                              T.C. Memo. 2019-34



                        UNITED STATES TAX COURT



          SYZYGY INSURANCE CO., INC., ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 2140-15, 2141-15,               Filed April 10, 2019.
                 2142-15, 2143-15,
                 2182-15.



      LeRoy L. Metz II, Brian T. Must, and Joshua D. Baker, for petitioners.

      John P. Healy, Dawn L. Danley-Nichols, Robin Lynne Herrell, Daniel M.

Trevino, and James D. Hill, for respondent.




      1
       Cases of the following petitioners are consolidated herewith: John W.
Jacob and Melinda L. Jacob, docket No. 2141-15; Michael VanLenten and
Elizabeth Jacob VanLenten, docket No. 2142-15; Vincent J. Jacob and Marjorie B.
Jacob, docket No. 2143-15; and Robert E. Jacob and Mary Ann Jacob, docket No.
2182-15.
                                        -2-

[*2]        MEMORANDUM FINDINGS OF FACT AND OPINION


       RUWE, Judge: These cases were consolidated for purposes of trial,

briefing, and opinion. The Commissioner determined deficiencies in petitioners’

Federal income tax and accuracy-related penalties under section 6662(a) as

follows:2

Docket No. 2140-15--Syzygy Insurance Co., Inc.

                                                            Penalty
             Year               Deficiency                sec. 6662(a)

             2009                $149,147                 $29,829.40
             2010                 149,248                  29,849.60
             2011                 105,502                  21,100.00

Docket No. 2141-15--John W. and Melinda L. Jacob

                                                            Penalty
             Year               Deficiency                sec. 6662(a)

             2009                $71,985                  $14,397.00
             2010                 62,362                   12,472.40
             2011                 41,779                    8,335.80




       2
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
                                        -3-

[*3] Docket No. 2142-15--Michael and Elizabeth Jacob VanLenten

                                                            Penalty
             Year               Deficiency                sec. 6662(a)

             2009                 $71,985                  $14,397.00
             2010                  62,362                   12,472.40
             2011                  41,779                    8,355.80

Docket No. 2143-15--Vincent J. and Marjorie B. Jacob

                                                            Penalty
             Year               Deficiency                sec. 6662(a)

             2009                 $31,414                   $6,283.80
             2010                  32,189                    6,437.80
             2011                  14,806                    2,962.20

Docket No. 2182-15--Robert E. and Mary Ann Jacob

                                                            Penalty
             Year               Deficiency                sec. 6662(a)

             2009                 $31,414                   $6,282.80
             2010                  26,934                    5,386.80
             2011                  18,508                    3,701.60

The issues for decision are: (1) whether payments through a microcaptive

insurance arrangement from Highland Tank & Manufacturing Co. (Highland

Tank) and its affiliates to Syzygy Insurance Co., Inc. (Syzygy), and its fronting

carriers are deductible as insurance premiums; (2) whether Syzygy’s section

831(b) election is invalid for the years in issue; (3) whether the purported premium
                                            -4-

[*4] payments are otherwise included in Syzygy’s income if we find the

arrangement is not insurance; and (4) whether petitioners are liable for accuracy-

related penalties for the years in issue.

                                FINDINGS OF FACT

      Some of the facts have been stipulated and are so found. The first amended,

first supplemental, and second supplemental stipulations of facts and the attached

exhibits are incorporated herein by this reference. Syzygy’s principal place of

business was in Pennsylvania when it filed its petition, and all individual

petitioners resided in Pennsylvania when they filed their petitions.

Petitioners

      Syzygy is a microcaptive insurance company established by John W. Jacob

and Michael VanLenten. John W. Jacob is married to Melinda L. Jacob and is

Highland Tank’s chairman of the board, secretary, treasurer, and a vice president.

He is responsible for Highland Tank’s overall management. John W. Jacob’s

parents are Robert and Mary Ann Jacob.

      Mr. VanLenten is married to Elizabeth Jacob VanLenten and is Highland

Tank’s president. Mrs. VanLenten is John W. Jacob’s first cousin. Her father is

Vincent J. Jacob, who is married to Marjorie B. Jacob.
                                       -5-

[*5] HT&A

      Highland Tank is a family business based in Stoystown, Pennsylvania, that

manufactures above-ground and below-ground steel tanks. Highland Tank has

been owned by the Jacob family since 1953. Various related companies have

formed under the Highland Tank umbrella, including Highland Tank of New

York, Inc. (HTNY), Highland Tank of North Carolina, Inc. (HTNC), Lowe

Engineering Co., Inc. (Lowe), and Bigbee Steel & Tank Co. (Bigbee).3 For all of

the years in issue each company elected to be treated as an S corporation for

Federal income tax purposes.4 HT&A had approximately 400 employees at six

different locations and during the years in issue had annual revenues of between

$54,138,272 and $61,086,066.

      During all of the years in issue Bigbee was owned 50% by the John W.

Jacob 2002 Irrevocable Trust (2002 Jacob Trust) and 50% by the Michael and

Elizabeth VanLenten 2002 Irrevocable Trust (2002 VanLenten Trust). In 2009


      3
        Highland Tank, HTNY, HTNC, Lowe, and Bigbee will sometimes be
collectively referred to as HT&A.
      4
       An S corporation is a corporation governed under the laws of subchapter S
of the Code. S corporations are not generally subject to Federal income tax but
like partnerships are conduits through which income flows to their shareholders.
See Gitlitz v. Commissioner, 531 U.S. 206, 209 (2001) (“Subchapter S allows
shareholders of qualified corporations to elect a ‘pass-through’ taxation system
under which income is subjected to only one level of taxation.”)
                                        -6-

[*6] John W. Jacob and Mr. VanLenten each owned 50% of the remaining HT&A

entities. The ownership structure of those entities changed in 2010, and each were

owned: (1) 33.3% by John W. Jacob; (2) 16.7% by the 2008 John W. Jacob, Sr.,

Separate Trust (2008 Jacob Trust); (3) 33.3% by Michael VanLenten; and

(4) 16.7% by the 2008 Michael and Elizabeth J. VanLenten Separate Trust (2008

VanLenten Trust). In 2011 those same entities were owned 50% by the 2008

Jacob Trust and 50% by the 2008 VanLenten Trust.

      Robert Jacob was the grantor of the 2002 Jacob Trust, Vincent Jacob was

the grantor of the 2002 VanLenten Trust, John W. Jacob was the grantor of the

2008 Jacob Trust, and Mr. VanLenten was the grantor of the 2008 VanLenten

Trust. Each trust was a grantor trust and its income was taxable to the grantor.

HT&A’s Commercial Insurance Coverage

      John W. Jacob has considerable experience with insurance. He sits on the

board of directors of Columbus Captive Insurance and the Luttner Financial Group

(a general agent for Guardian Life Insurance).

