the first two years.
24
[*24]
The more claims submitted, the higher this number would
be. For the first two years, Inman set this as 1 since there
was no claims history. As no claims were submitted in the
first two years, the number lowered to 0.7.
Limits on the policy
Inman testified that it was a multiplier, and a factor used
to calculate the risk factor for the size of the client’s
revenue. It was used for 2012 and 2013, but for 2014 and
beyond was removed from the calculation. She had no
explanation for how she arrived at the numbers for the first
two years.
Size of the insured
Size of the insured was a factor used to indicate the impact
that massive growth of a company had on their risk. Again,
there was no explanation of how this was determined for
Caputo’s.
Whether the
business was family
run
Artex used this factor in the first two years, and it was
supposed to show whether a family-run business affected
the risk. Inman testified, however, that since nearly all
captives insure family-run businesses this factor did not
make much sense as it would almost always be neutral.
Length of time in
business and how
seasoned was the
management
Inman described this as a risk factor that reflected how
seasoned management was, and how long it had been in
business. The longer a business had been around, the less
risk it had.
Number of products
sold in the business
Inman testified that since Caputo’s had eight or nine
stores, and each store had quite a number of products
including their own, this factor showed lower risk.
The type of
regulatory
environment for the
insured
A subjective factor to reflect the type of regulatory
environment for the insured.
Geographic Spread
of Risk
The higher the geographical spread, the lower this factor.
Claims history of
the insured
Not all factors were present in all years. From 2012 to 2015,
actuary Julie Ekdom worked with Inman to change the factors used in
the Artex model, 27 including the rate-loss cost multiplier, expense-loss,
increased-limits factor, deductible, and schedule-modification
27 The Commissioner points out that for 2012, 7 of the 10 policies that were
written by CFM were different from the calculations resulting from the equation
Inman testified to. We think it is more likely than not that the difference in
calculations was a result of the shifts that took place while Ekdom and Inman were
updating their actuarial method as Inman also testified that policy premiums were
determined outside this model.
25
[*25] factors. 28 There were also several policies for which Artex
determined premiums outside this rating system. 29
Policy
Collection Risk
Employment Practices Liability
Years Determined Outside Rating
System
2012, 2013
2012, 2013, 2014, 2015
Mechanical Breakdown DR
2015
Property DR
2015
VIII. How Things Went
Caputo’s New Farm submitted no claims for 2012 or 2013 and
only two for 2014. One of these, originally filed under the regulatorychange policy, was an almost $1 million claim for updating the
company’s network infrastructure to ensure it was in compliance with
Payment Card Industry (PCI) requirements. After Leavitt told Caputo’s
New Farm that the claim wasn’t covered under that policy, Caputo’s
New Farm resubmitted it under the business interruption DIC policy,
and argued that this cost was a response to a cyberattack. Artex then
approved the claim.
Caputo’s New Farm submitted only one other claim in 2014 and
three more in 2015. Artex handled them in a somewhat unusual way.
Some of them were paid before Caputo’s New Farm submitted a noticeof-claim form. And some were paid before CFM authorized payment.
28 Ekdom prepared a
written actuarial review of the property and liability
rating methodology of provincial insurance which she finished in February 2014. The
review memorialized the changes made to Artex’s rating model.
29 When the network security and privacy policy was added in 2014 Gabinski
got a quote from a commercial carrier which he provided to Inman. Inman used the
premiums for the commercial coverage to determine if the premiums she determined
were reasonable. She also considered the fact that the commercial policy had a selfinsured retention, which the insured had to pay before the policy would start paying
and CFM’s captive policy did not.
26
[*26] IX.
A.
The Returns
CFM’s Returns
For the 2012 tax year, CFM elected to be treated as a small
insurance company under section 831(b). 30 It did not withdraw that
election for any of the years before us. The insurance premiums that
CFM collected in 2012–15 never exceeded $1.2 million:
B.
Year
Total Premiums
2012
$1,199,136
2013
1,199,136
2014
1,196,148
2015
1,199,023
The Prestas’ Returns
The Prestas timely filed their returns for 2012–15. The Caputo’s
entities deducted the insurance premiums paid to CFM. The captiveinsurance premiums had been allocated to the various Caputo’s entities
according to their income and so were the deductions. While there were
no claims filed in the first two years, the Caputo’s entities included in
their income the five claims made in 2014 and 2015 that were paid. The
allocations for each year were as follows:
30 Unless otherwise indicated, statutory references are to the Internal Revenue
Code, Title 26 U.S.C., 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.
27
[*27] 2012 Allocations:
Gross Income
Captive Insurance
Premiums Deducted
Elmwood Park Store
$33,174,993
$275,801
Addison Store
21,657,954
179,870
Bloomingdale Store
17,857,290
143,896
Hanover Park Store
19,907,138
167,879
Naperville Store
31,062,156
263,810
South Elgin Store
19,108,458
167,878
LBR Importing &
Distributing
1,040,370
—
$143,808,359
$1,199,134
Gross Income
Captive Insurance
Premiums Deducted
Elmwood Park Store
$32,366,618
$287,793
Addison Store
20,172,869
167,879
Bloomingdale Store
17,570,081
155,888
Hanover Park Store
18,461,711
167,879
Naperville Store
29,331,714
251,819
South Elgin Store
19,405,186
167,878
LBR Importing &
Distributing
434,806
—
$137,742,985
$1,199,136
Entity
Total
2013 Allocations:
Entity
Total
28
[*28] 2014 Allocations:
Other Claim
Reimbursed
by CFM
Net
(Reduction of)
or Addition to
Taxable
Income
Entity
Gross Income
Captive
Insurance
Premiums
Deducted
Elmwood Park
Store
$31,414,166
$255,429
$142,000
($113,429)
Addison Store
18,490,825
150,297
129,000
(21,297)
Bloomingdale
Store
17,405,958
140,735
112,000
(28,735)
Hanover Park
Store
16,611,415
135,211
118,000
(17,211)
Naperville
Store
29,080,235
236,871
145,000
(91,871)
South Elgin
Store
19,714,996
159,816
124,000
(35,816)
Carol Stream
Store
6,577,707
45,451
39,000
(6,451)
Downers
Grove Store
9,847,266
72,338
96,000
23,662
LBR
Importing &
Distributing
1,576,938
—
95,000
95,000
$150,719,506
$1,196,148
$1,000,000
($196,148)
Total
2015 Allocations:
Entity
Gross Income
Captive
Insurance
Premiums
Deducted
Elmwood
Park Store
$28,556,105
$215,824
—
($215,824)
Addison Store
17,088,891
131,893
—
(131,893)
Bloomingdale
Store
16,558,996
119,902
—
(119,902)
Hanover Park
Store
15,340,815
107,912
—
(107,912)
Other Income
From Claim
Reimbursement
by CFM
Net (Reduction
of) or Addition
to Taxable
Income.
29
[*29]
Entity
Gross Income
Captive
Insurance
Premiums
Deducted
Naperville
Store
27,401,234
203,883
17,150
(186,733)
South Elgin
Store
19,557,413
143,883
—
(143,883)
Carol Stream
Store
19,511,488
143,883
—
(143,883)
Downers
Grove Store
17,316,746
131,893
—
(131,893)
LBR
Importing &
Distributing
881,009
—
15,459
15,459
$162,212,697
$1,199,073
$32,609
($1,166,464)
Total
Other Income
From Claim
Reimbursement
by CFM
Net (Reduction
of) or Addition
to Taxable
Income.
Since all of these were passthrough entities, the deductions
passed through to the Prestas. This meant the less income the entity
received, the less passthrough income the Prestas were obligated to
report on their returns. For 2012, 2013, and 2015, the Prestas reported
the following passthrough income on their returns. 31
Year
Passthrough Income
2012
$5,737,662
2013
1,616,703
2015
–1,458,537
In 2016, the Prestas filed a Form 1040X, Amended U.S.
Individual Income Tax Return, to amend their 2012 return in order to
carry back a claimed net operating loss (NOL) from taxable year 2014.
The 2012 Form 1040X claimed a refund of $480,371 which was refunded
March 2016. 32
31
return.
The Commissioner did not determine a deficiency for the Prestas’ 2014
32 The Prestas also submitted a Form 1040X in December 2016 to amend their
2013 return; however, the Commissioner denied the claimed refund on the basis that
the Prestas were not allowed to deduct the captive-insurance premiums they had paid
in 2015.
30
[*30] X.
Audit, Petitions, and Trial
In April 2019 the Commissioner sent notices of deficiency to CFM
for its 2012, 2013, 2014, and 2015 tax years and to the Prestas for their
2012, 2013, and 2015 tax years. CFM and the Prestas were not alone—
the Commissioner had noticed a boom in microcaptive insurance
transactions. 33 See I.R.S. Notice 2016-66, 2016-47 I.R.B. 745; I.R.S.
News Release IR-2015-19 (Feb. 3, 2015).
The Commissioner disallowed CFM’s section 831(b) election
because the premium income was paid as part of a transaction that was
“not [an] insurance transactio[n] within the meaning of federal tax law.”
He also asserted that CFM was liable for tax on insurance income under
section 61. 34
The Commissioner disallowed the Prestas’ passthrough
insurance deduction for 2012, 2013, and 2015 from the Caputo’s entities
because the payments to CFM were not insurance premiums and
therefore were not deductible.
The Commissioner also disallowed the nearly $1.2 million NOL
deduction for 2012 to the extent it was attributable to deductions for
captive insurance for 2014. He then imposed accuracy-related penalties
for all three years. 35
CFM and the Prestas timely petitioned our Court. We tried the
case in Chicago; the Prestas were residents of Illinois when they filed
the petition and therefore the presumptive venue for any appeal in their
case appears to lie in the Seventh Circuit. See § 7482(b)(1)(A). CFM did
not have a principal place of business or office when it filed its petition,
as well as when it e-filed its returns. Therefore, venue for any
33 As we noted in Avrahami, 149 T.C. at 173, the IRS began applying increased
scrutiny to microcaptive transactions beginning in 2015.
34 The notice of deficiency states that CFM was not “eligible for tax treatment
under section 831(b). The amounts that [they] were entitled to, and/or received, under
a purported captive insurance program [were] includible in [their] gross income under
section 61.” The Commissioner also asserted, but later conceded accuracy-related
penalties for the years at issue.
35 The Commissioner concedes the 40% rate enhancement under section 6662(i)
that he initially determined in the notice of deficiency. The Commissioner had also
determined penalties under section 6662(b)(6) for a transaction lacking economic
substance, but we have already held that the Commissioner did not comply with
section 6751(b)(1) for that penalty.
31
[*31] appeal of its case presumptively lies in the D.C. Circuit. See
§ 7482(b)(1).
OPINION
Insurance companies, other than life-insurance companies, are
generally taxed on their income in the same manner as other
corporations. See §§ 832, 831(a). This means that an insurance
company includes in its taxable income the insurance premiums that it
receives. But there is a carveout for insurance companies with
premiums that don’t exceed $1.2 million for the year. These companies
can elect to be taxed under section 831(b), which excludes premiums
from their taxable income. § 831(b)(1) and (2).
