The United States Court of Appeals for the Fifth Circuit recently affirmed the Tax Court’s decision disallowing tax deductions for insurance premium payments made by Dr. Bernard T. Swift’s medical practice to his captive insurance companies and upholding associated penalties. This case, Bernard T. Swift, Jr.; Kathy L. Swift v. Commissioner of Internal Revenue, No. 24-60270, provides crucial insights into the criteria for genuine insurance arrangements and the application of accuracy-related penalties in the context of micro-captive transactions.

Factual Background of the Swift Captive Structure

This case centers on a micro-captive insurance arrangement, defined as "an insurance agreement between a parent company and a ’captive’ insurer under its control". Such arrangements can offer tax advantages under Internal Revenue Code (I.R.C.) section 831(b), where a micro-captive (annual premiums under $1.2 million for the years at issue) pays no taxes on premium income, and the insured party can deduct premiums as a business expense under I.R.C. section 162(a). The potential result is that "the money does not get taxed at all," provided the payments are "really for insurance".

Dr. Bernard T. Swift, founder and sole proprietor of Texas MedClinic, an urgent care center with 18 locations, and two other smaller entities (collectively, the “Clinic”), began exploring captive insurance in 2004. He engaged Celia Clark, a lawyer specializing in forming and maintaining captive insurance companies. With Clark’s assistance, Swift incorporated Castlegate Insurance Co., Ltd. in 2004, which operated until 2009.

The dispute specifically concerned the tax years 2012–2015. In 2010, Swift, again with Clark’s help, formed two new captives: Castlerock Insurance Co., Ltd. and Stonegate Insurance Co., Ltd. (collectively, “the Captives”), incorporated in the Federation of Saint Christopher and Nevis. Each Captive was owned by a trust benefiting one of Swift’s two children, with Swift and his wife serving as trustees. The Captives’ business plans referenced concerns about obtaining medical malpractice coverage at a reasonable cost and appropriate levels of terrorism risk insurance. Swift also sought to insure "other risks" to "get closer to maxing out the premiums".

The Captives issued various lines of insurance to the Clinic:

Medical Malpractice Coverage: This was a "tail" policy, covering claims related to professional services rendered before the policy started but reported after its start date. KPMG actuaries determined pricing for these policies, considering factors like comparable policy premiums, reporting lag factors, physician specialties, and period of exposure. Swift selected a 20% "load" percentage for administrative expenses, profit, and contingencies, which determined the final premiums. These medical malpractice premiums constituted about one-third to over half of the total premium payments to the Captives annually.
Nonmedical Coverage: This included policies for administrative actions, business income, business risk indemnity, computer operations and data, employment practices, litigation expense, cost of defense, terrorism, and political violence. Allen Rosenbach, another actuary, priced these policies, often receiving a "total maximum premium" from Clark’s team.

To satisfy Clark’s interpretation of Internal Revenue Service (IRS) rulings requiring 30% of premiums from unrelated businesses, the Captives participated in two Clark-affiliated reinsurance pools: Jade Reinsurance Group, Inc. (2012-2013) and Emerald International Reinsurance, Inc. (2014-2015). These pools comprised around 100 Clark-affiliated captive insurance companies. The arrangement involved participating captives paying premiums to the pool, which then reinsured a portion of each captive’s risk. Captives also contracted with the pool to provide reinsurance coverage for a quota share of the pool’s blended liability, receiving a percentage of total premiums back from the pool for this coverage. Participation in these pools was limited to the Captives’ nonmedical policies.

From 2012 through 2015, the Clinic paid the Captives a total of $5.98 million in premiums. During this period, the Clinic submitted three claims to the Captives, totaling $339,224, despite some irregularities in handling. One claim ($13,212) was under a medical malpractice tail policy, while the largest ($275,793) was under an "Administrative Actions Insurance Policy" to cover a pending IRS audit. The Captives invested most of the received premiums, raising concerns from Clark about illiquidity. For context, the Clinic also paid approximately $480,000 to commercial insurance carriers for both medical and nonmedical coverage during these years.

Swift and his wife, Kathy L. Swift, claimed these premium payments as business expense deductions on their joint tax returns for the years 2012 through 2015. The IRS subsequently issued notices of deficiency, disallowing the deductions and imposing 20% accuracy-related penalties under I.R.C. section 6662 for negligence or substantial understatement. The Tax Court sustained the IRS’s determinations, and the Swifts appealed.

