The United States Tax Court recently issued T.C. Memo. 2025-81, Kadau v. Commissioner, a ruling for navigating the complexities of microcaptive insurance arrangements. This case, involving Curtis K. Kadau and Surface Engineering & Alloy Co., Inc. (an S corporation of which Mr. Kadau was the sole shareholder), delves into the deductibility of expenses for purported insurance coverage provided through affiliated captive insurance companies, Risk & Asset Protection Services, Ltd. (Risk & Asset) and RMC Property & Casualty, Ltd. (RMC Property). The Internal Revenue Service (IRS) challenged the arrangement, asserting that it did not constitute actual insurance, thus disallowing deductions and imposing accuracy-related penalties.

Factual Background of the Arrangement

Curtis K. Kadau was the president and sole shareholder of Surface Engineering during the tax years 2012 through 2017 (years at issue), which engaged in the production and sale of metal alloys. Surface Engineering also maintained commercial insurance policies with other carriers like Amerisure, Scottsdale, ACE USA, Fidelity, Travelers, Wright Flood, Liberty, and Comps Options, for which it paid substantial premiums and reported claims.

In 2012, Mr. Kadau, interested in a captive insurance arrangement, was referred to The RMC Group, a consortium of companies involved in insurance and employee benefits, including RMC Consultants, Ltd. and RMC Property. The RMC Group promoted these arrangements through marketing materials discussing tax implications. Surface Engineering retained RMC Consultants to prepare a business plan and act as its licensed insurance manager to form a captive insurance arrangement in Nevis.

Mr. Rivelle, an actuary hired by the RMC Group, conducted a feasibility study for Surface Engineering, concluding that a captive insurance company could be established in Nevis to cover risks not addressed by conventional policies. His study recommended annual premium funding of $1,195,680 for various lines of insurance. Based on this, RMC Consultants created a business plan for Risk & Asset, which was incorporated in Nevis on October 3, 2012. Mr. Kadau was the sole shareholder of Risk & Asset, having contributed $50,000 in capital, and served as its chairperson, president, and corporate secretary, with William Jackson Arnold appointed as treasurer to satisfy Nevis regulatory requirements.

Risk & Asset initially issued policies to Surface Engineering for excess business interruption, collection risk, and directors and officers liability, effective November 1, 2012. Simultaneously, Surface Engineering purchased excess layer coverage from RMC Property for the same types of policies and periods. The premiums paid to RMC Property were identical to those paid to Risk & Asset, with one-half for primary coverage with Risk & Asset and one-half for excess coverage with RMC Property. These funds paid by Surface Engineering to RMC Property were then transferred to Risk & Asset, less commissions retained by RMC Property.

The initial premium split for risk between the primary and excess layers was 50–50, later adjusted by Mr. Bleiweis of the RMC Group to 40% to 60% (Risk & Asset to RMC Property) from 2012 through 2015, and then to a 30–70 split for 2016 and 2017. This was done to get more claims to the excess layer, without additional actuarial analysis for the 30–70 split. Risk & Asset received claims exclusively under its collection risk policy, paying out $260,310 to Surface Engineering during 2016 and 2017.

Taxpayers' Requested Relief

Petitioners sought to deduct the amounts paid by Surface Engineering for the purported insurance coverage from Risk & Asset and RMC Property as ordinary and necessary business expenses under Internal Revenue Code (I.R.C.) Section 162.

They also contested the accuracy-related penalties asserted by the Commissioner. The IRS initially contended petitioners were liable for a 40% accuracy-related penalty under I.R.C. Section 6662(b)(6) and (i) for transactions lacking economic substance, for tax years 2012 through 2015. In the alternative, or if the 40% penalty did not apply, the IRS sought a 20% penalty under Section 6662(a) and (b)(1) or (2). Before trial, the 40% penalty under Section 6662(i) for tax years 2016 and 2017 was conceded by respondent.

Furthermore, the Commissioner asserted an increased tax deficiency of $131,308 for tax year 2017, arguing that petitioners were subject to tax on Risk & Asset’s subpart F income because it did not qualify as an insurance company under Section 953(d).

Petitioners raised two defenses against the penalties: (1) reasonable cause due to reliance in good faith on professional advice under Section 6664(c)(1) and Treas. Reg. § 1.6664-4, and (2) reduction of understatements due to substantial authority under Section 6662(d)(2)(B)(i).

Court's Analysis of the Law and Application to Facts

The Tax Court's analysis centered on whether the microcaptive arrangement constituted "insurance" for federal income tax purposes, a determination critical for deductibility of premiums and the validity of a Section 953(d) election.

Defining "Insurance"

Neither the Code nor Treasury regulations define "insurance," so the Court relied on caselaw, consistently considering four nonexclusive factors:

The arrangement involves an insurance risk.
The arrangement shifts the risk of loss to the insurer.
The insurer distributes its risk among its policyholders.
The arrangement is insurance in the commonly accepted sense.

In microcaptive cases, the Court has primarily focused on risk distribution and commonly accepted notions of insurance. The Court found that petitioners failed to meet their burden of proof for both elements, concluding the arrangement was not insurance for federal income tax purposes.

