Fifth Circuit Nixes Microcaptive Insurance Arrangements That Lacked Risk Distribution

(Parker Tax Publishing August 2025)

The Fifth Circuit affirmed the Tax Court and held that payments relating to a couple's microcaptive insurance arrangements were not deductible as insurance expenses because the arrangements did not achieve risk distribution and did not constitute insurance in the commonly accepted sense. Further, in an issue of first impression, the Fifth Circuit held that failure to secure supervisory approval for penalties before sending a letter to the couple indicating that they owed penalties, did not violate Code Sec. 6751(b). Swift v. Comm'r, 2025 PTC 239 (5th Cir. 2025).

Background

Dr. Bernard Swift is the founder and sole proprietor of an urgent care center with 18 locations, called Texas MedClinic, and two other smaller entities (together, the "Clinic"). In 2004, Swift began exploring the possibility of creating a captive insurance company, which is a company created and wholly owned by one or more non-insurance companies to insure the risks of its owner. The insured party claims business expense deductions for premiums paid for the insurance policies while the premiums end up with a captive insurance company owned by the owners of the insured entities or family members. The captive insurance company, in turn, can elect under Code Sec. 831(b) to exclude up to $2.2 million ($1.2 million for tax years beginning before January 1, 2017) of its net premium income per year, so that the captive is taxed only on its investment income. From 2004 through 2015, Swift's businesses supplemented their traditional insurance by purchasing assorted policies from microcaptive insurance companies (the Captives) that he set up and controlled.

In setting up the Captives, Swift sought advice from Celia Clark, a lawyer who specialized in forming and maintaining captive insurance companies. Clark advised Swift that 30 percent of the Captives' premiums should come from unrelated businesses. To achieve this, the Captives participated in two reinsurance pools affiliated with Clark. The premiums paid to the Captives dwarfed more traditional insurance premiums, resulting in large deductions for Swift. Relying on Code Sec. 831(b), the Captives themselves paid no tax on the premium income received from their sister entities.

On each of their joint federal income tax returns for 2012 through 2015, the years at issue, Swift and his wife deducted more than $1 million in premiums paid to the Captives as insurance expense and miscellaneous legal fees. The IRS audited those returns and in a letter, the IRS auditor notified the Swifts that he had completed his review, was recommending disallowance of the premium payment deductions, and enclosed a report including a 20 percent accuracy-related penalty under Code Sec. 6662 for negligence and substantial understatement. The IRS Group Manager signed a Civil Penalty Approval form approving the penalties after the letter was sent, but before the issuance of a deficiency notice. The notices for 2012 through 2015 reflected deficiencies of $893,809, $596,855, $494,259, and $461,524, respectively.

The Swifts challenged the deficiencies and penalties in the Tax Court. They argued that the premium payments made to the Captives were legitimate insurance business expenses. They challenged the penalties on two independent grounds: (1) the IRS's failure to comply with the Code Sec. 6751(b) requirement that supervisory approval be obtained for the "initial determination" of the assessment of particular penalties, and (2) a defense of reasonable cause or substantial authority.

In T.C. Memo. 2024-13, the Tax Court sustained the IRS's determinations with respect to both the deficiencies and penalties. The court noted that while neither the Code nor the regulations define the term "insurance," the Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (1941) explained that, historically and commonly, insurance involves risk-shifting and risk-distributing. Relying on the Supreme Court's explanation of insurance in Le Gierse, the Tax Court looked at the following four criteria to determine whether the Swifts' transactions constituted insurance: (1) risk-shifting; (2) risk-distribution; (3) insurance risk; and (4) whether the arrangement looks like commonly accepted notions of insurance. Focusing on the elements of risk distribution and commonly accepted notions of insurance, the Tax Court concluded that the Swift's microcaptive arrangements did not constitute insurance because they did not achieve risk distribution and did not constitute insurance in the commonly accepted sense. The Tax Court also upheld the penalty assessments, nothing that supervisory approval was not necessary because the penalty assessment was not an initial determination.