Taxpayer’s Assertions on Appeal

On appeal, the Swifts challenged the Tax Court’s decision on two primary grounds:

Deficiencies: They contended that the Tax Court erred in determining the arrangement with the Captives did not constitute insurance. They argued that the Captives achieved risk distribution either through:
- The medical malpractice tail policies issued directly to the Clinic.
- The Captives’ participation in the reinsurance pools.
Penalties: They argued that the Tax Court erred in finding them liable for penalties, asserting:
- The IRS failed to comply with I.R.C. section 6751(b), which requires supervisory approval of the "initial determination" of penalty assessments, specifically for tax years 2012 and 2013.
- They were entitled to a defense of reasonable cause or substantial authority for the underpayment.

Judicial Scrutiny: The Legal Framework and Application

The Fifth Circuit reviewed findings of fact for clear error and issues of law de novo. The characterization of a transaction for tax purposes is a question of law subject to de novo review, while the underlying facts are reviewed for clear error.

Characterization of Insurance for Tax Purposes

For premium payments to be deductible as business expenses under I.R.C. section 162(a), they must be "really for insurance". While the Code does not define "insurance," the Supreme Court has stated that "insurance involves risk-shifting and risk-distributing" (Helvering v. Le Gierse, 312 U.S. 531, 539 (1941)). The Tax Court generally considers four criteria: (1) risk-shifting; (2) risk-distribution; (3) insurance risk; and (4) whether an arrangement looks like commonly accepted notions of insurance (*Swift, 2024 WL 378671, at 16 (quoting *Caylor Land & Dev., Inc. v. Comm’r, 121 T.C.M. (CCH) 1205, 2021 WL 915613, at 10 (Mar. 10, 2021)); see also Avrahami v. Comm’r, 149 T.C. 144, 177 (2017); Rent-A-Center, Inc. v. Comm’r, 142 T.C. 1, 13 (2014)). Risk distribution is considered essential to insurance (Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir. 1978)). It relies on the "law of large numbers," which enables an insurer to accurately predict losses for a group of independent risks (Rsrv. Mech. Corp. v. Comm’r, 34 F.4th 881, 904–05 (10th Cir. 2022)).

The Tax Court concluded, and the Fifth Circuit affirmed, that the arrangement with the Captives did not constitute insurance primarily because it failed to achieve risk distribution.