Risk Distribution

Risk distribution occurs when an insurer pools a sufficiently large collection of unrelated risks. The Court agreed with the respondent that the handful of direct primary layer policies issued by Risk & Asset to Surface Engineering, on their own, failed to achieve risk distribution. Therefore, the analysis turned to whether risk distribution was achieved through Risk & Asset's participation in the RMC Property reinsurance pool. The Court assessed this by evaluating whether the RMC Property reinsurance pool functioned as a bona fide insurance company, examining factors such as circular flow of funds, arm's-length contracts, and actuarially determined premiums.

Circular Flow of Funds: The Court found a "near circular flow of funds". Surface Engineering paid premiums to RMC Property, which then transferred nearly all these funds to Risk & Asset (Mr. Kadau's wholly owned captive), less a small fee. This meant Mr. Kadau "never lost control of his money". This arrangement suggested a non-arm's-length transaction and insufficient capitalization.
Arm’s-Length Contracts: Respondent’s expert, Dr. Russell, testified that premiums paid by Surface Engineering were 2.5 to 3.5 times more expensive per dollar of coverage than comparable commercial policies. This high "rate-on-line" suggested the primary advantage of higher premiums was to increase deductions, rather than being the result of arm's-length negotiation. Furthermore, Risk & Asset’s limited capitalization of $50,000 plus initial premiums of $300,000 reflected undercapitalization. The Court concluded that the contracts were not arm's-length.
Actuarially Determined Premiums: The Court expressed "substantial reservations" about petitioners' reliance on Mr. Rivelle's actuarial report. The report was prepared in days after a single phone call with Mr. Kadau, who admitted not providing any documents about Surface Engineering. The RMC Group unilaterally changed the premium split (e.g., from 50–50 to 40–60, then 30–70) without sufficient actuarial justification, specifically to "get claims into the excess layer". Premiums for six years remained based on Mr. Rivelle's initial 2012 recommendations without revision, which respondent's expert, Dr. Crawshaw, noted was contrary to typical industry practice. The RMC Group even admitted to copying premiums from commercial carriers for 2017 and 2018 policies without revaluation or actuarial review. The Court found "insubstantial evidence to support the calculation of premiums".

Based on these findings, the Court held that risk distribution was not achieved through the reinsurance arrangement.

Commonly Accepted Notions of Insurance

Even if risk distribution had been achieved, the Court also analyzed whether the arrangement constituted insurance in the commonly accepted sense, examining factors such as organization and operation, capitalization, validity of policies, reasonableness of premiums, and claims payment.

Organization, Operation, and Regulation: While Risk & Asset was incorporated and regulated in Nevis, its operation was troubling. It had no employees, and Mr. Arnold’s participation was minimal. Little to no due diligence was performed on premium prices or reinsurance agreements. A significant portion of Risk & Asset’s investments, more than half by the end of 2017, comprised a $6 million life insurance policy on Mr. Kadau, chosen to cover his personal mortgages. This was not considered an effective means of investing premiums to hedge against risk and was later canceled after an IRS audit notice. The Court concluded that Risk & Asset's operations and investments weighed "heavily against its being an insurance company in the commonly accepted sense".
Minimum Capitalization Requirements: Risk & Asset met Nevis's minimum capitalization requirements but was thinly capitalized. The Court considered this factor neutral.
Valid and Binding Policies: While the policies generally contained necessary terms, several included terms that limited coverage beyond general scope, some failed to define beneficiaries, and the Directors and Officers Liability Reimbursement policies lacked a duty-to-defend provision. These were reimbursement policies, distinct from commercial market policies that pay "up front". The Court found the evidence mixed and this factor weighed "slightly against petitioners".
Reasonableness of Premiums: The Court reiterated its finding that premiums were not reasonable or the result of arm's-length transactions, citing the high rate-on-line and the lack of premium reductions despite no claims for the initial four years. The Court highlighted that if tax benefits were disregarded, petitioners would have been in the same economic position had they simply self-funded by placing the amounts in a bank account. This factor weighed "heavily against petitioners".
Review and Payment of Claims: Claims were paid by Risk & Asset, but the process was deemed "perfunctory". The claims committee, consisting only of Mr. Kadau and Mr. Arnold, met infrequently, and Mr. Kadau often acted as the sole determinant, approving payments without an independent adjuster. While claims payment generally weighs in favor of petitioners, the perfunctory process led the Court to deem this factor neutral.

The Court concluded that most factors weighed against petitioners, finding that the payments were not for insurance in the commonly accepted sense, nor for federal income tax purposes. Consequently, they were not deductible under Section 162.

Respondent's Concession Arguments and Revenue Ruling 2002-89

Petitioners argued that respondent had conceded three of the four elements of insurance in a prior District Court case involving the RMC Group (Ankner v. United States), implying estoppel. The Tax Court rejected this, clarifying that "not contesting an issue" is distinct from conceding it, and that collateral estoppel did not apply because Mr. Kadau, Risk & Asset, and Surface Engineering were not parties to the Ankner litigation, and the issues were not fully litigated in that case. Similarly, judicial estoppel did not apply as neither element of the Eleventh Circuit's stricter test (inconsistent position under oath calculated to mock the judicial system) was met.