There are also benefits for businesses that buy insurance—
amounts that a business sets aside in a loss reserve as a form of selfinsurance are not deductible. Harper Grp. v. Commissioner, 96 T.C. 45,
46 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992). But insurance premiums
are deductible as ordinary and necessary business expenses under
section 162(a). Treas. Reg. § 1.162-1(a).
Despite these laws governing the tax treatment of insurance
premiums for both insurance companies and businesses paying
premiums, neither the Code nor the regulations tell us what counts as
“insurance”. Avrahami, 149 T.C. at 174 (citing Securitas, 108 T.C.M.
(CCH) 490). For that we need to go to the caselaw. In Helvering v. Le
Gierse, 312 U.S. at 539, the Supreme Court stated that insurance
involves “an actual ‘insurance risk’” and that “[h]istorically and
commonly insurance involves risk-shifting and risk-distributing.”
Drawing the distinction between what counts as insurance and
what doesn’t can get a bit tricky when the insurer and the insured are
related since the line between actual insurance and self-insurance
begins to blur. Avrahami, 149 T.C. at 176. As we explained in
Avrahami, a “pure captive insurance company is one that insures only
the risks of companies related to it by ownership.” Id. As captive
insurance became more popular, the IRS challenged whether payments
between companies and their captives were deductible insurance
expenses. Id. at 177 (citing Rev. Rul. 77-316, 1977-2 C.B. 53).
Captive insurance for large corporations became widely accepted.
See, e.g., AMERCO & Subs. v. Commissioner, 96 T.C. 18, 42 (1991), aff’d,
979 F.2d 162 (9th Cir. 1992); Harper Grp., 96 T.C. at 60; Rent-A-Center,
142 T.C. at 24.
32
[*32] The grafting of captive insurance onto the benefits afforded small
insurance companies under section 831 produced microcaptive
insurance. As we noted in Avrahami, it is possible that one of these
microcaptives could operate legitimately—just as captive insurance
companies can operate legitimately. See Avrahami, 149 T.C. at 179.
But, as we’ve found on numerous occasions, when a microcaptiveinsurance company generates insurance premium deductions but
doesn’t actually provide insurance, the tax advantages of the transaction
fall apart. See generally id.; Patel, T.C. Memo. 2024-34; Swift, T.C.
Memo. 2024-13; Keating, T.C. Memo. 2024-2; Caylor, 121 T.C.M. (CCH)
at 1217–18; Syzygy, 117 T.C.M. (CCH) at 1176; Rsrv. Mech. Corp., 115
T.C.M. (CCH) at 1489–90.
I.
The Parties’ Arguments
The Commissioner argues that CFM is just another illegitimate
microcaptive. The Prestas argue that these cases are distinct from the
others and present us with new arguments we have not yet considered.
They first argue that under federal law Utah gets to decide whether
CFM qualifies as an insurance company within the meaning of section
831. Since Utah has unequivocally deemed CFM an insurance company,
they argue that should be the end of our inquiry. Even if we reject this
argument, the Prestas claim, CFM still qualifies as an insurance
company under the common-law definition.
If all else fails, they argue that we should unwind the entire
construction of CFM and treat the money paid to CFM as either a
contribution of capital or deposits to a loss reserve. Though the Caputo’s
entities would not be entitled to the deductions they took for the
payment of insurance premiums, CFM would not be liable for tax on
those payments. And if we characterize CFM as a loss reserve, the
Prestas argue that they would also be entitled to an adjustment to
reimbursement for the insurance payouts that the Caputo’s entities
reported as taxable income in previous years and that flowed through to
them. 36
II.
McCarran-Ferguson Act
The Prestas begin by arguing that it is not up to the
Commissioner or our Court to decide what does and does not count as
36 The Prestas argue that CFM is entitled to deduct the expenses that resulted
from processing the claims. They failed, however, to provide any evidence of the
amount that CFM would be entitled to deduct.
33
[*33] insurance. They claim instead that this choice is one Congress
explicitly left to the states in the McCarran-Ferguson Act (Act). The Act
provides:
15 U.S.C. § 1012. Regulation by State law; Federal law
relating specifically to insurance; applicability of certain
Federal laws after June 30, 1948
(a) State regulation—
The business of insurance, and every person engaged
therein, shall be subject to the laws of the several States
which relate to the regulation or taxation of such business.
(b) Federal regulation—
No Act of Congress shall be construed to invalidate,
impair, or supersede any law enacted by any State for the
purpose of regulating the business of insurance, or which
imposes a fee or tax upon such business, unless such Act
specifically relates to the business of insurance . . . .
(Emphasis added.)
This is a new argument. CFM is a domestic company, and most
of the microcaptive cases we’ve seen so far have featured insurance
companies operated and regulated offshore. See Avrahami, 149 T.C.
at 149 (insurer incorporated in St. Kitts); Rsrv. Mech. Corp., 115 T.C.M.
(CCH) at 1475 (Anguilla); Caylor, 121 T.C.M. (CCH) at 1208 (Anguilla);
Rent-A-Center, 142 T.C. at 4 (Bermuda). But see Securitas, 108 T.C.M.
(CCH) 490 (Ireland and Vermont); Syzygy, 117 T.C.M. (CCH) 1165
(insurer incorporated in Delaware); Jones, T.C. Memo. 2025-25 (insurer
incorporated in Montana).
CFM was incorporated in and regulated by Utah. The Prestas
argue that Title 31A of the Utah Code regulates the business of
insurance. The Utah Insurance Department has determined CFM is a
valid insurance company, and continues to examine it periodically to
ensure that it remains an insurance company in good standing under
state law. That means, in CFM’s view, that Utah has regulated CFM
and found it be an “insurance” company. CFM then asserts that there
is no Code section or regulation that defines what “insurance” is, and so
when federal courts define “insurance” in the common-law fashion of
explaining the concept in a case-by-case evolution, we are not properly
deferring to state legislators and regulators who have already done so.
In the case of Utah, both legislators and regulators have defined “captive
insurance” and pronounced CFM to have to be selling a legal form of it.
34
[*34] If we were to find that what CFM provided was not “insurance”
that would mean we’d be finding CFM was not an “insurance company,”
and that finding would crash into the McCarran-Ferguson Act’s
prohibition.
This may be a novel argument, but we don’t think it a persuasive
one. The Act’s prohibition is not against recharacterizing what a state
may call “insurance”. The prohibition is against construing the Code to
“invalidate, impair, or supersede any law enacted by any State for the
purpose of regulating the business of insurance.” 15 U.S.C. § 1012(b)
(emphasis added).
There is a distinction between “insurance” and “the business of
insurance.” As the Supreme Court has explained:
The relationship between insurer and insured, the type of
policy which could be issued, its reliability, interpretation,
and enforcement—these were the core of the ‘business of
insurance.’ . . . [W]hatever the exact scope of the statutory
term, it is clear where the focus was—it was on the
relationship between the insurance company and the
policyholder.
SEC v. Nat’l Sec., Inc., 393 U.S. 453, 460 (1969).
In these cases, nothing we do in interpreting and applying the
Code in any way regulates the relationship between CFM and Caputo’s
Fresh Market. We can leave that to Utah.
There is also another problem here for CFM, because the
prohibition is not on federal regulation of the “business of insurance,”
it’s on invalidating, impairing, or superseding state law “for the purpose
of regulating the business of insurance.” See id. at 457. Section 831
imposes tax consequences on particular transactions. The congressional
choice of taxing or not taxing a transaction is not (within perhaps very
broad limits that might amount, for example, to taxation so high as to
be destructive) invalidating, impairing, or superseding state law. Again,
as the Supreme Court has held, “[w]hen federal law does not directly
conflict with state regulation, and when application of the federal law
would not frustrate any declared state policy or interfere with a State’s
administrative regime, the McCarran-Ferguson Act does not preclude
its application.” Humana Inc. v. Forsyth, 525 U.S. 299, 301 (1999).
35
[*35] Just so here. We may conclude that the Prestas don’t get
deductions for the premiums Caputo’s New Farm paid CFM; we may
decide that CFM doesn’t get to exclude the money it got from Caputo’s
New Farm from its taxable income. This would undoubtedly reduce the
attractiveness of microcaptive insurance. But it would not invalidate or
impair or supersede Utah law, any more than making the purchase of
life insurance a nondeductible personal expense in most cases impairs
any of the state laws regulating that part of the insurance business. See,
e.g., AMERCO, 96 T.C. at 42; Patel, T.C. Memo. 2024-34, at *51 n.21.
We therefore hold that the Act does not require us to defer to the Utah
Insurance Department regulators’ determination that CFM is an
insurance company.
III.
Whether This Was Insurance
We can now turn to the familiar question of whether what CFM
provided Caputo’s New Farm was insurance under federal tax law. Was
it a transaction that
•
shifted risk;
•
distributed risk;
•
involved insurance risk; and
•
met the commonly accepted notion of insurance?
See Avrahami, 149 T.C. at 177.
The Commissioner concedes that the transactions satisfy the
insurable-risk and risk-shifting parts of this test, so we need to decide
only whether CFM’s policies distributed risk and met the commonly
accepted notion of insurance.
A.
Risk Distribution
Risk distribution is one of the essential characteristics of
insurance that the Supreme Court identified in Helvering v. Le Gierse,
312 U.S. at 539. Courts will find sufficient risk distribution when a
company pools a large enough collection of unrelated risks. Rent-ACenter, 142 T.C. at 24. The rule is rooted in 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.” Patel, T.C.
Memo. 2024-34, at *38 (quoting Avrahami, 149 T.C. at 181). In other
36
[*36] words, “[b]y assuming numerous relatively small, independent
risks that occur randomly over time, the insurer smooths out losses to
match more closely its receipt of premiums.” Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987), aff’g 84 T.C. 948
(1985).
In the first three microcaptive-insurance cases we saw, the
insurers attempted to satisfy this requirement by engaging in
“insurance pools.” An insurance pool is “a way to reinsure a large
number of geographically diverse third parties.” Caylor, 121 T.C.M.
(CCH) at 1213 (citing Avrahami, 149 T.C. at 163). In each case, we
found that insurance pools alone were not sufficient to satisfy the riskdistribution requirement for insurance. See id.
Microcaptives have also tried to show that they met the riskdistribution requirement by issuing policies to their own brother and
sister entities. Id. The key question then became whether there was a
large enough pool of unrelated risk. Id. The answer to this question
does not hinge solely on “the number of brother-sister entities insured,
but [on] the number of independent risk exposures.” Id. (emphasis
added). In all our previous microcaptive cases, we came to the same
conclusion—there wasn’t a large enough pool of unrelated risk for the
policies issued to the related entities to satisfy the law of large numbers.
Id. at 1213–14; see also Avrahami, 149 T.C. at 181–82 (seven types of
policies to four entities insufficient); Syzygy, 117 T.C.M. (CCH) at 1169
(eight policies to one entity insufficient); Rsrv. Mech. Corp., 115 T.C.M.