Analysis of Risk Distribution in Direct Policies:
- The Tax Court found that the medical malpractice policies failed to distribute risk due to an insufficient number of "unrelated risks to allow the law of large numbers to predict losses" (*Swift, 2024 WL 378671, at 17). The Clinic’s exposure involved at most nine lines of coverage, three entities, 28 locations, and 530 workers, which the Tax Court deemed insufficient.
- The Swifts argued that "patient visits" (millions) should be the relevant exposure unit, not the number of physicians (199). However, the Tax Court, supported by government experts and industry standard, sided with the view that a physician is the relevant exposure unit for medical malpractice. The Fifth Circuit found no clear error in this determination.
- The Swifts’ argument that 199 physicians provided sufficient risk reduction (92.9% by a recognized formula) was rejected. The Court found this formula measured relative risk reduction compared to a single physician, not sufficient reduction to make losses predictable. Government experts concluded the Captives’ expected losses were too unstable for the law of large numbers to apply. Furthermore, the number of independent risks was "at least a couple orders of magnitude smaller" than in cases where sufficient distribution was found, such as Rent-A-Center (14,300–19,740 employees, 7,143–8,027 vehicles, 2,623–3,081 stores) or Securitas Holdings (200,000+ employees, 2,250 vehicles) (Rent-A-Center, 142 T.C. at 24; *Securitas Holdings, 2014 WL 5470747, at 9–10; *Swift, 2024 WL 378671, at 18).
- Conclusion: The Fifth Circuit affirmed that the Captives failed to establish risk distribution through the direct medical malpractice policies.
Analysis of Risk Distribution Through Reinsurance Pools:
- A reinsurance pool can achieve risk distribution by allowing a captive to exchange few, related risks for many, unrelated risks (Harper Grp. v. Comm’r, 979 F.2d 1341, 1342 (9th Cir. 1992)). While the Captives ceded about 30% of their business to the pools, consistent with a threshold from Harper, the issue was whether the arrangement truly constituted an insurance arrangement for risk distribution in substance (Rsrv. Mech., 34 F.4th at 912).
- The Tax Court referenced nine factors to determine if a company is a bona fide insurer, not to formally define an insurance company, but to assess if their products genuinely distributed risk (*Swift, 2024 WL 378671, at 19). The Fifth Circuit found this multi-factor approach consistent with requiring "substance over form" in tax matters (Arevalo v. Comm’r, 469 F.3d 436, 439 (5th Cir. 2006)).
- The Tax Court focused on three key factors where the arrangement failed:
  - Circular Flow of Funds: The Captives received premiums from the pool for covering their share of blended liability that were very close to 100% of what they paid the pool (ranging from 94.98% to 99.59%). This arrangement "looks suspiciously like a circular flow of funds" (*Swift, 2024 WL 378671, at 19).
  - Lack of Arm’s-Length Contracts: The pools were "thinly capitalized," raising doubts about whether a reasonable business would enter these contracts without tax motivations. The contracts also included meaningful deterrents to making claims, such as requiring a retained limit and retaining authority to exclude captives with "excessive claims" from future pools.
  - Questionably Determined Premiums: The Swifts failed to demonstrate how the reinsurance premiums were derived, and evidence suggested Clark and Rosenbach manipulated numbers to allocate 30% of total premiums to reinsurance before retrocession. The "tiny loss ratios" (e.g., 8% for the pool vs. 66% industry standard in 2015) suggested premiums were much higher than warranted. The use of uniform percentages for all captives failed to account for specific risks, and allowing captives to choose terrorism/political violence reinsurance percentages created a "flexible tool to adjust the reinsurance premiums to whatever level necessary to hit 30% risk distribution overall" (*Swift, 2024 WL 378671, at 21).
- Conclusion: Based on the circular flow of funds, lack of arm’s-length contracts, and questionable premiums, the Tax Court concluded that the reinsurance policies were not bona fide insurance arrangements and thus could not achieve risk distribution. The Fifth Circuit agreed, finding the arrangement was not "a true insurance arrangement for the distribution of risk" (Rsrv. Mech., 34 F.4th at 312).
Overall Conclusion on Deficiencies: Since neither the direct policies nor the reinsurance pools achieved the essential risk distribution, the premium payments to the Captives were not "really for insurance" and thus not deductible. The Fifth Circuit also noted that additional Tax Court findings, such as the lack of business need, irregular claims handling, unreasonable reverse-engineered premiums, and availability of similar commercial coverage at lower cost, further supported this conclusion.

Scrutiny of Penalties under I.R.C. § 6662

The Swifts challenged the 20% accuracy-related penalties imposed under I.R.C. section 6662.