      HT&A had extensive commercial insurance coverage. During each year in

issue they maintained between 11 and 13 policies and paid premiums of between

$981,882 and $1,471,042. The average rate-on-line for all of HT&A’s
                                            -7-

[*7] commercial insurance policies was 1.14% as calculated by the

Commissioner’s expert.5

Formation of Syzygy

         In 2008 John W. Jacob explored forming a captive insurance company.

Seubert & Associates, an insurance broker, eventually connected John W. Jacob

with Alta Holdings, LLC (Alta). Alta, a company based in Irvine, California, ran a

captive insurance program and provided management services for captive

insurance companies.6

         Throughout 2008 Alta and John W. Jacob had multiple discussions about

forming a captive insurance company. Emanuel DiNatale, a certified public

accountant (C.P.A.) and then partner of Alpern Rosenthal, who advised HT&A on

tax and business matters, participated in some of these meetings.7 On October 2,

2018, Alta regional director Brian Flinchum held a webinar with Mr. Jacob and

Mr. DiNatale. One version of the agenda for the meeting stated that a captive



         5
             Rate-on-line is an insurance policy’s premium divided by the occurrence
limit.
         6
      Alta was owned 90% by Bruce J. Molnar, 5% by Donald B. Rousso, and
5% by Greg Taylor.
         7
       Mr. DiNatale is now a partner of BDO, which is Alpern Rosenthal’s
successor.
                                        -8-

[*8] insurance company is not feasible unless there are at least $600,000 of annual

premiums and that Alta had identified that amount and needed more information

on how much more premium was achievable.

      On November 26, 2008, Alta’s chief underwriter, Greg Taylor, sent an email

to another Alta employee saying that as a “will ass guess” he identified $500,000

to $800,000 of premiums. Sometime thereafter, Mr. DiNatale advised John W.

Jacob that he should consider proceeding with a captive insurance company. Mr.

DiNatale testified that he felt that the arrangement complied with the revenue laws

and was appropriate from a business perspective. On December 5, 2008, John W.

Jacob decided to proceed.

      On December 15, 2008, Syzygy was incorporated in Delaware, and on

December 31, 2008, it received from the State of Delaware Department of

Insurance (DDI) a certificate of authority. Syzygy was initially capitalized with a

$250,000 irrevocable letter of credit naming the DDI as the beneficiary. Syzygy

was owned 50% by MV Investment Management (MV), LLC, and 50% by MJ

Investment Management (MJ), LLC. MV’s sole owner was the 2008 VanLenten

Trust, and Mr. VanLenten was its manager. MJ’s sole owner was the 2008 Jacob

Trust, and John W. Jacob was its manager. Syzygy’s only officers were Mr.
                                        -9-

[*9] VanLenten and John W. Jacob. Mr. VanLenten was president, and John W.

Jacob was secretary and treasurer.

Operation of Alta’s Captive Program and Syzygy’s Participation

      Syzygy and HT&A participated in Alta’s captive insurance program.

Participants in Alta’s program consisted of companies purchasing captive

insurance and their related captive insurance companies. Typically, participants

did not directly purchase policies from their captive insurance companies but from

fronting carriers8 related to Alta. From 2008 until December 31, 2010, the

fronting carrier was U.S. Risk Associates Insurance Co. (SPC), Ltd. (U.S. Risk).

From the end of 2010 until the end of 2011, Newport Re, Inc. (Newport Re), acted

as the fronting carrier.

      The fronting carriers’ policies were written on behalf of their segregated

portfolios. The policies issued by the fronting carriers had a maximum aggregate

benefit of $1 million. Syzygy directly wrote one policy to HT&A for 2011, which




      8
       Fronting companies issue fronting policies, which are “a risk management
technique in which an insurer underwrites a policy to cover a specific risk but then
cedes the risk to a reinsurer.” Hanover Ins. Co. v. Urban Outfitters, Inc., 806 F.3d
761, 764 n.3 (3d Cir. 2015).
                                       - 10 -

[*10] also had an aggregate maximum benefit of $1 million. All of the policies

had a 12-month term and were claims-made policies.9

       HT&A paid premiums directly to the fronting carriers, but the fronting

carriers ceded 100% of the insurance risk. Each fronting carrier charged a fronting

fee, which was deducted from the gross premiums HT&A paid to the fronting

carrier. U.S. Risk charged 2.5% of the gross premiums paid, but it is unclear what

NewPort Re charged.10 The responsibility for paying a covered claim can best be

understood as a two-layered arrangement. The first $250,000 of a single loss was

allocated to layer 1, and any loss between $250,000 and $1 million was allocated

to layer 2.

       Alta uniformly allocated 49% of each captive participant’s premiums to

layer 1 and 51% to layer 2. Syzygy reinsured the first $250,000 of any HT&A




       9
        A claims-made policy is “[a]n agreement to indemnify against all claims
made during a specific period, regardless of when the incidents that gave rise to
the claims occurred.” Black’s Law Dictionary 821 (8th ed. 2004).
       10
         In the participation agreement among Syzygy, HT&A, and Newport Re the
stated fronting fee was 3.5% of the gross premiums. But it appears that Newport
Re deducted only 2.5% of the gross premiums paid by HT&A.
                                      - 11 -

[*11] claim (layer 1 claims).11 Shortly after the fronting carriers received HT&A’s

premiums, they ceded 49% of the net premiums to Syzygy.12

      For HT&A’s claims between $250,000 and $1 million (layer 2 claims),

Syzygy agreed to reinsure its quota-share percentage of losses. The quota share

was the ratio of: (1) the net premium HT&A paid to that portfolio to (2) the

aggregate net premiums the portfolio received for the insurance period.

Additionally, Syzygy provided layer 2 reinsurance for a diverse array of

approximately 857 policies issued to unrelated companies in the fronting carriers’

pools. Syzygy reinsured approximately 40 to 50 unrelated companies per pool.




      11
       In Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 278 (1996), we
explained:

             Reinsurance is an agreement between an initial insurer (the
      ceding company) and a second insurer (the reinsurer), under which
      the ceding company passes to the reinsurer some or all of the risks
      that the ceding company assumes through the direct underwriting of
      insurance policies. Generally, the ceding company and the reinsurer
      share profits from the reinsured policies, and the reinsurer agrees to
      reimburse the ceding company for some of the claims that the ceding
      company pays on those policies.
      12
         The net premiums were the gross premiums paid by HT&A to the fronting
carriers less the fronting fees.
                                         - 12 -

[*12] Three and one-half months after the policy periods ended, the fronting

carriers ceded the remaining 51% of net premiums to Syzygy less the amount of

any claims paid for layer 2 losses.