(CCH) at 1479–80 (eleven to thirteen policies for three 3 entities
insufficient).
Caylor was the first case where we saw a microcaptive-insurance
company that did not engage in pooling. Caylor, 121 T.C.M. (CCH)
at 1213. In that case, we examined the independent risk exposures that
arose from issuing policies to brother-sister entities. Id. at 1214. We
looked at seven different policies and found that the maximum
independent exposures from each policy ranged from 1 to 12. Id. We
compared this with the risk exposures that we found sufficient in largecaptive cases. Id.
37
[*37]
•
In Harper Group, we found that 7,500 customers, 30,000 different
shipments, and 6,722 special cargo policies were sufficient. Id.
(citing Harper Grp., 96 T.C. at 51). 37
•
In Rent-A-Center the captive insured 3 types of risks, 14,000
employees, 7,000 vehicles, and 2,600 stores; we found it to have
sufficient exposure units. Id. (citing Rent-A-Center, 142 T.C. at 2).
•
In R.V.I. Guaranty, the insurance company insured one type of
risk but issued 951 policies to 714 different insured parties and
their 754,000 passenger vehicles, over 2,000 real-estate
properties, and 1.3 million commercial equipment assets. R.V.I.
Guar. Co. v. Commissioner, 145 T.C. 209, 214 (2015).
As we stated in Caylor, “[t]here is no precise number of
independent risks that must exist for risk to be sufficiently distributed
to meet this element—we’re not a legislature or regulator, and that’s not
the way common-law concepts become clearer over time.” 121 T.C.M.
(CCH) at 1214. In that case, however, we found that the number of
independent risks that the insured faced were “at least a couple orders
of magnitude smaller than the captives in cases where we’ve found
sufficient distribution of risk.” Id.
1.
Safe Harbor
There is no bright line rule for what constitutes sufficient risk
exposures, but there may be a safe harbor. The Commissioner conceded
in Revenue Ruling 2002-90, 2002-52 I.R.B. 985, that risk distribution
may be adequate if a captive insurer insures the risk of 12 or more
related entities all of which have liability coverage between 5% and 15%
of the total risk insured. See Rauenhorst v. Commissioner, 119 T.C. 157,
171 (2002) (treating as concessions in litigation relevant positions taken
by the Commissioner in revenue rulings). 38
37 For perspective, this meant that more than 260,000 air shipments, 18,000
air flights, and 40,000 shipments on more than 3,000 ocean voyages were covered.
Harper Grp., 96 T.C. at 51.
38 The Commissioner himself describes the revenue ruling in his brief as
finding adequate risk distribution with “12 brother-sister entities, none of which
represented more than 15% of the total risk insured.”
38
[*38] Though Caputo’s entities have sufficient numbers to satisfy the
number of related entities that the Commissioner described in the
revenue ruling, 39 the Prestas made no arguments and presented no
evidence that none of the entities represented more than 15 percent of
the total risk insured. Because of this, we cannot find them to have
docked in this safe harbor.
2.
Independent Risk Exposures
We turn to the question of whether the number of CFM’s
independent risk exposures was large enough to satisfy the law of large
numbers. This requires us to first determine (1) how many risk
exposures existed and (2) whether those risk exposures were sufficiently
independent.
a.
Exposure Units
The Commissioner claims that the Prestas’ failure to connect the
specific risk exposures to specific policies is detrimental to their case.
He argues this failure makes it impossible to determine which, if any, of
the policies satisfies the risk-distribution requirement. The problem for
the Commissioner here—and indeed for almost all his positions about
risk distribution in these cases—is that it was unsupported by his own
experts. Professor Angelina testified on behalf of the Prestas that an
insurance company does not need risk distribution for every single policy
to satisfy risk distribution as a whole. It needs only risk distribution
from the collection of policies that it issues. One of the Commissioner’s
experts, Mark Meyer, likewise testified that the law of large numbers
“not only refers to the number of individual initiating events, but again,
the policies and the procedures and the like.”
The Commissioner’s main expert, Roberta Garland, conceded that
the only way risk distribution could be achieved with these types of
policies is by combining the risks with other policies. Garland began her
testimony with a conclusion—that in her opinion CFM did not provide
enough risk distribution. She articulated that she would look, not at the
number of risk exposures but at the number of claims made. If the
volume of claims were small, she said she would look for “tens of millions
of dollars of premium paid.” When asked about the specific policies that
CFM issued, she couldn’t answer even with a range of how many
39 The Commissioner argues that we should disregard some of the entities
insured by CFM. As we discuss infra Part III.A.2.b, we do not agree.
39
[*39] exposures would suffice to trigger the law of large numbers. But
then she conceded that a captive manager like Tribeca/Artex could
accumulate through its own experience enough data for the law of large
numbers to apply.
It went much worse for the Commissioner with his other expert,
Meyer. In his report he also testified that there was inadequate risk
distribution in CFM. But on cross-examination he admitted that that
was a conclusion without supporting analysis. He then proceeded to go
through many of the policies at issue in these cases and agree with the
Prestas:
•
50,000 different products “could be” separate risk events;
•
3–4 million customer visits “would certainly figure into the risk
distribution analysis for the commercial insurance;”
•
every pizza sold could carry a risk of food poisoning, and “they
sell a lot of pizzas” so the law of large numbers would “probably”
kick in;
•
in discussing the regulatory-change policy, he conceded that “the
government could do an infinite number of regulatory changes,
and there are multiple levels of government.”
The transcript goes on like this for page after page. The Prestas’ counsel
summed it up: “I don’t see here . . . where you analyze the number of
exposure units under the policies that are at issue in this case. Is that
a fair statement?” “Correct.”
Consistent with the experts who testified, we look to see whether
there is sufficient risk across all of the policies CFM issued to determine
whether this risk-distribution requirement is satisfied: “The legal
requirement for ‘insurance’ is that there be meaningful risk distribution;
perfect independence of risks is not required.” See R.V.I. Guar., 145 T.C.
at 230 (citing Rent-A-Center, 142 T.C. at 24). We will therefore look to
see whether there are sufficient risk exposures across all of the policies
issued to determine whether, collectively, they satisfy the law of large
numbers on the record we have before us.
i.
Customer Transactions
We begin with the fundamental question of what counts as a risk
exposure? The Prestas learned from our earlier cases that counting each
40
[*40] business, or each business location, would probably not work for
them. So they put on display in these cases a much broader definition
of risk exposure and supported it not only with their own experts’
testimony but with the testimony on cross-examination of the
Commissioner’s own experts.
They first posited that each consumer transaction in each of the
Caputo’s stores was a unique risk exposure. That gets the numbers up—
the average number of customer transactions during the years at issue
was around 4.5 million in all of the Caputo’s stores. The Commissioner
did not object. Angelina and Meyer, as well as Garland, all testified that
for certain policies, the number of customers is an appropriate exposure
unit. 40 As the Prestas highlight in their brief, the number of customer
transactions is substantially lower than the number of actual customers
who frequent the store, because paying customers routinely shop with
friends and family even if they buy only one item, or even none at all.
This makes the number of customer transactions actually lower than
the exposure unit that all of the experts, including the Commissioner’s,
testified would be an appropriate measure of risk exposure.
The Commissioner resists using customer transactions as the
unit of risk, and argues that this would misdirect our analysis from the
insurer to the insured. He reminds us that “[i]n analyzing risk
distribution, we look at the actions of the insurer because it is the
insurer’s, not the insured’s, risk that is reduced by risk distribution.”
Rent-A-Center, 142 T.C. at 24 (citing Harper Grp., 96 T.C. at 57). The
Commissioner points out how in Rent-A-Center, the insurer’s risk
distribution was determined by the number of vehicles insured because
“no matter the number of drivers, there is only one vehicle that can
cause damage or be damaged.” See Resp’t Seriatim Answering Br. 384,
No. 170.
We would have to discount the testimony given by all of the
experts and adopt the Commissioner’s extrapolation on brief from RentA-Center to reach a similar result here. Like the cars driven by
customers that counted as exposure units, it appears on the unusual
record before us as the parties created it in these cases that each
individual item purchased by a customer is a similarly appropriate
exposure unit. This figure would far outstrip the average 4.5 million
40 Professor Angelina opined that CFM achieved adequate risk distribution.
Meyer agreed that the “law of large numbers was present in the General Liability DIC,
Legal/Litigation Expense, Mechanical Breakdown-DIC, and Product Recall policies.”
41
[*41] transactions that took place at the Caputo’s stores in each year—
we take judicial notice that a typical trip to the grocery store typically
results in a customer’s leaving with more than just one item.
The Commissioner’s experts, as well as the logic of the
Commissioner’s own argument, lead us to find on these facts that
customer transactions themselves may not be an appropriate exposure
unit, but they can serve as a proxy to set a floor for how many customers
shopped at the store.
ii.
Products Sold
There were more than 50,000 different products sold at Caputo’s
stores. Meyer and Garland testified that products sold was an
appropriate exposure unit for at least one of the policies at issue. The
Commissioner doesn’t argue that products sold is an insufficient
exposure unit, but posits that 50,000 is an inflated figure. Most of the
products sold by the Caputo’s stores were manufactured and distributed
by third parties who themselves carried the risk of a product recall. The
Commissioner claims that because the third parties were responsible for
product recalls, there was no risk that Caputo’s had in carrying these
products. With no risk, they should not be considered exposure units.
We disagree. Just because a product was covered by a third party
for recall does not mean that the storage and handling of that product
didn’t pose a risk to Caputo’s. If a recall did take place, Caputo’s would
bear the cost of recalling products even if they were purchased from a
vendor and the stores’ commercial general liability policies would not
otherwise cover the expense. Based on these facts we find that the
50,000 different product types sold at the Caputo’s stores are risk
exposures.
iii.
Major Equipment
The Prestas reported that they had 2,000 pieces of major
equipment that each created an independent risk. They defined major
equipment as anything mechanical or worth more than $5,000. The
Commissioner does not contest that major equipment is an adequate
exposure unit. He instead contests the sufficiency of the Prestas’ proof
of the number of pieces of major equipment.
The Commissioner correctly points out that the only evidence we
have that there were roughly 2,000 pieces of major equipment was from
Robertino Presta’s testimony. We have the depreciation schedules from
42
[*42] Carol Stream and Downers Grove, but the assets listed aren’t
itemized. The Prestas concede that the list groups assets together and
does not list them individually. The books and records contain
depreciation schedule of LBR Importing. According to those, there were
475 tangible depreciable assets in 2012 and 2013 and around 700 in
2014 and 2015.
These figures include both mechanical and
nonmechanical assets and there is nothing in the record to distinguish
them.
Based on these facts, we agree with the Commissioner on this
point. Though major equipment created some number of increased risk
exposures, we don’t have enough in the record to corroborate Presta’s
testimony that the number of pieces of equipment was 2,000.
iv.
Computer Logins
There were 1,300–1,500 computer logins. The Prestas claim that
each login posed a unique risk exposure. The Commissioner again
argues that this is an inappropriate exposure unit.