Supervisory Approval under I.R.C. § 6751(b)(1): A Matter of First Impression
- I.R.C. section 6751(b)(1) states that "[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor...". For tax years 2012 and 2013, IRS Agent Allen Sohrt sent a letter to the Swifts recommending disallowance and including a 20% penalty. Group Manager Cynthia Tam signed the Civil Penalty Approval form after this letter was sent but before the issuance of a deficiency notice.
- The Swifts argued approval was required before the letter was sent. The Tax Court applied its own interpretation, requiring approval before "formal communication" to the taxpayer, but found the letter lacked sufficient concreteness and formality for this purpose.
- The Fifth Circuit noted that the Tax Court’s interpretation of "initial determination" had "no basis in the text of the statute" (Laidlaw’s Harley Davidson Sales, Inc. v. Comm’r, 29 F.4th 1066, 1072 (9th Cir. 2022)). The statute does not refer to communication to the taxpayer.
- Addressing this issue as a matter of first impression in the Fifth Circuit, the Court adopted the interpretation consistent with other circuits (Laidlaw’s, 29 F.4th at 1074; *Minemyer v. Comm’r, No. 21-9006, 2023 WL 314832, at 5 (10th Cir. Jan. 19, 2023); Kroner v. Comm’r, 48 F.4th 1272, 1276, 1279 n.1 (11th Cir. 2022); Chai v. Comm’r, 851 F.3d 190, 220–21 (2d Cir. 2017)). The Fifth Circuit held that I.R.C. section 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 (Laidlaw’s, 29 F.4th at 1074). Discretion is typically lost upon the issuance of a notice of deficiency (Laidlaw’s, 29 F.4th at 1071 n.4; I.R.C. § 6213(c)).
- Conclusion: Since supervisory approval was obtained before the issuance of a deficiency notice, the statutory requirement was met. Therefore, the failure to obtain approval before sending the initial letter did not violate I.R.C. section 6751(b)(1).
Reasonable Cause and Good Faith Defense:
- I.R.C. section 6664(c)(1) provides a complete defense to accuracy-related penalties if the taxpayer acted in "good faith" and with "reasonable cause" (Bemont Investments, L.L.C. ex rel. Tax Matters Partner v. United States, 679 F.3d 339, 346 (5th Cir. 2012)). The taxpayer bears the burden of proof, and the determination is made case-by-case (Ray v. Comm’r, 13 F.4th 467, 482 (5th Cir. 2021)). Reliance on professional advice can establish reasonable cause if the taxpayer proves the adviser was independent, competent, conflict-free, and had expertise; the taxpayer provided all necessary information; and the taxpayer relied in good faith (Nevada Partners Fund, L.L.C. ex rel. Sapphire II, Inc. v. U.S. ex rel. I.R.S., 720 F.3d 594, 617 (5th Cir. 2013)). Courts often find reliance unreasonable when the adviser is a promoter of the transaction with an inherent conflict of interest (106 Ltd. v. Comm’r, 684 F.3d 84, 90–91 (D.C. Cir. 2012)).
- The Tax Court found that Swift could not reasonably rely on Clark due to her role as a primary promoter. The Swifts argued reliance on other professionals (Rosenbach, Swift’s accountant, KPMG).
- Conclusion: The Fifth Circuit found no clear error in the Tax Court’s decision, noting "no evidence showing that [Swift] ever communicated with Rosenbach; that [Swift’s] accountant had any expertise in insurance; or that [Swift] discussed the captive arrangements with KPMG beyond the premiums for the tail policies".
Substantial Authority Defense:
- A defense to the substantial understatement penalty exists "if there is or was substantial authority for such treatment" (I.R.C. § 6662(d)(2)(B)). Substantial authority exists if the weight of supporting authorities is substantial relative to those supporting contrary treatment (Chemtech Royalty Assocs., L.P. v. United States, 823 F.3d 282, 290 (5th Cir. 2016)). Authority is not relevant if "materially distinguishable on its facts" (Treas. Reg. § 1.6662–4(d)(3)(ii)).
- The Swifts relied on IRS private letter rulings (PLRs) where adequate risk distribution was found for captive insurers deriving at least 30% of premiums from reinsurance pools (e.g., I.R.S. P.L.R. 201224018; I.R.S. P.L.R. 201219009; I.R.S. P.L.R. 201219010; I.R.S. P.L.R. 201219011).
- Conclusion: The Fifth Circuit agreed with the government that these PLRs were materially distinguishable because they "presuppose that the insurance arrangement discussed were otherwise bona fide" and involved the use of "recognized actuarial techniques, based, in part, on commercial rates for similar coverage" (I.R.S. P.L.R. 201219011). In contrast, the issue in Swift was whether these particular Clark-affiliated reinsurance pools were bona fide, a question the PLRs did not address. Therefore, the Swifts failed to establish the defense of substantial authority.

Conclusion: Affirmation of the Tax Court’s Holdings

For the reasons detailed above, the Fifth Circuit AFFIRMED the Tax Court’s decision, upholding both the disallowance of the premium payment deductions and the imposition of the 20% accuracy-related penalties against Dr. Bernard T. Swift and Kathy L. Swift. This ruling underscores the critical importance of demonstrating genuine risk distribution and adherence to arm’s-length principles in captive insurance arrangements, as well as the strict requirements for penalty defenses. Tax professionals advising clients on captive insurance structures should carefully consider the substance over form doctrine and the detailed scrutiny applied to premium setting, claims handling, and the bona fide nature of any reinsurance arrangements.

Prepared with assistance from NotebookLM.