      During the years in issue HT&A paid gross premiums to the fronting

carriers and the fronting carriers ceded net premiums to Syzygy as follows:

                      Gross
                    premiums                         Layer 1 net     Layer 2 net
                      paid to                        premiums        premiums
                     fronting                         ceded to        ceded to
    Tax year          carrier         Fronting fee    Syzygy          Syzygy
     2009           $510,000            $12,750      $243,652.50    $253,597.50
     20101            545,000            13,625       260,373.75     250,894.51
     2011             318,500                (2)      152,163.38     158,374.12
       Total        1,373,500            37,522       656,189.63     662,866.13

      1
         For 2010 the net premiums and fronting fee do not add up to the gross
premiums paid by HT&A because Syzygy contributed $20,106.74 to a layer 2
claim, which is discussed later in the opinion.
       2
         The record is conflicted as to how much HT&A was charged as a fronting
fee for 2011.

Allocation of Premiums Between Layers 1 and 2

      Alta requested that Taylor-Walker & Associates, Inc. (Taylor-Walker), an

actuarial consulting firm based in Midvale, Utah, provide input regarding the
                                        - 13 -

[*13] allocation of premiums between Layers 1 and 2.13 Randall Ross, an

associate of the Casualty Actuarial Society and a member of the American

Academy of Actuaries, worked on the request. In response to Alta’s request, Mr.

Ross sent an email on April 25, 2007, to Alta’s chief financial officer, stating:

             We reviewed various industry indications and simulated
      distributions to determine the reasonableness of the proposed split
      between the primary layer ($0-$250,000) and the excess layer
      ($250,000-$1,000,000). Based on our review, we would expect more
      than 49% of the loss experience to fall in the primary layer, given the
      proposed limits.

              Our review of industry experience by layer suggests that a
      reasonable portion of experience to attribute to the primary layer
      might range from roughly 57% to 78%, depending on the type of
      coverage offered. However, we did find one medical malpractice
      liability increased limits factor that implied a 47%/53% breakdown
      into the respective layers.

             Additionally, we attempted to model loss experience in such a
      manner that would support the proposed split of 49%/51% * * *. In
      order to achieve such a split, we determined that we would have to
      assume an average unlimited claim size in excess of $500,000. While
      some claims can be expected to exceed this amount, we would expect
      the average severity over all claims to be significantly lower.

            We note that the proposed split between primary and excess
      experience may be more easily supported by either lowering the




      13
         It is unclear when Alta made the request, but the Commissioner claims that
it was in 2007.
                                         - 14 -

[*14] attachment point to something below $250,000 or increasing the limit
      to something greater than $1 million.[14]

On May 16, 2007, Mr. Ross sent Alta another email estimating that 70% of the

losses would occur in layer 1 and 30% in layer 2.

      Alta did not change the premium allocation in response to Mr. Ross’

findings. Mr. Ross was unaware of why Alta allocated 49% of premiums to layer

1 and 51% to layer 2 and never asked. John W. Jacob testified that the purpose of

the allocation was to take advantage of a tax-related “safe harbor”.15

Policies and Premiums

      Although John W. Jacob testified that the original intent behind forming a

captive insurance company was to obtain coverage for potential warranty claims,

HT&A did not purchase a captive warranty policy for the years in issue.16 For

2009 and 2010 U.S. Risk issued HT&A the following policies:17




      14
         Mr. Ross testified that as discussed in the email, the “primary layer” is
layer 1, and it is clear from his testimony that the “excess layer” is layer 2.
      15
           The safe harbor is almost certainly Rev. Rul. 2002-89, 2002-2 C.B. 984.
      16
           Highland Tank did purchase warranty insurance for 2012.
      17
       The policies issued for 2009, 2010, and 2011 were in effect, respectively,
from December 31, 2008, to December 31, 2009; December 31, 2009, to
December 31, 2010; and December 31, 2010, to December 31, 2011.
                                        - 15 -

 [*15] Policy type                  2009 premium              2010 premium
 Administrative actions                     (1)                   $50,000
 Bankruptcy preference                 $25,000                     40,000
 Cyber liability                        25,000                     25,000
 Deductible
  reimbursement                        250,000                    250,000
 Legal expense                          50,000                     40,000
 Intellectual property
  defense                               25,000                     25,000
 Intellectual property
  enforcement                           50,000                     40,000
 Property DIC2                          85,000                     75,000
  Total premiums                       510,000                    545,000

      1
          HT&A did not procure an administrative actions policy for 2009.
      2
          DIC means “difference in conditions”.

For 2011 Syzygy directly wrote the intellectual property enforcement policy to

HT&A. HT&A procured the following policies from Newport Re for 2011:
                                       - 16 -

 [*16]          Policy type                            2011 premium
         Administrative actions                            $25,000
         Bankruptcy preference                              20,000
         Cyber liability                                    20,000
         Deductible reimbursement                          162,500
         Legal expense                                      26,000
         Intellectual property                              20,000
         Property DIC                                       45,000
          Total premiums                                   318,500

      Excluding HT&A’s life, health, and workers’ compensation policies, the

deductible reimbursement policies had the third highest premiums of any HT&A

policy procured for 2009 and 2010 and the fourth highest for 2011. The legal

expense, intellectual property, intellectual property enforcement, administrative

actions, and property DIC policies were excess-coverage policies, under which the

insurer agreed to indemnify against a loss only if it exceeded the amount covered

by another policy. The policies did not provide for pro rata refunds if they were

canceled during the policy terms. Claims could be made only within seven days

after the policy period closed, and there was no option to purchase an extended

claims reporting period.
                                         - 17 -

[*17] The premiums for the 2009 policies were set by Mr. Taylor, who is not an

actuary. Before Mr. Taylor set the premiums, HT&A provided Alta with a series

of answers to underwriting questionnaires and accompanying documents. Mr.

Taylor then created an underwriting report recommending premiums for 2009,

which is dated December 9, 2008. It appears that Mr. Taylor relied on the

information provided by HT&A. However, the underwriting report does not detail

Mr. Taylor’s rating model, calculations, or any other detailed analysis describing

how he arrived at the premiums. The report provided only general information

about projected losses, previous claims, and information about HT&A’s other

insurance. There is nothing in the underwriting report that suggests that Mr.

Taylor used comparable premium information to price the premiums.

      Alta hired Taylor-Walker to create an actuarial feasibility study for

Syzygy.18 The feasibility study was prepared in support of Syzygy’s captive

insurance application. Mr. Ross prepared and cosigned the feasibility study,

which is dated December 15, 2008. The feasibility study mentions the premium

prices, but its primary purpose was to determine Syzygy’s ability to remain

solvent, not to determine whether the premiums were reasonable.




      18
           Greg Taylor did not have an ownership interest in Taylor-Walker.
                                        - 18 -

[*18] Mr. Ross testified that he did not have a role in pricing the premiums and

did not look at publicly available State rating models when preparing the

feasibility study. With respect to the premiums the study states that Syzygy’s

“selected premium levels appear to be somewhat conservative in relationship to

the insured risks and policy limits * * *. For this reason, it is our opinion that

* * * [Syzygy] is feasible from a financial solvency perspective.” Mr. Ross

testified that conservative meant “not too low.”