There is no expert testimony to indicate that this would have been
an independent risk exposure for any of the policies. It is possible that
this could have been an exposure unit taken into consideration to
determine risk distribution for the cyber-risk policy. Angelina testified
that the proper metric for a cyber-risk policy would be either the number
of servers or the revenue of the company. The Prestas didn’t give us a
good reason to count the number of logins as risk exposures. We agree
with the Commissioner here.
v.
Employees
There were between 1,023–2,183 employees during the years at
issue. The Prestas claim that each employee is a risk exposure. The
Commissioner made no compelling arguments to refute this.
vi.
Key Employees
The Prestas claim that there were 90 key employees that should
each be considered an independent risk exposure. The Commissioner
does not contest that key employees is an appropriate risk unit, but says
that CFM failed to prove how many—if any—key employees existed.
The only evidence we have of key employees is Robertino Presta’s
testimony at trial and a list of 90 key employes sourced from an email
43
[*43] sent in 2022, which was two months before trial. The email does
not provide the period of employment, job title, or duties of any of the
individuals named. Because of these omissions, the list is insufficient
for us to conclude that it represents an adequate number of key
employees.
We agree with the Commissioner that the Prestas failed to prove
how many, if any, key employees they had during the years at issue.
vii.
Regulatory Changes
For this category, the Prestas ask us to somehow calculate
“unlimited” into the number of risk exposure units. They cite Meyer’s
testimony that there are an “infinite number of regulatory changes.”
Though this may be true, we cannot find that the unlimited reach of the
regulatory state can be used as an exposure unit. Angelina testified that
to determine the exposure units for a regulatory-change policy, one looks
at revenue. We find this more plausible and therefore reject the Prestas’
attempt to inflate their exposure units to unlimited.
viii.
Store Location
Caputo’s had between six and eight store locations during the
years at issue. The Commissioner concedes “each posed a risk to
CFM.” 41 The Commissioner does not contest that the stores count as
exposure units. Instead, he challenges that they are independent risks.
ix.
Suppliers
The Prestas claim that Caputo’s had 301 suppliers and that each
of them was a risk to CFM. The Commissioner does not contest that the
number of suppliers is an adequate measure of risk exposure. He claims
instead that the number of suppliers was not adequately established by
the record.
The Commissioner does concede that for 2012, Robertino Presta’s
testimony was sufficient to establish that they had one key supplier,
Central Grocers. But since the 2013 policy covered only key suppliers
who had written agreements in place, the Commissioner says there is
no proof Central Grocers—even if it was considered a key supplier—
would have been covered. The only evidence of a written agreement we
41 The Commissioner contests that though these may be adequate exposure
units, they do not satisfy the qualification of independent exposure units.
44
[*44] have between Caputo’s and Central Grocers is an application to
use Central Grocers as a primary supplier.
Despite Presta’s admitting at trial that he believed he did not
have a written agreement in place with Central Grocers, the Prestas
urge us to construe the application as a contract. We agree with the
Commissioner that an application is not an agreement. Based on the
facts we agree with the Commissioner that there was one key supplier
for 2012 which counted as a risk exposure, and that there were none in
2013.
x.
Unrelated Tenants
The Prestas allege that 91 unrelated tenants were risks to CFM.
The Commissioner claims that the record does not identify most of the
tenants. He is right on that point. All we have is Robertino Presta’s
uncorroborated testimony. That is not enough.
xi.
Insured Entities and Policies
There were 17 to 19 insured entities that were each a risk to CFM
and 11 to 14 captive policies that were each a risk to CFM. The
Commissioner does not contest the number of insured entities or captive
policies. He claims instead that the exposures were not independent.
We find that the number of entities and policies were adequate exposure
units.
b.
Were the Risk Exposures Independent?
Having identified the number of exposure units, we must now
determine whether the exposure units are independent. We must suss
out whether any of the exposure units overlap with one another so we
don’t count them more than once. The Commissioner challenges the
exposure units derived from the number of insured entities, the number
of store locations, and the number of insured policies as failing to
We don’t need perfect
generate independent risk exposure. 42
42 The Commissioner argues only about the related nature of the Caputo’s
entities and the different policies. He makes no argument as to why each customer
transaction, the number of products sold, the number of employees, or the number of
suppliers should not be treated as independent, but he claims that somehow the lack
of independence between the Caputo’s entities undermines the independent nature of
all the exposure units. This is not correct. In Securitas, we found that “statistically
independent risk exposures” do not change simply because “multiple companies merge
45
[*45] independence of risk because the legal requirement for insurance
is meaningful risk distribution. See Royalty Mgmt. Ins. Co. v.
Commissioner, T.C. Memo. 2024-87, at *26. When looking for whether
there is independent risk exposure, we have identified factors such as
the reliance on a single entity, the lack of geographic diversity in
locations, the relative concentration of the industry, the revenue, and
the interaction of the policies. See Caylor, 121 T.C.M. (CCH) at 1214;
see also Patel, T.C. Memo. 2024-34, at *26 (finding a lack of independent
exposures where the captives issued a few dozen policies to only 3
entities the taxpayers owned and covered less than 100 employees in the
same industry and regional area).
i.
Number of Entities
The Commissioner argues that we should treat all of the Caputo’s
stores as one entity since they shared a corporate office, had centralized
HR and IT departments, purchased products from the same vendors,
and delivered products to the same warehouses. He argues that because
of these commonalities, we should discount the corporate structure of
each individual entity and treat all of the Caputo’s entities as one for
the purpose of this test.
He then argues that it would follow that only LBR Importing and
LBR Construction, of which Caputo’s was the sole customer, would
become dependent on Caputo’s. Additionally, 1811 Fullerton, 3115
111th, 520 North, and 7200 Harlem were almost entirely dependent on
Caputo’s, and 510 Lake Mill Plaza received most of its rent from
Caputo’s. He argues that this means that this cuts against our finding
independent risks.
The Commissioner runs into an issue because he never gives an
explanation, other than the similarities the Caputo’s stores have, as to
why we should treat them as a single entity for the purpose of this test.
As the Prestas point out, each Caputo’s store was set up as a separate
legal entity, had a separate location, separate employees, separate
infrastructure, separate customers, and separate equipment. The
Commissioner provides us with no precedent or legal theory through
into one.” Instead, we held that “[t]he risks associated with those companies [do] not
vanish once they all [fall] under the same umbrella.” 108 T.C.M. (CCH) at 496. Even
if we found that it was appropriate to consider all of the Caputo’s entities as one unit,
this would not undercut the number of independent risk exposures that exist whether
or not we count the entities as separate.
46
[*46] which we can disregard the independent corporate status of all the
Caputo’s companies to find that they are all one mega-entity.
We therefore don’t see how we can find that all of the Caputo’s
entities should be considered a single entity.
ii.
Geographic Diversity
As we said in Caylor, concentration of geographic location and
industry cut against finding independent risk among different entities.
Caylor, 121 T.C.M. (CCH) at 1214. The Commissioner highlights how
every brother-sister entity that CFM insured existed in a single
metropolitan area.
This factor unequivocally supports the Commissioner. It also
influences the weight we give to the separate Caputo’s store locations.
Because they are all in the same metropolitan area, perhaps there is
some overlap in the nature of the risk that each storefront generated.
We are willing to find for the Commissioner that geographical
concentration cuts against finding independence.
iii.
Diversity of Industry
The Commissioner also attacks industry concentration. He cites
Caylor, where we found that in one way or another all of the insureds
were involved in the real-estate industry. Caylor, 121 T.C.M. (CCH)
at 1214. The Commissioner says this case is similar because all the
Caputo’s entities were in or related to the grocery-store industry.
The Commissioner mischaracterizes Caylor as stating that when
entities can all somehow be connected to an industry, they automatically
fail the diversity-of-industry test. This is not the case. In Caylor, all of
the entities were in the primary business of real estate, held stock in
companies focused on real estate, or provided funding for companies that
engaged in real-estate transactions. Caylor, 121 T.C.M. (CCH) at 1214.
All necessary steps to the real-estate industry, but again, all siloed to
that one industry. Id.
We must remember that when we look at whether an industry
was concentrated, we do so with an eye to determining whether risk was
adequately distributed (i.e., if a single industry collapsed, would all of
the related entities fall together?).
47
[*47] Though all of the Caputo’s entities admittedly are in the grocery
business and most of the entities are somehow connected to that
business, they are not all dependent on that one industry. Since LBR
Importing and LBR Construction never engaged in either importing or
construction outside of the grocery-store industry, like the financial
institution which financed only real-estate ventures in Caylor, it seems
safe to say that these two entities were primarily focused on the grocerystore industry.
The same cannot be said for the real-estate holding company or
any of the real-estate entities. Under Caylor, all of these entities would
fall within the real-estate industry. Caputo’s did not own every building
that their stores were in, and some of the real-estate companies did not
even rent buildings to Caputo’s or the related entities. They were not
necessarily dependent on the grocery-store industry to survive. There
may have been some overlap, but there was also independent risk that
these companies brought.
iv.
Revenue as a Proxy for Risk
In Caylor, we found it appropriate to use revenue as a proxy for
risk when the premiums were calculated using revenue. See Caylor, 121
T.C.M. (CCH) at 1214. Here, many of the policies’ premiums were
computed using revenue, and therefore it is appropriate to use the
revenues as a proxy for risk and in turn the determination of the spread
of risk. We found that since most of the companies’ revenue was
dependent on Caylor Construction, it was likely the companies and
therefore the risks they faced were not independent. Id.
The Commissioner argues that 94–95% of the revenue of the
insured entities stemmed from the combination of all the Caputo’s
stores. And the support entities, like those in Caylor, are mostly
dependent on all of the Caputo’s stores for their revenues. The
Commissioner, however, mischaracterizes the analysis we performed in
Caylor. In that case, we did not combine all the entities we deemed to
be sufficiently related, and then determine whether revenue from the
other entities was sufficiently related to that conglomerate. Id. We
instead looked to see whether one company within the family was the
linchpin for them all. Id.
To reiterate, the Commissioner provides no valid explanation
through his experts as to why we should treat all of the Caputo’s
separate entities as a single entity for the purpose of this test.
48
[*48] Consequently, the revenues for each of the Caputo’s should be
looked at separately. If we do so, the other entities’ reliance on any
single Caputo’s store is distributed more evenly. We don’t think that
the revenues of the companies indicate a lack of independence among
the entities.
v.
Independence of Policies
In Caylor we found that when an event that happened to one
insured would have a severe effect on the other insured, it showed that
there was not independence. Caylor, 121 T.C.M. (CCH) at 1214. The
Commissioner presents us with two hypotheticals to illustrate the
“cascade of losses” that a single event could cause under multiple
policies. One example he provides is how the Caputo’s stores would
suffer the same type of loss in the event of a regulatory change.
As we have stated, the policies don’t need to be completely
independent of each other to demonstrate independence. “[P]erfect
independence of risks is not required.” R.V.I. Guar., 145 T.C. at 230.