Petitioners also argued that Risk & Asset achieved risk distribution by earning over 50% of its premiums from unrelated entities through the RMC Group reinsurance pool, qualifying for a "safe harbor" under Rev. Rul. 2002-89, 2002-2 C.B. 984. The Court declined to apply the ruling, finding that the facts were not substantially the same. Specifically, the RMC Property arrangement was not operated "consistently with the standards applicable to an insurance arrangement between unrelated parties," and the premiums were "extraordinarily high when compared to premiums set by standard industry formulas". Furthermore, Dr. Crawshaw opined that the RMC Group reinsurance pooling arrangement did not meet the 50% standard, calculating only 18% of Surface Engineering's future losses reached the excess or reinsurance layer.

Accumulated Earnings and Profits (Subpart F Income)

The Commissioner asserted an increased deficiency for tax year 2017, arguing that because Risk & Asset was not an insurance company, its election under Section 953(d) to be treated as a U.S. corporation was invalid. This would subject petitioners to tax on Risk & Asset’s subpart F income. The Court noted that the Commissioner bears the burden of proof for an increased deficiency.

The Court found the Commissioner’s arguments uncompelling and not well supported. While the contracts were not insurance and lacked legitimate business purpose for premium deductibility, the Court stated this did not preclude the transfer of funds from serving "an otherwise legitimate business purpose such as the contribution of capital". Citing Reserve Mechanical Corp. v. Commissioner, the Court emphasized that Rev. Rul. 2005-40, 2005-2 C.B. 291, does not mandate recharacterization as a contribution to capital when an insurance arrangement fails risk distribution, but mentions other alternatives like a deposit arrangement or a loan. The Court found that respondent had "not otherwise established that the transfer of funds from Surface Engineering to Risk & Asset should not be reclassified as nontaxable contributions of capital". Therefore, the increased deficiency of $131,308 was not sustained.

Penalties

Penalty Approval: The parties stipulated that the IRS satisfied its burden under Section 6751(b)(1) regarding supervisory approval of penalties.
Gross Valuation Misstatement Penalty (40%): The Court deferred ruling on the applicability of the 40% penalty under Section 6662(b)(6) and (i) for tax years 2012 through 2015, pending further briefing on the "relevancy" question of the economic substance doctrine under Section 7701(o)(1).
Reasonable Cause Defense: Petitioners cited reliance on RMC Consultants and Mr. Rivelle. While Mr. Rivelle was a qualified actuary, his initial work for Mr. Kadau was limited to a single phone call and questionnaire, lacking comprehensive documentation. Furthermore, the RMC Group was a promoter of the microcaptive arrangement. The Court firmly stated that advice "hardly qualifies as disinterested or objective if it comes from parties who actively promote or implement the transactions in question". Given the RMC Group's promotional role, Mr. Kadau could not reasonably rely on their advice. The Court concluded that Mr. Kadau failed to establish his reasonable cause defense, finding his reliance unjustified and lacking good faith.
Substantial Authority Defense: Petitioners relied on Rev. Rul. 2002-89 and the "case of first impression" observation from Avrahami. The Court found Rev. Rul. 2002-89 distinguishable as its facts were not substantially the same as those in the Kadau case. Regarding Avrahami, the "case of first impression" comment was made in the context of reasonable reliance, which was not established here. The Court stated that this case involved "application of well-settled principles of taxation," not novel questions of law, thus rejecting the substantial authority defense.
Section 6662(a) Accuracy-Related Penalties (20%): Since the understatements were substantial (exceeding the greater of 10% of tax or $5,000) for all years at issue, and petitioners' reasonable cause and substantial authority defenses were rejected, the Court sustained the 20% accuracy-related penalties as determined in the Notices of Deficiency.

Conclusion

The Tax Court in Kadau reiterated its stringent interpretation of what constitutes "insurance" for federal income tax purposes, particularly for microcaptive arrangements. The decision emphasizes the critical importance of demonstrable risk distribution and adherence to commonly accepted notions of insurance. Key takeaways include the Court's skepticism toward arrangements exhibiting a circular flow of funds, non-arm's-length and non-actuarially determined premiums, and operations inconsistent with bona fide insurance companies.

While the Court denied the deductibility of premiums, it did not sustain the increased deficiency related to Subpart F income, finding that the funds could be reclassified as nontaxable contributions of capital. However, the Court sustained the 20% accuracy-related penalties, firmly rejecting the taxpayers' defenses of reasonable cause and substantial authority due to reliance on a promoter and the lack of truly novel legal issues. Tax professionals should advise clients that the bar for demonstrating genuine insurance risk, risk shifting, risk distribution, and operating as an insurer in the commonly accepted sense remains high for microcaptive arrangements.

Prepared with assistance from NotebookLM.