      In preparing the report Mr. Ross did not use any independent data but only

data provided by Alta. The report goes on to state:

      We accepted, without audit, the premium and loss assumptions
      provided to us. It is our opinion that these assumptions represent the
      best available information from which to project losses and premiums
      for the Captive. We reviewed these assumptions for reasonableness
      and consistency. However, we acknowledge that these assumptions
      are highly subjective.

After Syzygy submitted its application, a DDI contractor performed an initial

examination of Syzygy that offered no recommendations. The initial examination

included an actuarial review. William White, director of captive insurance for the

DDI during Syzygy’s application process and the actuarial review, testified that

the actuarial review focused on whether the premiums were sufficient for Syzygy

to remain solvent and that the DDI was unconcerned with premiums being too
                                       - 19 -

[*19] high. The initial report sheds no light on whether the contractor evaluated

the reasonableness of Syzygy’s premiums.

      The parties’ experts calculated an average rate-on-line of 6.08% to 6.2% for

HT&A’s captive insurance policies during the years in issue. Neither U.S. Risk

nor Newport Re timely issued a policy to HT&A during the years in issue.

Newport Re did not issue policies until after the policy years ended.

Projected Losses and Claims

      Alta’s underwriting report projected that Syzygy would pay annual layer 1

claims under the legal expense, property difference in condition, and deductible

reimbursement policies. The feasability study projected that Syzygy would have

an overall loss and loss adjustment expense (LLAE) ratio of 56% overall and 29%

in layer 2 from 2008 to 2012.19 Syzygy’s actual LLAE ratio was 1.5%. The LLAE

ratio was 0% for layer 1 and 3% for layer 2.

      HT&A did not file any claims under their captive program policies during

the years in issue but did file multiple claims under their commercial insurance

policies and incurred deductibles. In response to Alta’s underwriting

questionnaires, HT&A stated that they did not keep specific records of the

      19
        The LLAE ratio is the cost of losses and loss adjustment expenses divided
by the total premiums. The feasability study did not provide a specific LLAE ratio
for layer 1.
                                         - 20 -

[*20] incurred deductibles they paid because the deductibles were “too numerous

to list.” Although the deductible reimbursement policies issued by U.S. Risk for

2009 and 2010 state that they applied only to one specific policy--STICO policy

No. PLR0009-04--John W. Jacob testified that all deductibles were covered except

for workers’ compensation and health insurance. From 2009 to 2010 HT&A made

payments for a $56,012.58 deductible resulting from a claim filed under STICO

policy No. PLR0009-04. Petitioners do not dispute that coverage was available

for an additional $43,456.08 of deductibles paid or incurred during the years in

issue.

         John W. Jacob spent significant time working on HT&A’s insurance matters

during the years in issue. He testified that he did not file captive program claims

because of time management issues and that they did not hit his “radar screen”.

John W. Jacob acknowledged that HT&A did not have a claims management

system in place for their captive program but had “different processes” in place

depending on the claim for their commercial policies.

         Syzygy paid $20,106.74 to satisfy its quota-share responsibility of an

approximately $1,483,889 layer 2 claim in 2010.20 The claim was filed by


         20
       U.S. Risk withheld $20,106.74 from the layer 2 net premiums ceded to
Syzygy for 2010.
                                        - 21 -

[*21] Pyrotek, Inc. (Pyrotek), under an intellectual property policy for the period

of June 30, 2009, to June 30, 2010. It is unlikely that the loss was covered, but

U.S. Risk settled the claim.21 Syzygy did not investigate whether the loss was

covered.

Syzygy’s Capitalization and Assets

      Syzygy met Delaware’s minimum capitalization requirements during the

years in issue. Syzygy was initially capitalized with a $250,000 irrevocable letter

of credit of which the DDI was the beneficiary.22 Syzygy’s assets were listed on

audited financial statements for each year in issue. By the end of 2009 Syzygy’s

listed assets totaled $1,218,713 and consisted of: (1) the $250,000 letter of credit,

(2) $183,740 of cash and cash equivalents, and (3) $784,973 of unceded

premiums. By the end of 2010 Syzygy’s listed assets increased to $1,460,931 and

consisted of: (1) the $250,000 letter of credit, (2) $349,500 of cash and cash

equivalents, (3) $561,431 of unceded premiums, and (4) two life insurance

policies worth $300,000. By the end of 2011 Syzygy’s listed assets decreased to



      21
        According to Alta the claim was not covered because its was not timely
reported and Pyrotek did not disclose the loss when the policy was written
although it knew about the loss.
      22
        The letter of credit was canceled in 2011, and it seems this was done with
the consent of the DDI.
                                       - 22 -

[*22] $1,136,389 and consisted of: (1) $45,395 of cash and cash equivalents,

(2) $158,374 of unceded premiums, (3) a $250,000 certificate of deposit,

(4) mutual funds holding bonds worth $79,436, and (5) two life insurance policies

worth $603,184.

      Syzygy did not own the life insurance policies listed on the financial

statements. Rather, they were owned by the 2008 Jacob Trust and the 2008

VanLenten Trust.23 Syzygy was not a beneficiary of either policy. The policies’

respective beneficiaries were the trusts. On June 23, 2010, Matthew Michael

Jacob was appointed as special investment adviser to the 2008 Jacob Trust and the

2008 VanLenten Trust. In his capacity as special investment adviser Matthew

Michael Jacob had “the sole authority to direct the Trustee regarding all life

insurance policies” on the lives of John W. Jacob and Mr. VanLenten.

      On the same day of Matthew Michael Jacob’s appointment as special

investment adviser, Syzygy entered into separate split-dollar life insurance

agreements with the respective trusts regarding the life insurance policies. Under

the terms of the agreements, Syzygy agreed to pay premiums for a life insurance

policy insuring John W. Jacob and a separate policy insuring Mr. VanLenten. The


      23
      The policy insuring Mr. VanLenten’s life lists the owner as Stewart
Management Co. as trustee of the 2008 VanLenten Separate Trust.
                                        - 23 -

[*23] policy insuring John W. Jacob’s life had a face amount of $8,034,280, and

the policy insuring Mr. VanLenten’s life had a face amount of $7,356,547.

      Syzygy’s only rights to the policies’ proceeds were defined in the split-

dollar agreements. Upon the death of an insured, Syzygy was entitled to the

greater of: (1) the premiums that it had paid with respect to the policy or (2) the

policy’s cash value. If the policy was terminated during the life of an insured,

Syzygy was entitled to the total amount payable under the policy.