Though we can imagine scenarios where the policies could overlap, the
Commissioner’s own expert Meyer credibly testified that there were
plenty of instances and situations where the risk between the policies
was not correlated—an employee selling liquor to a minor resulting in a
fine at one Caputo’s store, an employee at a different store mishandling
a catering tray and poisoning a customer, or a third employee creating
a situation hazardous enough to be a fire code violation in a building
that is owned by one of the real-estate entities.
With his own witnesses repeatedly testifying in support of the
Prestas’ positions, we are mostly left with the Commissioner’s
hypotheticals on brief to undermine what his own expert testified were
uncorrelated risks. Based on the peculiar record, we find that the
policies were sufficiently independent to count as distributed risk.
c.
Were the
Sufficient?
Independent
Risk
Exposures
To summarize, we find on the facts of these cases that the
following independent exposure units existed over the years:
49
[*49]
Exposure Unit Type
Number of Exposure Units
Customer Transactions
4.5 million 43
Products Sold
50,000
Employees
1,023–2,183
Store locations
6–8
Suppliers
0–1
Insured Entities
17–19
Insured Policies
11–14
Total
4,551,057–4,552,225
Here, we have a total of 4,551,057–4,552,225 exposure units.
previous cases we have found the following to be insufficient:
In
Avrahami
Syzygy
Reserve
Caylor
7 types of Policies
8 policies
11 to 13 policies
7 policies
1 entity
3 entities, 17
employees, some
machinery and 12
mines
1 to 12 exposures
per policy
4 entities
Compared to the cases where we found sufficient exposure units:
R.V.I.
Rent-A-Center
Securitas
Harper Group
714 insured
parties
More than 14,000
employees
200,000 employees
7,500 customers
More than 754,000
passenger vehicles
7,000 vehicles
More than 2,000
vehicles
More than 30,000
shipments
More than 2,000
real estate
properties and
more than 1.3
million
commercial
equipment assets
2,600 stores
Provided
guarding, alarm
system
installation, and
cash handling
services
260,000 air
shipments, 18,000
air flights, and
40,000 shipments
on more than
3,000 ocean trips
1 policy type
3 policy types
5 policy types
2 policy types
2,056,715
exposure units
23,603 exposure
units
202,005 exposure
units
358,502 exposure
units
43 As we noted, this is a proxy for actual customers in the store. The actual
number of exposure units is much higher.
50
[*50] Looking at the independent exposure units generated from
customer transactions alone, CFM was subject to over 200 times the
exposure units we have found sufficient in previous cases. 44 Still, the
Commissioner wants us to find that the law of large numbers is not
satisfied.
We are not inclined to disregard thresholds set by caselaw absent
a reason such a high number of exposure units is insufficient to satisfy
risk distribution. We stress again that the experts on both sides provide
us with no reason to believe these standards have not been met. At trial
Angelina and Meyer agreed that for some, if not all, of the policies, there
was adequate risk distribution. The Commissioner’s own expert even
testified that for certain policies as few as 30 exposure units would be
sufficient to adequately distribute risk. This is the record we have, and
so we find that there were sufficient independent exposure units for the
law of large numbers to apply and find that the policies CFM issued
sufficiently distributed risk.
This is a startling conclusion. In a recent microcaptive case
involving an insurer of medical practices, we looked at the number of
entities and the number of doctors—not the number of doctor-patient
visits. Swift, T.C. Memo. 2024-13, at *29–30. Given the stakes involved
in microcaptive-insurance cases, it is to be expected that taxpayers will
try to define risk exposures in such a way as to get the numbers up. (As
the old entomological couplet asserts, “Great fleas have little fleas upon
their backs to bite ‘em, and little fleas have lesser fleas and so
ad infinitum.” Augustus De Morgan, A Budget of Paradoxes (2d ed.
1915)). It is always possible to split a risk into more risks—consider a
car-rental agency with a single car and ten customers a year. Is that
one exposure, or ten, or is every intersection or every parking lane a
toddler might race across or every tree driven past that could be run
into, its own risk exposure?
In Swift we had a record that included expert testimony about
what is generally regarded in the industry as a single risk exposure. The
parties’ experts disagreed, but a “majority” of them, including one for
44 The number of insured entities and the number of storefronts, as well as the
number of policies, were sufficiently independent to count as independent risk
exposures. Together these add up to only 51,057–52,225 exposure units. Less than
1% of those generated by customer transactions alone. Having found the customer
transactions to be appropriate independent exposure units, the question of whether
these three units are independent is relatively inconsequential in our overall
determination of whether there were sufficient independent risk exposures.
51
[*51] the taxpayers themselves, agreed that the industry standard was
to treat each doctor as a single risk exposure. See Swift, T.C. Memo.
2024-13, at *30. We went with the majority of experts in Swift. Id. But
in these cases, we have expert witnesses who by and large agreed with
each other—and the Prestas.
This sometimes happens in litigation. In one of the only cases
that allowed tax affecting 45 in the valuation of an asset, we ended up
with a record in which “respondent objects vociferously in his brief to
petitioner’s tax-affecting, [while] his experts are notably silent.” Estate
of Jones v. Commissioner, 118 T.C.M. (CCH) 143, 153 (2019). On that
record, we used tax affecting. But, as we did in Estate of Jones, we will
also state plainly here that we have to decide cases on the basis of the
record before us. Our factfinding from such peculiar records is unlikely
to feed precedents in the future.
B.
Commonly Accepted as Insurance
As we noted in Caylor, this criterion begs the question: “[H]ere—
we say something’s not insurance because it doesn’t look enough like
something we do say is insurance—but it is one of the four criteria
precedent tells us to look for.” 46 121 T.C.M. (CCH) at 1215.
There is no fixed list of factors we look for. But we usually start
by looking at whether a company is formally organized and regulated as
an insurance company. See, e.g., Patel, T.C. Memo. 2024-34, at *46.
Formal compliance with some jurisdiction’s regulations is not by itself
enough, however, because what may look like an insurance company on
paper may not behave as one in real life. So we also look to see whether
a company:
•
backed into premiums or charged unreasonable premiums;
•
issued valid and binding policies or issued them only after the
coverage period;
•
handled claims in an irregular way;
45 Tax affecting is a method of valuing a corporation by reducing its earnings
to reflect its cash flow by a hypothetical corporate-level tax.
46 In other words, we must determine to what extent CFM partakes in the form
of “insurance.” See generally Plato, Meno, Parmenides, and Theaetetus (Benjamin
Jowett trans., 2008 ed.) (explaining Socrates’s theory of the forms).
52
[*52]
•
had no or very few employees or absentee owners; and
•
failed to engage in due diligence to determine if it was adequately
distributing risk.
Caylor, 121 T.C.M. (CCH) at 1215–16; Rsrv. Mech. Corp., 115 T.C.M.
(CCH) at 1486–87.
1.
Formal Operation
CFM was organized, licensed, and regulated as an insurance
company in Utah. Each year, that state’s regulators reviewed CFM’s
insurance operations and its audited financial statements and
statements of actuarial opinions, and each year renewed its license.
CFM met Utah’s capitalization requirement. See Utah Code Ann. § 31A37-204 (West 2015). The Utah Insurance Department also reviewed
CFM’s operations and discovered no issues with capitalization, solvency,
and compliance with its regulations. CFM properly obtained approvals
for changes to its business plan and coverages. CFM underwent a
limited-scope audit and no issues were found.
The Commissioner does not contest that CFM was formally
organized and regulated as an insurance company, but instead argues
that it failed to behave as one.
2.
Premium Calculations
In Caylor, we found that backing into premiums instead of using
historical loss data to price policies suggested that a company was not
operating as an insurance company. Caylor, 121 T.C.M. (CCH) at 1216.
In that case, the insurer started with a budget, $1.2 million, and the
policies were priced around the budget. Id. The ten years of loss history
that the company experienced were not taken into account despite
expert testimony that such a factor was a common consideration in
pricing policies. Id. We recognized that the insurer may have been
hesitant to use the loss history since ten years may have been
insufficient to produce an adequate measure of risk, but we found its
failure even to consider that history to be one clue that it was not
operating as an insurance company. Id.
In these cases CFM’s premiums were also very close to, but never
more than, $1.2 million. We think this is sufficient for us to find that it
53
[*53] is more likely than not that the premiums, though calculated
individually, were determined within a specific budget. And there is
nothing in the record that suggests CFM ever consulted its own history
of losses in setting premiums each year. This is one sign that CFM did
not operate as an insurance company.
We also need to look at whether those premiums were reasonably
similar to premiums charged in arm’s-length transactions. The
reasonableness of premiums depends on their relation to the risk of loss
and whether the insurance company actually determined them. Rsrv.
Mech. Corp., 115 T.C.M. (CCH) at 1474–75.
The Prestas presented us with two sets of computations for what
their experts calculated as reasonable premiums for each policy for 2012
and 2013, and one set of comparable premiums for 2014 and 2015. The
premium calculations were done by an actuary, Ekdom, who helped to
revamp CFM’s underwriting process starting in 2012, as well as Rhodes,
a licensed actuary. The premiums they calculated were based on the
specific policies that CFM had for each year. The total policy premiums
they determined for each year, compared to those determined by Inman
and charged by CFM are the following:
Year
Inman
Ekdom (90th)
Rhodes (85th)
2012
$1,199,136
$1,116,031
$1,177,000
2013
1,199,136
1,119,042
1,071,000
2014
1,196,148
1,123,212
994,000
2015
1,199,023
1,154,459
999,000
The Commissioner argues that the Prestas can’t fix Inman’s
mistakes by bolstering her calculations with corroborating premium
calculations. He claims that Inman’s original premium calculations left
a “black box” of questions since Inman did not testify about on how she
calculated every factor she put into the equation for every policy for
every year.
Inman testified generally as to what the different factors plugged
into the equation were and also went into detail on how she determined
the final numbers. We find her testimony credible and also sufficient to
establish that the process through which the premiums were calculated
was reasonable. Looking at whether the end result matches up with the
reasonable premiums calculated by other experts, we think, is therefore
54
[*54] a good indicator of whether the premium calculations, and not just
the process, were reasonable.
As Rhodes credibly testified, actuaries and underwriters looking
at the same data are going to come up with different answers and in
some cases those differences can be large. Actuarial work produces a
range of potential answers. Some of the premiums that CFM charged
were higher than those calculated by Ekdom and by Rhodes, some of
them were lower, and some of them were in between. In general, we
find there were no premiums in any of the years that we found to diverge
drastically from the reasonable premiums that Ekdom and Rhodes
calculated independently.