The Swifts appealed to the Fifth Circuit, arguing that the Captives achieved risk distribution in two independent ways. First, the medical malpractice policies the Captives issued directly to the Clinic were sufficient to distribute risk and second, even if these direct policies were not sufficient, the Captives' participation in the reinsurance pools distributed risk. The Swifts further argued that independent of its ruling on the deficiencies, the Tax Court erred in finding them liable for penalties because (1) the IRS failed to comply with Code Sec. 6751(b)'s requirement of obtaining supervisory approval of the "initial determination" of the assessment, and (2) they had reasonable cause and/or substantial authority for their positions.

Analysis

The Fifth Circuit affirmed the Tax Court with respect to both the tax deficiencies and the penalties. The court rejected the Swifts' arguments that the Tax Court erred in determining there was an insufficient number of risks by counting the number of physicians (199) in the urgent care centers, rather than the number of individual physician-patient interactions (millions). The Fifth Circuit agreed with the government that relative risk reduction missed the point. While the possibility that a single costly claim will exceed the premiums taken in may be reduced with each added risk, the court said that the question of whether it is sufficiently reduced, such that losses are predictable, remained.

With respect to the Captives' participation in the reinsurance pools, the Fifth Circuit agreed with the Tax Court's use of a nine-factor test which found that the arrangement with the reinsurance pools did not accomplish risk reduction at all. That approach, the court said, was consistent with precedent requiring that insurance involve risk distribution in substance, not form. The court also agreed with the Tax Court that (1) the reinsurance arrangement looked suspiciously like a circular flow of funds; (2) the Captives did not enter into arm's length contracts with the pools for reinsurance coverage; and (3) the fact that that the pools were "thinly capitalized" and could struggle to pay claims raised questions about whether a reasonable business would enter into these contracts absent tax motivations.

With respect to the penalty assessments, the Fifth Circuit found that the Swifts presented compelling reasons why the IRS letter mentioning the 20 percent penalties constituted a formal communication requiring supervisory approval. To resolve the dispute, the Fifth Circuit said it had to interpret the statute to determine exactly when supervisory approval was required, an issue of first impression in the Fifth Circuit.

The Fifth Circuit noted that Code Sec. 6751(b)(1) requires supervisory approval of the "initial determination of such assessment" and the Tax Court interpreted "initial determination" to mean a formal communication notifying the taxpayer of a definite decision to assert penalties. The problem with this interpretation, the Fifth Circuit said, was that it has no basis in the text of the statute. Further, the court observed, Code Sec. 6751(b)(1) provides that no penalty "shall be assessed unless the initial determination of such assessment" is approved. Citing Chai v. Comm'r, 851 F.3d 190 (2d Cir. 2017), the Fifth Circuit said that "assessed" in this context refers to the formal recording of a taxpayer's tax liability, which is the last of a number of steps required before the IRS can collect a tax or penalty from a taxpayer. Additionally, the court said, the term "unless" in this context makes the assessment of penalties conditional upon supervisory approval, but it does not impose a requirement that supervisory approval be obtained at any particular time before assessment. According to the Fifth Circuit, if supervisory approval is to be required at all, it must be the case that the approval is obtained when the supervisor has the discretion to give or withhold it.

Taken together, the Fifth Circuit was convinced that Code Sec. 6751(b)(1) requires written supervisory approval before the assessment of the penalty or, if earlier, before the relevant supervisor loses discretion whether to approve the penalty assessment. The court concluded that this requirement was met in the Swifts' case because supervisory approval was obtained before the issuance of the deficiency notice. In conclusion, the Fifth Circuit agreed that failure to obtain approval before sending the letter to the Swifts did not violate Code Sec. 6751(b)(1), but for different reasons than those given by the Tax Court.

For a discussion of the taxation of captive and microcaptive insurance arrangements, see Parker Tax ¶92,730. For a discussion of the procedural requirements for computing penalties, see Parker Tax ¶262,195.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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