      Syzygy was prohibited from accessing the cash values of the policies,

borrowing against the policies, surrendering or canceling the policies, or taking

“any other action with the respect to the polic[ies].” Syzygy and the trusts were

allowed to assign their rights.

      The agreements could be terminated only through the mutual consent of

Syzygy, the respective insured, and the respective trust. Within 60 days of

termination, the owner had the option to obtain a release of Syzygy’s interest in

the policy. To obtain the release, the policy owner was required to pay Syzygy the

greater of: (1) the premiums that it paid with respect to the policy or (2) the

policy’s cash value. If the policy owner did not obtain a release, ownership of the

policy reverted to Syzygy.
                                       - 24 -

[*24] Syzygy paid $300,000 of premiums for the life insurance policies in both

2010 and 2011. Neither the policies nor the agreements were terminated during

the years in issue.

Syzygy’s Exit From Alta’s Captive Program

      In 2011 Syzygy decided to exit Alta’s captive insurance program. Syzygy’s

premiums dropped by more than $200,000 in 2011. John W. Jacob sent an email

to Alta explaining that Syzygy was changing managers because, among other

things, he was displeased with the decrease in premiums.

      At trial John W. Jacob testified the he was disappointed in the premium

decrease because there were fixed costs associated with a captive manager and it

makes the most sense to have as much coverage as possible with the captive

manager.

Returns and Notices of Deficiency

      Petitioners each filed returns for the years in issue. Syzygy made a section

831(b) election and reported no taxable income for any of the years in issue.

      The premium payments to the fronting carriers were apportioned among the

various entities under the Highland Tank umbrella, and the entities deducted those

payments. Because HT&A were S corporations, the deductions flowed through to
                                        - 25 -

[*25] the shareholders. The deductions that flowed through to the trusts were

claimed by the trusts’ grantors.

      The Commissioner selected petitioners’ returns for examination and timely

issued notices of deficiency. With respect to Syzygy, the Commissioner

determined that Syzygy did not engage in insurance transactions and was not an

insurance company. Accordingly, the Commissioner determined that the section

831(b) election was invalid and the premiums Syzygy received were taxable

income. The Commissioner also imposed accuracy-related penalties.

      With respect to the individual petitioners, the Commissioner determined:

(1) the arrangement was invalid for lack of economic substance, (2) the premium

payments were not payments for insurance, and (3) the amounts deducted were not

ordinary and necessary business expenses. Accordingly, the Commissioner

disallowed the deductions and imposed accuracy-related penalties.24

      Petitioners timely filed petitions with this Court.




      24
         The notices of deficiency for 2009 issued to John W. Jacob and Melinda L.
Jacob, and Michael VanLenten and Elizabeth Jacob VanLenten have a
computational discrepancy that the parties do not explain. In the explanation of
items portion of the notices, the Commissioner stated that he disallowed $268,307
of “Insurance Expenses” paid by Highland Tank. However, only $193,306.79 of
the total premiums paid for 2009 was allocated to Highland Tank.
                                        - 26 -

[*26]                                OPINION

        The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer bears the burden of proving that the

determinations are incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Deductions are a matter of legislative grace, and taxpayers bear the

burden of proving that they are entitled to any deduction claimed. INDOPCO, Inc.

v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice, Co. v. Helvering, 292

U.S. 435, 440 (1934).

        Under section 7491(a), if the taxpayer provides credible evidence

concerning any factual issue relevant to ascertaining the taxpayer’s liability and

complies with certain other requirements, the burden of proof shifts to the

Commissioner as to the factual issue. At trial on December 13, 2017, petitioners

filed a motion to shift the burden of proof. On April 6, 2017, we issued a pretrial

order requiring “[t]hat all motions to shift the burden of proof will be filed by

September 22, 2017”. Therefore, petitioners violated the pretrial order, and we

will issue an order denying their motion to shift the burden of proof.

        The issues we must decide are (1) whether the amounts received by Syzygy

as premiums are excluded from its gross income and (2) whether the individual

petitioners are entitled to the benefit of deductions taken by their S corporations
                                       - 27 -

[*27] for insurance under section 162. Petitioners argue that the premiums

received by Syzygy were payments for insurance and, therefore: (1) these

premiums are excluded from Syzygy’s income under section 831(b) and (2) the

individual petitioners are entitled to deduct the premiums as payments for

insurance under section 162.

      The Commissioner argues that (1) the premiums Syzygy received were not

insurance premiums and therefore are not excluded under section 831(b) and

(2) the premium payments are not deductible under section 162 as payments for

insurance.

      We begin our discussion by briefly explaining the taxation and deductibility

of microcaptive insurance payments. Insurance companies--other than life

insurance companies--are generally taxed on their income in the same manner as

other corporations. See secs. 11, 831(a). However, section 831(b) provides an

alternative taxing structure for certain small insurance companies. During the

years in issue, an insurance company with net written premiums (or, if greater,

direct written premiums) that did not exceed $1.2 million for the year could elect

to be taxed under section 831(b).25 Sec. 831(b)(2). A small insurance company

      25
       The 2015 amendments to sec. 831(b) increased the premium ceiling to
$2.2 million--adjusted for inflation--and added new diversification requirements
                                                                      (continued...)
                                        - 28 -

[*28] that makes a valid section 831(b) election is subject to tax only on its

investment income. Sec. 831(b)(1). These companies are not subject to tax on

their earned premiums and are commonly referred to as “microcaptive” insurance

companies. See sec. 831(b)(1).

      Typically, amounts paid for insurance are deducible under section 162(a) as

ordinary and necessary expenses paid or incurred in connection with a trade or

business. Sec. 1.162-1(a), Income Tax Regs. Section 162(a) does not prohibit

deductions for microcaptive insurance premiums.

      An inherent requirement for a company to make a valid section 831(b)

election is that it must transact in insurance. See Avrahami v. Commissioner, 149

T.C. 144 (2017). Likewise, the deductibility of insurance premiums depends on

whether the premiums were truly payments for insurance. Thus, these cases hinge

on whether the captive insurance arrangement meets the definition of insurance.

I. Whether the Arrangement Is Insurance

      Neither the Code nor the regulations define insurance, and we are guided by

caselaw in determining whether a transaction constitutes insurance for Federal


      25
         (...continued)
that an insurance company must meet to be eligible to make a sec. 831(b) election.
See Consolidated Appropriations Act, 2016, Pub. L. No. 114-113, sec. 333, 129
Stat. at 3106.
                                         - 29 -

[*29] income tax purposes. Avrahami v. Commissioner, 149 T.C. at 174. Courts

have looked to four criteria in deciding whether an arrangement constitutes

insurance: (1) the arrangement involves insurable risks, (2) the arrangement shifts

the risk of loss to the insurer, (3) the insurer distributes the risk among its policy

holders, and (4) the arrangement is insurance in the commonly accepted sense.