As with the question of risk distribution, our factfinding about the
reasonableness of the premiums CFM charged is heavily influenced by
the Commissioner’s failure to ask any of his experts to calculate what
reasonable premiums would have been. He tries to fill this gap by
argument in his brief that the calculations that the Prestas presented
are not reliable, but his own expert testified that she had no idea
whether 50% or more of the premiums were reasonable because she had
not been asked to make any calculations. She did some calculation that
was a flawed comparison of the rate-on-line for the premiums charged
by CFM to the premiums charged for the commercial policies purchased
by Caputo’s New Farm. 47 What’s more, the only critique that Garland
had about Inman’s analysis was the captive-risk factor, an analysis
which we found reasonable. 48
The Commissioner presents us with his own rate-on-line
comparison with commercial policies, something that we have looked to
in previous cases to determine whether there was an arm’s-length
transaction. See, e.g., Rent-A-Center, 142 T.C. at 12. We found in RentA-Center that comparing commercial insurance companies’ premiums to
surplus ratio with captives was useless since commercial insurance
companies have lower premium to surplus because they face more
competition. Id.
47 Notably the commercial policies that Garland discussed cover different perils
from the policies issued by CFM.
48 We don’t think that a captive risk factor is appropriate when it is used to
simply juice the premiums. However, when, as here, the factor was used to actually
determine the level of risk the individual company bore, and we have a credible expert
testimony explaining not only how that factor was determined, but also how most of
the considerations were weighted for each year, we find it reasonable.
55
[*55] The Commissioner not only disregards the rate-on-line analysis
prepared by his own expert but also his expert’s own testimony on what
an adequate rate-on-line analysis would consist of for a captive policy.
Garland testified that a rate on line to comparable commercial policies
would not be appropriate to use when comparing them to captiveinsurance policies. She went on to explain that a general-liability policy
would be the best comparison for this type of rate-on-line analysis. Not
only did the analysis the Commissioner provided on brief lack support
from an expert, but it was actually performed contrary to the way his
own expert testified to be most adequate. As with risk distribution, it is
very difficult to find for a party on such a complicated issue when the
actual record before us holds expert testimony from both sides that
contradicts the facts the party seeks to establish.
We have previously declined to substitute the Commissioner’s
judgment for that of a credible expert. Acuity, 106 T.C.M. (CCH) at 246.
We will do so again here. 49
The Commissioner argues we should look beyond the premiums
charged to the evolution of the premiums over time to determine if they
are reasonable. In the 2012 and 2013 collection-risks policies there was
a $300,000 limit for a $30,560 premium. The 2014 version provided the
same $300,000 limit but the premium increased to $47,186. Caputo’s
New Farm had not submitted any claims and the risk profile didn’t
change, so the only difference appears to be that Inman priced the policy
outside Artex’s database and for 2014 she priced the policy using that
database. The administrative-actions policy limit went from $250,000
in 2012 and 2013 to $500,000 in 2014 to $200,000 in 2015. The loss-ofkey employer policy limit dropped from $1 million to $500,000 in 2012
and 2013. The employment practices liability policy limit changed from
$300,000 in 2012 and 2013 to $750,000 in 2014 and 2015.
We have considered such odd fluctuations in other cases, but it
was but one of many factors that led us to conclude the premiums were
not reasonable. See Rsrv. Mech. Corp., 115 T.C.M. (CCH) at 1488–89.
We do agree that these fluctuations weigh in favor of the Commissioner,
but in light of the credible alternative reasonable premiums that CFM’s
experts provided us, and the absence of such premium calculations from
49 The Commissioner also claims that comparable commercial coverage was
available for less, and CFM’s policies were both more expensive and more restrictive
in their coverage. But on this record, we have no expert testimony to corroborate the
Commissioner’s assertions and at least credible expert testimony to the contrary.
56
[*56] the Commissioner’s own experts, we give them little weight one
way or the other.
The history of how CFM collected these premiums, however, does
bolster the Commissioner’s position that it was not acting like a normal
insurance company. None of the invoices identified a specific due date,
but they all contained options for semiannual, quarterly, and monthly
payment plans. The invoices state: “[P]lease note that this is the only
invoice you will receive regardless of the payment plan you select.” We
agree with the Commissioner that this means Caputo’s New Farm was
obligated to pay the premium according to one of the payment plans
provided on the invoice. The 2012 payment, however, was not sent until
December 2012; the 2013 payment was not sent until December 2013.
This made both years’ premiums untimely.
The general terms and conditions applicable to the 2014 policies
stated that the insured was “responsible for the payment of all
premiums quarterly but in no event later than the expiration of the
Coverage Period.” Caputo’s New Farm made a partial payment in July
2014 and the remainder in December 2014, thus violating one
requirement and barely meeting the second.
The 2015 terms and conditions required only that premium
payments be made before the end of the coverage period. Caputo’s New
Farm paid them in December 2015. So we’ll find this payment timely.
The Commissioner does not argue that the losses were not
satisfied, and CFM did timely pay out claims to Caputo’s New Farm. 50
The premium payments it received for two of the four years, however,
were not timely. And allowing payment even at the very end of a
coverage year is eccentric. We find this weighs against treating CFM as
a normal insurance company.
3.
Valid and Binding Policies
A policy is binding if it identifies the insured, contains an effective
period for the policy, specifies what is covered by the policy, states the
premium amount, and is signed by an authorized representative. See
Securitas, 108 T.C.M. (CCH) at 497. In microcaptive cases we look to
see if a company timely issues its policies. Caylor, 121 T.C.M. (CCM)
50 The Commissioner argues that CFM routinely paid claims without cause.
We discuss below CFM’s claim-handling process as it relates to whether CFM operated
as an insurance company and so there is no need to do so again.
57
[*57] at 1216. We have also looked at factors beyond whether the
policies are simply binding, such as whether there are conflicting policy
terms or whether the policies were simply cookie cutter with little
relationship to the taxpayer’s business. Avrahami, 149 T.C. at 194
(examining conflicting policy terms); Rsrv. Mech. Corp., 115 T.C.M.
(CCH) at 1487 (describing that policies were cookie cutter and not
necessarily appropriate).
a.
Untimely Policies
In Caylor, we found that billing for premiums after the end of the
coverage period was a sign that the company did not operate as an
insurance company. Caylor, 121 T.C.H (CCM) at 1216. In that case, it
led us to believe that “[w]riting and delivering ‘claims made’ insurance
policies after the claim period is . . . abnormal and is to any reasonable
observer just plain silly.” Id. We relied on more than just intuition; our
finding was based on the testimony of the experts at trial. Id.
Here Angelina testified that it is common for a binder to hold a
policy in place. Under Utah law a binder is “a writing which describes
the subject and amount of insurance and temporarily binds insurance
coverage pending the issuance of an insurance policy.” 51 Utah Code Ann.
§ 31A-21-102(1) (West 2015). The purpose of a binder is “to evidence
that the insurance coverage attaches at a specified time and continues
. . . until the policy is issued or the risk is declined and notice thereof is
given.” Syzygy, 117 T.C.M. (CCH) at 1175 n.27 (quoting MDL Cap.
Mgmt., Inc. v. Fed. Ins. Co., 274 F. App’x 169, 170–71 (3d Cir. 2008)).
The Seventh Circuit, however, has held that in certain cases
binders are “meaningless” and provide “no benefits” to the insured
where the insurer purported to bind a policy but had not sent any policy
terms to the insured. Hardin, Rodriguez & Boivin Anesthesiologists,
Ltd. v. Paradigm Ins. Co., 962 F.2d 628, 634–35 (7th Cir. 1992). We
acknowledge that the situation is a bit mixed here, as the policies for
2013 and 2014 were evergreen, meaning that they were automatically
renewed. But the 2012 the policies were issued for the first time, and
the policies for 2015 were not evergreen, but reissued.
We find that it more likely than not that the only binders that
could possibly be valid were the ones issued for 2013 and 2014. Even so,
51 This definition of a binder is not directly applicable to captive-insurance
companies incorporated in Utah, but we find is common in the industry.
58
[*58] this does not speak to whether they were sufficient for us to
overlook the timing of when those policies were actually issued. In
Syzygy, we considered whether issuing binders was enough to create a
valid and binding policy, when the insurer did not timely issue an actual
policy. 117 T.C.M. (CCH) at 1175. We noted expert testimony that
explained that in the insurance industry it’s not unusual for policies to
arrive late, but that most of the binders are timely. Id. Nevertheless,
we found that “the failure to timely issue even a single policy weighs
against the arrangement being insurance in the commonly accepted
sense.” Id. (emphasis added).
We acknowledge that Syzygy didn’t quite provide us with a
definition of what constitutes timely issuance in all cases. We do find in
these cases that for 2012 and 2015 CFM did not issue the policies until
the coverage period was over, and for 2013 the policies were not issued
until four days before the end of the coverage period. We therefore find
that for at least three of the four years CFM did not timely issue its
polices. The only policies that we could possibly find timely were the
2014 policies that CFM issued with five months left in the policy year.
This is better, but we still don’t find them timely.
Utah has laws that pertain to binders with respect to noncaptive
insurance policies. The law states that “[n]o binder is valid beyond the
issuance of the policy as to which the binder was given, or beyond 150
days from the binder’s effective date, whichever occurs first.” Utah Code
Ann. § 31A-21-102(3). We acknowledge that this law does not govern
microcaptive-insurance companies; however, if a binder expires 150
days after the effective date absent a policy, it seems that at least for
some types of insurance in Utah, presumably, a policy to be timely must
be issued within 150 days of the effective date. The 2014 policy was
issued in July 2014 with an effective date of January 1, 2014. That’s
more than 150 days.
Neither the Prestas nor the Commissioner provided us with any
specific testimony on what makes a policy timely. Our purpose in
looking at timeliness, however, is not to find whether a policy is legally
binding or not, but instead whether CFM was behaving like a normal
insurance company. Given Utah’s law on the subject, and the generally
acknowledged irregularity of issuing policies after all or most of a policy
year is over, we find that CFM’s untimeliness is another sign that it was
not behaving as a normal insurance company would.
59
[*59]
b.
Ambiguity
For all of the years before us, the policies had conflicting terms.
They simultaneously included a list of the insureds, but also identified
“you” as the “Named Insured.” This makes it unclear as to whether the
policies for those years that referenced “you” referred to only the Named
Insured, or all of the entities that were covered by the policy.
We also find that many of the policies failed to define material
terms or lacked criteria to determine if a particular loss was covered.
The 2012 key-supplier policy, for example, did not define “key supplier.”
The crisis management/reputation risk policies for 2012 and 2013 did
not provide criteria to determine when a reputation was damaged. The
key-employee policies did not define the criteria they imposed for what
constitutes a key employee for any of the four years. 52
And then there was the business-interruption DIC policy. The
2014 policy provided coverage for a long list of events but did not define
any of the terms used, including “economic sanctions” and “denial of
access” in the 2014 policy. Most alarming is that the 2014 and the 2015
business-interruption DIC policies purported to cover losses from
terrorism, pollution, and dishonest acts by employees, but also included
a blanket exclusion for claims based on those very conditions.
We recognize that discerning whether a policy is “valid and
binding” includes looking at “policy ambiguities and conflicting terms
and how they fit in with the spirit of a transaction.” Syzygy, 117 T.C.M.