Harper Grp. v. Commissioner, 96 T.C. 45, 58 (1991), aff’d, 979 F.2d 1341 (9th

Cir. 1992); AMERCO & Subs. v. Commissioner, 96 T.C. 18, 38 (1991), aff’d, 979

F.2d 162 (9th Cir. 1992). These four nonexclusive criteria establish a framework

for determining the existence of insurance for Federal income tax purposes.

AMERCO & Subs. v. Commissioner, 96 T.C. at 38. We consider all of the facts

and circumstances in the light of the criteria outlined above. See Rent-A-Center,

Inc. v. Commissioner, 142 T.C. 1, 13-14 (2014). We will first look at risk

distribution.

      A. Risk Distribution

      Petitioners argue that Syzygy distributed risk by participating in the U.S.

Risk and Newport Re captive insurance pools and reinsuring unrelated risks.

Therefore, before we can decide whether Syzygy distributed risk through the

fronting carriers, we must decide whether those carriers were bona fide insurance

companies. See Avrahami v. Commissioner, 149 T.C. at 185 (citing Rent-A-
                                        - 30 -

[*30] Center, Inc. v. Commissioner, 142 T.C. at 10). In determining whether an

entity is a bona fide insurance company, we have considered factors such as:

      (1)    whether it was created for legitimate nontax reasons;

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

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

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

      (5)    whether the entity charged actuarially determined premiums;

      (6)    whether comparable coverage was more expensive or even available;

      (7)    whether it was subject to regulatory control and met minimum
             statutory requirements;

      (8)    whether it was adequately capitalized; and

      (9)    whether it paid claims from a separately maintained account.

Id.; see Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 10-13. Many of these

factors are interrelated, and we will address those most relevant.

             1. Circular Flow of Funds

      Under the arrangements with the fronting carriers, HT&A paid premiums to

the carriers. The fronting carriers then reinsured all of the risk, making sure that

Syzygy received reinsurance premiums equal to the net premiums paid by HT&A

less Syzygy’s liability for any layer 2 claims. For the years in issue, this resulted
                                       - 31 -

[*31] in HT&A’s paying the fronting carriers $1,373,500 of gross premiums and

the fronting carriers’ ceding $1,319,055.76 of reinsurance premiums to Syzygy. In

considering similar circumstances we have determined that “[w]hile not quite a

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

Avrahami v. Commissioner, 149 T.C. at 186; see also Reserve Mech. Corp. v.

Commissioner, T.C. Memo. 2018-86, at *41 (quoting Avrahami v. Commissioner,

149 T.C. at 186).

              2. Arm’s-Length Contracts

      HT&A’s captive program policy premiums had an average rate-on-line of

6.08-6.2%, while the policies they purchased outside of the captive program had

an average rate-on-line of 1.14%. This amounts to HT&A’s paying upwards of

five times more for their captive program policies than noncaptive program

policies. A higher rate-on-line means that insurance coverage is more expensive

per dollar of coverage. Thus, a higher rate-on-line leads to a greater deduction for

premiums.

      Various terms in the captive program policies indicate that HT&A should

have paid less for the captive program policies than the noncaptive policies.

During each year in issue at least half of HT&A’s captive program policies were

for excess coverage, which should result in a lower rate-on-line. See Avrahami v.
                                        - 32 -

[*32] Commissioner, 149 T.C. at 187-188. None of the captive program policies

provided for a refund of premiums upon cancellation. The Commissioner’s

expert, James Macdonald, explained in his expert report that this was unusual.

Petitioners argue that Mr. Macdonald conceded there are commercial policies with

premiums earned at inception, but petitioners have not pointed to any of HT&A’s

noncaptive policies that does not provide for a refund of unearned premiums. Of

HT&A’s noncaptive program policies that the Court looked at, each provides a

refund for unearned premiums.

      Each captive program policy also required claims to be filed within the

earlier of 30 days after the loss was incurred or 7 days after the policy expired. In

these cases the problem centers on the seven-day period after the policy expired.

In his expert report, Mr. Macdonald explained that the seven-day reporting period

“would not be acceptable in an arm’s-length transaction because it simply does not

allow enough time for a policyholder to become aware of an incident that may

result in a formal claim.” At trial Mr. Macdonald testified that the claims-made

policies typically provide a period of 30 to 60 days after a policy’s expiration to

report claims for no additional premium. Petitioners argue that Mr. Macdonald

conceded that there are commercial claims-made insurance policies with shorter

reporting periods than HT&A’s, but petitioners have not pointed to any of
                                         - 33 -

[*33] HT&A’s noncaptive program claims-made policies with a reporting period

of seven days or less. Of the policies that the Court reviewed, none had a

reporting period of less than 30 days.

      Petitioners contend that the rate-on-line analysis is flawed because Mr.

Macdonald testified at trial that he would never price a commercial policy

premium by averaging an insured’s other commercial policies. However, Mr.

Macdonald did not use the average rate-on-line for HT&A’s noncaptive program

policies to properly price another individual policy; he used it to show that on

average HT&A paid more for their captive program coverage than their

noncaptive program coverage. Thus, we think the rate-on-line analysis is

appropriate. There is nothing in the record that justifies why HT&A, on average,

paid higher premiums for policies with more restrictive provisions than their

commercial policies. The higher average rate-on-line coupled with the policies’

restrictive provisions leads us to conclude that the policies were not arm’s-length

contracts.

      Additionally, John W. Jacob’s email to Alta stating that one of the reasons

HT&A was leaving the Alta program was the decrease in premiums deepens our

view that the policies were not arm’s-length contracts. It is fair to assume that a

purchaser of insurance would want the most coverage for the lowest premiums. In
                                       - 34 -

[*34] an arm’s-length negotiation, an insurance purchaser would want to negotiate

lower premiums instead of higher premiums. Seemingly, the main advantage of

paying higher premiums is to increase deductions. Therefore, the fact that John

W. Jacob sought higher premiums leads us to believe that the contracts were not

arm’s-length contracts but were aimed at increasing deductions.

            3. Actuarially Determined Premiums

      Neither the Code, caselaw, nor regulations define “actuarially determined”

premiums in the context of captive insurance, but our cases have provided some

guidance. We have held that premiums charged by a captive insurance company

were actuarially determined when the company relied on an outside consultant’s

“reliable and professionally produced and competent actuarial studies” to set

premiums, and we have looked favorably upon an outside actuary’s determining

premiums to be reasonable. Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 27

(Buch, J., concurring) (noting that premiums were actuarially determined when set

in reliance on an actuarial study); see Securitas Holdings, Inc. v. Commissioner,

T.C. Memo. 2014-225. We have held that premiums were not actuarially

determined when there has been no evidence to support the calculation of

premiums and when the purpose of premium pricing has been to fit squarely

within the limits of section 831(b). See Avrahami v. Commissioner, 149 T.C. at
                                       - 35 -

[*35] 196; Reserve Mech. Corp. v. Commissioner, at *43. In the instant cases,

there are two issues with respect to actuarially determined premiums: (1) the

reasonableness of captive program premiums and (2) the 49% to 51% allocation of

premiums between layer 1 and layer 2. We will begin by discussing the first issue.