(CCH) at 1175. Though “ambiguous and conflicting terms do not
prevent every policy from being insurance for tax purposes,” as we noted
in Syzygy, id. at *44 (citing Merck & Co. v. United States, 652 F.3d 475,
481 (3d Cir. 2011)), when we are dealing with a related-party
transaction, we look at the policies and their terms with heightened
scrutiny.
52 For 2012 a key employee was defined as “any person on who you depend to
either generate a significant portion of your revenue or provide intellectual services on
which you depend,” but neither “depend” nor “significant portion” was defined.
This definition was amended for 2013, 2014, and 2015 to define a key employee
as “material” or “vital,” but those terms were not defined.
60
[*60]
4.
Claims Handling
Handling claims as an insurance company would ask us to look
for two things: Did CFM have procedure in place for handling claims?
And how did it actually handle claims?
a.
CFM’s Procedure
A lack of procedure for processing claims is a sign that a company
is not behaving as a normal insurance company would. See Avrahami,
149 T.C. at 188–89. In these cases CFM outsourced everything to Artex,
and from 2012 until March 2014, we find that Artex did not even have a
claims department or any licensed claims adjusters. It wasn’t until 2013
that Artex drafted two documents to provide instructions for how to
handle claims, even specifying where on its network a notice of claim is
saved. Artex then hired Leavitt at the end of March 2014. When he was
brought on, Artex still had no formal claims manual. Leavitt said that
Artex required all claims to have a notice-of-claim form to formally
document the report of a claim or loss. The notice-of-claim form was to
be filled out by the insured. The insured was supposed to prepare the
notice-of-claim form as soon as possible after a covered loss occurred.
Then if Artex approved the claim, it was supposed to prepare a proof-ofclaim form that identified the responding policy, date of loss, and
amount to pay.
We acknowledge that that there are no bright-line tests for
whether a claims process or procedure is “normal”. We also find that
over the years Artex worked to improve its claims-handling
infrastructure. Angelina testified that Artex’s process was somewhere
between very sloppy and perfect. The Commissioner’s own expert
Hogan even admitted during trial that the claims process is not
something that is etched in stone but rather something that varies from
claim to claim.
In light of Hogan’s testimony, we credit Leavitt’s and Angelina’s
testimony that CFM’s claims processing was adequate when compared
to other insurers’ processing. We don’t find that this weighs against the
Prestas, but the informal nature of the procedure does not weigh in their
favor either. We think this is neutral.
b.
CFM’s Claims Processing in Reality
CFM’s actual processing of claims is a different story. The failure
of an insured to submit claims is a strong sign that a company is not
61
[*61] operating as an insurance company. See id. at 192. An insurance
company’s approval of claims without supporting evidence makes it less
likely that the company operated as an insurance company. Id. (insurer
functioned differently from a normal insurance company as “[i]t dealt
with claims ‘on an ad hoc basis.’”) An insurer that bends procedure to
meet the demands of its insured is not acting like a normal insurance
company. Caylor, 121 T.C.M. (CCH) at 1215. In Caylor, the insurer
asked the insured for more information on a claim when it was received.
Id. Though we found requesting additional information to be consistent
with the common notion of operating as an insurance company, what we
found abnormal was that instead of providing the information, the policy
holder simply told the insurer to pay the claim. Which it then did. Id.
We note first that the insureds here did not submit even a single
claim in either 2012 or 2013. They did submit a total of five claims in
2014 and 2015, but CFM handled them all in an unusual way. Three of
the five claims were paid before a notice-of-claim form was submitted
and before CFM prepared a proof-of-claim form to authorize payment.
For one of the claims CFM signed a proof-of-claim form before it had
issued the policy. And when that claim showed a loss in excess of the
policy limit, Artex just changed the policy limit. We find that this is
most unlike what a normal insurance company would do.
The last of these five claims had even more serious problems. It
was initially submitted under the regulatory-change policy for costs
which various Caputo’s entities incurred to come into compliance with
PCI requirements. They submitted an invoice for the claim with a loss
amount of around $1 million. Leavitt did not believe that PCI
noncompliance was a covered loss and so denied the claim. The Prestas
then argued that new information revealed that this expenditure wasn’t
incurred to come into PCI compliance but to secure the Prestas’ network
after a cyberattack.
As the story shifted, so did CFM’s willingness to pay the claim.
With this new story, Inman informed Caputo’s New Farm that the claim
could be covered under the mechanical-breakdown DIC policy and or
other-business-interruption DIC policy.
This meant that an
underwriter was essentially overruling the claims adjuster. We find
that this is actually contrary to common industry practice.
We therefore find that Artex managed CFM in a way that reaped
optimal benefits for the Caputo’s entities—something we find is contrary
to what an actual insurance company would do. Paying a claim before
62
[*62] an insured files a notice of claim or an insurer drafts and reviews
a proof of claim is a strong signal that CFM was not operated as an
insurance company. The Prestas argue that we shouldn’t expect CFM
to operate perfectly at all times, and we can agree with that. But when
every single claim filed in the years before us has material defects in the
way it was processed, the strength of that signal only increases.
Though the processing procedures don’t by themselves mean that
CFM wasn’t an insurance company, we think that the way the claims
were handled and processed ultimately weighs heavily against our
finding that CFM operated as an insurance company.
5.
Absentee Owners
We found in Reserve Mechanical that an insurer with no
employees of its own and a chief executive officer, president, and 50%
owner with no knowledge of the insurance business weighed against
finding the company was operating as an insurance company as
commonly understood.
Rsrv. Mech. Corp., 115 T.C.M. (CCH)
at 1486–87. As in these cases, the insurer in Reserve Mechanical was
managed by an outside company. Id. at 1478. We reasoned that when
an insurer fails to participate in the structuring or execution of an
insurance transaction, it’s a sign that the company did not operate as an
insurance company. Id.
While CFM was managed by Artex, Presta was the 50% owner
and president of the company. He testified at trial that he knew little
of the operations—he even forgot that he had appointed himself as
CFM’s president. We don’t think that outsourcing the operation of a
captive undercuts in all cases the characterization of a company as an
insurance company, but when the president of the company doesn’t even
know that he is the president, something is off.
6.
Due Diligence
A lack of due diligence is another sign that a company does not
operate as an insurance company. In Reserve Mechanical, we found a
lack of due diligence in the fact that a feasibility study to analyze the
benefits of a captive was completed only after policies from the insurer
had already been issued. Rsrv. Mech. Corp., 115 T.C.M. (CCH) at 1487.
The Commissioner argues that CFM did not adequately engage in due
diligence since the feasibility study here had boilerplate language
instructing Caputo’s to consult outside accountants to ensure the plan
63
[*63] adequately distributed risk. 53 Though there may have been a
standard disclaimer CFM, unlike the insurer in Reserve Mechanical,
had Artex perform a feasibility study which was completed before any
policies were issued. We find that CFM engaged in adequate due
diligence in creating the captive. But we also do find that the
ambiguities and inconsistencies in the policies are quite problematic.
Overall, we think that CFM was organized and regulated as an
insurance company and was adequately capitalized. On the basis of the
extremely unusual battle of the experts in which the Commissioner’s did
not take up arms on the issue, we also find that CFM charged reasonable
premiums. But these factors don’t outweigh the other facts that show
CFM failed to operate as an insurance company normally would. It did
not regularly issue valid and binding policies or collect premiums in a
timely way for most of the years and policies at issue. The haphazard
handling of the few claims that CFM received is a particularly strong
sign that it did not operate the way an insurer would.
It’s a much closer call than is usual in microcaptive cases, but in
the end we find by a preponderance of the evidence that CFM was not
offering something that would be commonly accepted as insurance. This
means we find CFM ineligible to make a section 831 election on its
returns. This also means that the Caputo’s entities were not entitled to
deduct the payments sent to CFM as “insurance”.
IV.
Unwinding the Transaction
Since CFM does not qualify as an insurance company under the
Code, the next question for us to answer is whether CFM is liable for tax
on the money it received from the Caputo’s entities. The Commissioner
attempts to eat his cake and have it too, arguing that not only should we
disallow the deductions taken by the Caputo’s entities, but we should
also tax the money transferred to CFM. The Prestas, however, argue
that we should unwind the transaction and characterize the payments
53 The study stated that “while Caputo’s has more than the minimum of twelve
entities insured as suggested under Rev. Rul. 2002-90, it may not meet the technical
requirement of that Ruling by having all entities paying under 15% of the premium.
Caputo’s is advised to seek the advice of a qualified tax advisor to ensure that the risk
distribution occurring between these 18+ entities is sufficient for tax purposes. Artex
is not a qualified tax advisor.”
64
[*64] to CFM as either capital contributions, or alternatively payments
to a loss reserve. 54
The problem with recharacterizing a payment as a capital
contribution is that it requires us to find that the Caputo’s entities
intended the payments to CFM to be treated as capital contributions.
See Rsrv. Mech. Corp., 115 T.C.M. (CCH) at 1490 (citing Bd. of Trade v.
Commissioner, 106 T.C. 369, 381 (1996)). The intent of the Caputo’s
entities, however, was to pay insurance premiums. Presta testified at
trial that the whole reason for creating CFM was to protect the Caputo’s
entities against the unforeseen. Since the premiums were not intended
to be capital contributions, we can’t recharacterize them. 55
Though we can’t treat the premium payments as capital
contributions, the Prestas argue that we should still unwind the
transaction and treat them as contributions to a loss reserve. This
would not be the first time we did so. In Humana the Sixth Circuit
agreed with our reasoning when we found premium payments were not
deductible, but “they likewise should be considered additions to a
reserve for losses.” 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).
54 The Prestas argue that the Commissioner has the burden of showing that
these payments were not income because he characterized them as section 832
premium income in CFM’s notice of deficiency. They also argue that this is a case of
unreported income which imposes an additional burden on the Commissioner to
connect the income to an income-producing activity. The notice of deficiency, however,
stated that the payments were includible in CFM’s income under section 61, which
includes all other income. This means the Commissioner is not raising a new issue,
and we will not shift the burden of proof. The Commissioner connected CFM to income
by producing bank statements showing the deposits. See Naylor v. Commissioner, 105
T.C.M. (CCH) 1122 (2013) (respondent established actual receipts with account
statements). The parties have also stipulated that the amounts were wired to CFM
for every year at issue. See Ward v. Commissioner, 69 T.C.M. (CCH) 3025 (1995)
(respondent established actual receipts where parties stipulated to receipt of funds),
aff’d sub nom. I&O Publ’g Co. v. Commissioner, 131 F.3d 1314 (9th Cir. 1997).
55 The Prestas cite Chapman Glen Ltd. v. Commissioner, 140 T.C. 294, 350
(2013) (citing Carnation Co. v. Commissioner, 640 F.2d 1010, 1013–14 (9th Cir. 1981),
aff’g 71 T.C. 400 (1978)), where we held that even though an insurer “did not provide
insurance during the subject years, . . . the funds that it received as insurance
premiums could not have been received as such but were instead received as
contributions to its capital.”
In these cases, there is no evidence that the premium payments were intended
to be anything other than what they were.
65
[*65] The Commissioner contends that nothing in Humana requires
that we recharacterize CFM as a loss reserve, and he is right. We have
already rejected this recharacterization in two other cases. In Syzygy,
we found that “there [was] no evidence that any such recharacterization
[was] appropriate.” 117 T.C.M. (CCH) at 1176. We cited to Reserve
Mechanical where we rejected the recharacterization of the payments as
capital contributions and found the petitioners “failed to specify why the
payments might otherwise be treated as nontaxable deposits.” 115
T.C.M. (CCH) at 1490.
For us to recharacterize the transaction, the Prestas must prove
that (1) the substance of the transaction did not match the form, and
(2) the form of the transaction “was not chosen for the purpose of
obtaining tax benefits . . . that are inconsistent with those the taxpayer
seeks through disregarding that form.” Complex Media, Inc. v.
Commissioner, 121 T.C.M. (CCH) 1089, 1104 (2021). In both Syzygy and
Reserve Mechanical, we found that the taxpayer failed to meet this
burden. Syzygy, 117 T.C.M. (CCH) at 1176; Rsrv. Mech. Corp., 115
T.C.M. (CCH) at 1489.
Our finding that CFM does not qualify as an insurance company
necessarily means that the substance of the transaction did not match
its form. The only question is whether the Prestas chose to create a
captive-insurance company instead of a loss reserve because of the
deductions their entities could claim for the insurance premium
payments. Huish testified that in the presentation to potential clients
that Gallagher put on, the clients were informed of the advantages and
disadvantages of setting up a captive insurer. He stated that he
discussed with prospective clients how in lieu of setting up a captive
insurance company, they “could still set up this reserve account and not
take the tax benefit.”
There is no evidence in the record to indicate that the Prestas
structured the payments as captive insurance instead of a loss reserve
for any reason other than the additional tax benefits that a captive
would have provided. Huish’s testimony makes it more likely than not
that the Prestas were at a minimum informed that choosing to create a
captive-insurance company instead of a loss reserve was a better option
specifically because of the greater tax benefits it provided. Because of
66
[*66] this, we find that the Prestas have failed to meet the burden of
proof necessary to recharacterize the transaction. 56
V.
Penalties
The Commissioner asserted section 6662(a) penalties against the
Prestas for 2012, 2013, and 2015. Section 6662(a) and (b)(2) imposes a
20% penalty for any underpayment of tax required to be shown on a
return that is due to “[a]ny substantial understatement of income tax.”
The Commissioner has both a burden of proof and a burden of production
here. His burden of proof is to show that he complied with section 6751.
On August 3, 2018, Revenue Agent Van Nguyen finalized a substantialunderstatement penalty lead sheet. Group Manager Ted Spencer signed
it on August 6, 2018 and the IRS mailed a Letter 950 that listed all of
the penalties at issue, including the penalties for substantial
understatements. Before mailing the letter, Nguyen’s group manager,
Ted Spencer, approved the penalties by signing the letter. That’s
enough. See Chai v. Commissioner, 851 F.3d 190, 215–23 (2d Cir. 2017),
aff’g in part, rev’g in part T.C. Memo. 2015-42; see also Graev v.
Commissioner, 149 T.C. 485, 492–93 (2017), supplementing and
overruling in part 147 T.C. 460 (2016).
The Commissioner has the burden of production on the merits of
the section 6662(a) penalties. See § 7491(c). He shoulders it here with
simple arithmetic:
Year
Reported
Taxable
Income
Taxable
Income
Required
to Be
Shown
10% of
the
Taxable
Income
Required
to Be
Shown
Understatement
Commissioner’s
Burden of
Production
Satisfied?
2012
$1,623,966 $2,462,311
$246,231
$838,345
Yes
2013
433,987
923,091
92,309
489,104
Yes
2015
2,617
50,606
5,060
49,989
Yes
56 The Prestas also argued that recharacterizing the payments to CFM as a
loss reserve would entitle the Caputo’s entities to adjustments for the previous years
in which they reported the insurance payouts as taxable income. We don’t need to
address this issue since we have already determined that recharacterization is not
appropriate.
67
[*67] On the basis of these numbers, the Prestas substantially
understated their income tax liabilities for all of the years.
The Prestas argue, however, that they claimed the deductions
reasonably and in good faith. This is a defense to the section 6662(a)
penalties. See § 6664(c)(1); Treas. Reg. § 1.6664-4(a). The regulation
tells us to look at all the relevant facts and circumstances. See Treas.
Reg. § 1.6664-4(b)(1). One circumstance where the exception applies is
“an honest misunderstanding of fact or law that is reasonable in light of
all of the facts and circumstances, including the experience, knowledge,
and education of the taxpayer.” Id. The most important factor for us to
look for is the extent of the taxpayer’s efforts to assess the proper tax
liability. See Higbee v. Commissioner, 116 T.C. 438, 448–49 (2001).
Reasonable cause requires a taxpayer to exercise ordinary business care
and prudence as to the disputed items. See United States v. Boyle, 469
U.S. 241, 246 (1985); see also Hatfried, Inc. v. Commissioner, 162 F.2d
628, 635 (3d Cir. 1947); Girard Inv. Co. v. Commissioner, 122 F.2d 843,
848 (3d Cir. 1941); Estate of Young v. Commissioner, 110 T.C. 297, 317
(1998).
Proof of reliance on a professional’s advice is another way of
showing reasonable cause and good faith. Treas. Reg. § 1.6664-4(b)(1),
(c). There is, however, a difference between tax preparation and tax
advice. A tax preparer is “any person who prepares [a return] for
compensation.” § 7701(a)(36)(A). A tax adviser, in contrast, is a person
who analyzes an issue and communicates his conclusions to the
taxpayer. See Treas. Reg. § 1.6664-4(c)(2); see also Woodsum v.
Commissioner, 136 T.C. 585, 592–93 (2011) (advice reflects adviser’s
analysis or conclusion and taxpayer relied in good faith on adviser’s
judgment).
The caselaw lists three factors we look at to decide whether this
defense exists.
•
First, was the adviser a competent professional who had sufficient
expertise to justify reliance?
•
Second, did the taxpayer provide necessary and accurate
information to the adviser?
•
Third, did the taxpayer actually rely in good faith on the adviser's
judgment?
68
[*68] E.g., Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99
(2000), aff’d, 299 F.3d 221 (3d Cir. 2002). Whether a taxpayer relied on
advice and whether his reliance was reasonable hinge on the facts and
circumstances of the case. See Treas. Reg. § 1.6664-4(c)(1).
The Prestas’ accountant Hamilton Kwon worked at Miller Cooper
& Co. Ltd. (Miller Cooper). He worked with the Prestas throughout the
creation of CFM. He was a CPA with eighteen years of public accounting
experience, and he credibly testified that before advising the Prestas on
the creation of CFM, he informed himself about captive insurance and
its taxation.
In 2012 Kwon provided Presta with advice regarding captive
insurance as well as the tax implications of the transaction. Kwon
opined that Presta was purchasing policies that covered insurable risks
and paying premiums to a licensed insurance company, and that this
made those premiums deductible business expenses. He communicated
this advice to Presta before the first tax return reporting the captive
insurance transaction was filed. 57
He arrived at the advice
independently: He conducted his own research, consulted with the
Miller Cooper service team including partner Ignacio Mendez, and
considered technical resources. We find that the Prestas’ reliance on
him was reasonable.
We also find that Kwon took the following steps with the
information that he was provided: He reviewed the information Caputo’s
provided to Artex, as part of the formation process, for accuracy, the
engagement letter, and the Artex feasibility study, and he understood
the captive would be, as it ultimately was, licensed and regulated in
Utah, subject to that state’s regulation. He also reviewed the captive
policies for any coverage that seemed unusual for Caputo’s business.
Kwon had direct access to Artex, and he assessed Artex and gained
comfort with its expertise regarding captive insurance. We therefore
also find that Kwon received necessary and accurate information from
Caputo’s about the transaction and contacted Artex to assess its
57 The Commissioner notes that Kwon did not review the feasibility study
before giving his opinion. But this is not a requirement. In both Avrahami and Syzygy
we found that the taxpayers reasonably relied on tax professionals and did not factor
into our analysis whether those professionals reviewed the feasibility studies of the
captive transactions. Avrahami, 149 T.C. at 207–08; Syzygy, 117 T.C.M. (CCH)
at 1177.
69
[*69] expertise to provide the advice. We also find that Kwon actually
conveyed advice to the Prestas and did not simply prepare their returns.
While Presta has been very successful in the grocery and realestate business, he is a man of humble beginnings—having worked at
the Elmwood Park store from the age of thirteen—and has received no
classroom education beyond high school. Other than dutifully paying
his taxes and buying insurance coverage, he has no experience in the tax
or insurance industries, so he did what any prudent businessperson
would do: He found and relied on competent professionals. Presta felt
Miller Cooper was a reputable public accounting firm and had no reason
to doubt anyone at Miller Cooper, or their advice.
Kwon was a qualified tax professional and had adequate access to
CFM’s records. He was responsible in updating himself on the rules
regarding captive insurance and informed Presta that upon forming
CFM the Caputo’s entities would be entitled to deduct premium
payments. Presta reasonably relied on Kwon’s advice. This alone is
sufficient to find the Prestas are not liable for the accuracy-related
penalties.
We also note that both when CFM was formed and when each of
the returns at issue was filed, the validity of microcaptive insurance was
an issue of first impression. See Avrahami, 149 T.C. at 207–08 (filed
August 2017). When we first saw this issue, we ruled that the taxpayers’
reliance on their adviser, an attorney, was in good faith. See id. We
were sympathetic to the taxpayers and noted that we tend to decline
imposing accuracy-related penalties “when there is no clear authority to
guide taxpayers.” Id. (first citing Petersen v. Commissioner, 148 T.C.
463, 481 (2017), aff’d and remanded, 924 F.3d 1111 (10th Cir. 2019);
then citing Williams v. Commissioner, 123 T.C. 144, 153 (2004); and
then citing Hitchins v. Commissioner, 103 T.C. 711, 719–20 (1994)). The
absence of guidance available to the Prestas regarding the appropriate
tax treatment of microcaptive insurance for the years at issue also helps
us find the Prestas should not be liable for the accuracy-related
penalties the Commissioner asserted against them.
CFM does not meet the definition of an insurance company under
section 831 because it failed to operate as an insurance company as
commonly accepted. The deductions that the Caputo’s entities claimed
for the premiums they paid to CFM were not deductible. The Prestas
did not meet the burden of proof required for us to characterize the
payments to CFM as something other than income under section 61. As
70
[*70] a result, CFM has an obligation to pay tax on the sums it received,
and the Caputo’s entities were not entitled to adjust their income to
exclude the insurance payouts, and the benefits therefore cannot be
passed through to the Prestas. We do, however, find that the Prestas
reasonably relied on the advice of a competent tax professional when
they took the positions they did on their returns and are not liable for
any penalties.
Decisions will be entered under Rule 155.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.