      The only detailed evidence in the record relevant to how the premiums were

set concerns the 2008 premiums. Petitioners argue that the premiums were

actuarially determined because they were set by Mr. Taylor using “a quantitative

risk analysis”, and then Mr. Ross reviewed the premiums and loss assumptions.

Further, they contend that the premiums were reviewed by actuaries contracted by

the DDI. We disagree.

      Mr. Taylor is not an actuary. We recognize that premiums can be set by

nonactuaries, but Mr. Taylor’s underwriting report has no calculations showing

how he arrived at the premium prices. Mr. Taylor does not appear to have used

any type of actuarial rating model or compared premium prices with similar

publicly available policies. As stated by Mr. Taylor, he was using a “will ass

guess” at one point during the pricing process.

      Petitioners’ argument that the actuarial reviews by Mr. Ross and the DDI-

contracted actuaries prove that the premiums were actuarially determined is not

supported by the record. Mr. Ross testified that he reviewed the premiums in the
                                       - 36 -

[*36] context of Syzygy’s solvency and that the purpose of the review was not to

determine whether the premiums were reasonable. Additionally, the director of

captive insurance for the DDI during Syzygy’s application process testified that

the main purpose of the DDI actuarial review was also to determine Syzygy’s

solvency. There is nothing in the DDI initial examination report that indicates that

the examination focused on whether the premiums were reasonable. Accordingly,

the policies issued by the fronting carriers did not have actuarially determined

premiums.

      There are also problems with the allocation of premiums between layer 1

and layer 2. Mr. Ross sent two emails to Alta stating that the majority of the

premiums should be allocated to layer 1, but Alta did not change the allocation.

John W. Jacob testified that he understood that the purpose of the allocation was

to take advantage of a tax-related safe harbor. As in Avrahami and Reserve Mech.

Corp., we are concerned with one-size-fits-all approaches. See Avrahami v.

Commissioner, 149 T.C. at 186; Reserve Mech. Corp. v. Commissioner, at *43.

Accordingly, we find that the allocation of premiums between layer 1 and layer 2

was not actuarially determined.

      All of the above-mentioned factors indicate that U.S. Risk and Newport Re

were not bona fide insurance companies, which in turn means that they did not
                                       - 37 -

[*37] issue insurance policies. See Avrahami v. Commissioner, 149 T.C. at 190.

This means Syzygy’s reinsurance of those policies did not distribute risk;

therefore, Syzygy did not accomplish sufficient risk distribution for Federal

income tax purposes through the fronting carriers.26

      B. Insurance in the Commonly Accepted Sense

      Syzygy’s absence of risk distribution by itself is enough to conclude that the

transactions among Syzygy, HT&A, and the fronting carriers were not insurance

transactions. Avrahami v. Commissioner, 149 T.C. at 190. But as an alternative

ground we can also look at whether the transactions constituted insurance in the

commonly accepted sense. Id. at 191. To determine whether an arrangement

constitutes insurance in the commonly accepted sense, we look at numerous

factors including: (1) whether the company was organized, operated, and

regulated as an insurance company; (2) whether it was adequately capitalized;

(3) whether the policies were valid and binding; (4) whether premiums were

reasonable and the result of arm’s-length transactions; and (5) whether claims

were paid. R.V.I. Guar. Co. & Subs. v. Commissioner, 145 T.C. 209, 231 (2015);


      26
        We have found as a fact that Syzygy wrote a single policy to HT&A for
2011. See supra pp. 9-10. We need not consider whether Syzygy achieved any
type of risk distribution with respect to that policy because we conclude below that
the arrangement is not insurance in the commonly accepted sense.
                                       - 38 -

[*38] see Rent-A-Center, Inc. v. Commissioner, 142 T.C. at 24-25; Harper Grp. v.

Commissioner, 96 T.C. at 60. We will address each of these factors in turn.

             1. Organization, Operation, and Regulation

      Syzygy was organized as an insurance company and regulated in the State

of Delaware. The Commissioner, however, argues that Syzygy ran afoul of

various insurance regulations. We will not address this as it does not affect the

outcome of these cases. The important question is whether Syzygy was operated

as an insurance company. In making this determination “we must look beyond the

formalities and consider the realities of the purported insurance transactions”.

Hosp. Corp. of Am. v. Commissioner, T.C. Memo. 1997-482, 1997 WL 663283, at

*24 (citing Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835, 842-843 (6th Cir.

1995), rev’g T.C. Memo. 1989-604).

      We have concerns with Syzygy’s operation. The first problem is claims.

During the years in issue HT&A did not submit a single claim to a fronting carrier

or Syzygy. John W. Jacob testified that there were various claims that were

eligible for coverage under the deductible reimbursement policy that were not

submitted, and petitioners do not dispute that approximately $100,000 worth of

claims was covered. Additionally John W. Jacob testified that HT&A had no

claims process for the captive program claims but did have “different processes”
                                        - 39 -

[*39] for their other claims. The deductible reimbursement policy was one of

HT&A’s most expensive insurance policies, and HT&A’s failure to submit claims

after paying deductibles is indicative of the arrangement’s not constituting

insurance in the commonly accepted sense. Our concern is bolstered by HT&A’s

statement on the underwriting questionnaire that before 2009 their incurred

deductibles were “too numerous to list.” Petitioners’ contention that John W.

Jacob was too busy to submit claims does not lead us to believe the arrangement

was insurance in the commonly accepted sense because HT&A had claims

processes for commercial policies that they did not implement for the captive

program policies.

      The problem with claims also extends to the sole claim Syzygy paid. It is

unclear whether the claim was covered, yet Syzygy did not investigate coverage

before paying the claim.

      Syzygy’s investment choices are also troubling. At the end of 2011 the life

insurance policies insuring John W. Jacob and Mr. VanLenten totaled more than

50% of Syzygy’s assets and were its largest investments. Under the terms of the

split-dollar agreements, Syzygy could neither access the cash value of the policies,

borrow against the policies, surrender or cancel the policies, nor unilaterally

terminate the agreements with the trusts.
                                        - 40 -

[*40] We do not think that an insurance company in the commonly accepted sense

would invest more than 50% of its assets in an investment that it could not access

to pay claims. The arrangement is even more troublesome because the 2008 Jacob

Trust and the 2008 VanLenten Trust were the beneficiaries of the policies. If

Syzygy needed to access the policies to pay a claim, it could not do so without the

trusts’ special investment adviser’s consent. The special investment adviser would

potentially be deterred from allowing Syzygy to access the policies because that

would be detrimental to the respective trusts’ beneficiaries’ interests.

      Petitioners contend that Steven Kinion--who has been director of captive

insurance for the DDI since mid-2009--had no issues with the life insurance

policies. However, Mr. Kinion’s testimony is unclear as to whether he had

knowledge of the terms of Syzygy’s split-dollar agreements. When asked whether

it was irrelevant that Syzygy could not access the policies’ cash values, Mr. Kinion

stated: “Once we became aware of these types of policies where a captive

insurance company for instance could not access cash values, we would go to the

captive manager * * * and seek out a change to those requirements.” This does

not amount to Mr. Kinion’s having no issues with Syzygy’s inability to access the

policies’ cash values to pay claims. We find that the circumstances surrounding
                                        - 41 -

[*41] Syzygy’s life insurance investments weigh heavily against Syzygy’s being

an insurance company in the commonly accepted sense.

      Petitioners did not call any Alta employees as trial witnesses to explain how

the insurance arrangement worked or discuss whether the fronting carriers

operated in a bona fide fashion.

             2. Capitalization

      Syzygy met Delaware’s minimum capitalization requirements. In Avrahami

v. Commissioner, 149 T.C. at 194, we discussed how a consensus of our caselaw

has held that an insurer is adequately capitalized if it meets the relevant

jurisdiction’s minimum capitalization requirements.

             3. Valid and Binding Policies

      The caselaw is not entirely clear on what makes a policy “valid and

binding”. We have held that policies were valid and binding when “[e]ach

insurance policy identified the insured, contained an effective period for the

policy, specified what was covered by the policy, stated the premium amount, and

was signed by an authorized representative of the company.” Securitas Holdings,

Inc. v. Commissioner, at *28. In R.V.I. Guar. Co. v. Commissioner, 145 T.C. at

231, we found that policies were valid and binding when the insured filed claims

for covered losses and the captive insurance company paid them. We have also
                                        - 42 -

[*42] looked at factors beyond whether the policies are simply binding such as

conflicting policy terms and whether the policies were simply cookie cutter.

Avrahami v. Commissioner, 149 T.C. at 194 (examining conflicting policy terms);

Reserve Mech. Corp. v. Commissioner, at *54 (describing that policies were

cookie cutter and not necessarily appropriate).

      Here the dispute surrounding valid and binding policies centers on whether

the policies were timely issued, identified the insured, and specified what was

covered by the policies. During the years in issue neither Syzygy nor the fronting

carriers timely issued a policy to HT&A. The policies for 2009 and 2010 were not

even issued until after the policy years ended. Despite the late issuances,

petitioners contend that the risk binders issued by the fronting carriers bound

coverage.27 Although petitioners’ expert Dr. Michael Angelina testified that late

issuances are common in the insurance industry, we conclude that the failure to




      27
        An insurance binder is a “written instrument, used when a policy cannot be
immediately issued, 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.” MDL Capital Mgmt. Inc. v. Fed. Ins. Co., 274 F. App’x 169,
170-171 (3d Cir. 2008) (quoting Harris v. Sachse, 52 A.2d 375, 378 (Pa. Super.
Ct. 1947)).
       There is no dispute that the binders for 2009 and 2010 were timely issued,
but there is a dispute as to 2011.
                                          - 43 -

[*43] timely issue even a single policy weighs against the arrangement being

insurance in the commonly accepted sense.

      The policies issued to HT&A have ambiguities and conflict as to whether

HT&A were insured or whether only Highland Tank was insured. In response to

informal discovery requests petitioners stated that Highland Tank, HTNY, HTNC,

Lowe, and Bigbee were insured. The 2009 and 2010 policies name Highland Tank

as the insured. But the risk binders for 2010 name Highland Tank’s nominees,

affiliates, and subsidiaries of affiliates as insureds.

      There are also various ambiguities and conflicts concerning what the

policies covered. For example John W. Jacob testified that the deductible

reimbursement policies applied to all of HT&A’s insurance policies except for

workers’ compensation and health insurance. The deductible reimbursement

policies for 2009 and 2010 stated that they applied only to STICO insurance

policy No. PLR00004-04. That STICO policy was not in effect in 2010.

Additionally, the deductible reimbursement policy for 2011 stated that it applied

to only five specific policies.

      We recognize petitioners’ argument that ambiguous policy terms are a major

source of insurance litigation. Petitioners contend that regardless of the

ambiguities and conflicting terms, the intent of the parties is controlling and the
                                        - 44 -

[*44] policies are therefore binding. The meaning of “valid and binding” for

Federal tax purposes also looks at policy ambiguities and conflicting terms and

how they fit in with the spirit of a transaction. Obviously, ambiguous and

conflicting terms do not prevent every policy from being insurance for tax

purposes but related-party transactions are given heightened scrutiny. Merck &

Co. v. United States, 652 F.3d 475, 481 (3d Cir. 2011) (citing Geftman v.

Commissioner, 154 F.3d 61, 75 (3d Cir. 1998), rev’g in part, vacating in part T.C.

Memo. 1996-447); Mazzei v. Commissioner, 150 T.C.           ,    (slip op. at 47)

(March 5, 2018). Viewing the policies’ late issuances, ambiguities, and

conflicting terms in the context of a related-party transaction leads us to conclude

that the valid and binding policies factor weighs against petitioners.

               4. Reasonableness of Premiums

      As discussed in considering whether the policies were arm’s-length

contracts, the premiums were unreasonable. This factor weighs against

petitioners.

               5. Payment of Claims

      The only claim submitted to Syzygy during the years in issue was the

Pyrotek layer 2 claim. As discussed in connection with the “Organization,

Operation, and Regulation” factor, see supra pp. 38-39, the claim was paid, but
                                        - 45 -

[*45] there are problems with the way that it was handled. This factor weighs

slightly in petitioners’ favor. But we do not regard this as overwhelming evidence

that the arrangement constituted insurance in the commonly accepted sense

because of the way the claim was handled.

         Although Syzygy was organized and regulated as an insurance company,

met Delaware’s minimum capitalization requirements, and paid a claim, these

insurance-like traits do not overcome the arrangement’s other failings. Syzygy

was not operated like an insurance company. The fronting carriers charged

unreasonable premiums and late-issued policies with conflicting and ambiguous

terms.

         C. Arrangement Not Insurance

         The arrangement among HT&A, Syzygy, and the fronting carriers lacked

risk distribution and was not insurance in the commonly accepted sense. Thus, the

arrangement is not insurance for Federal income tax purposes and we need not

address the Commissioner’s economic substance arguments.

II. Effect on Syzygy

         Because the arrangement is not insurance, Syzygy’s section 831(b) election

is invalid and it must recognize the premiums it received as income. Therefore,

we sustain the Commissioner’s determinations with respect to Syzygy.
                                        - 46 -

[*46] III. Effect on the Individual Petitioners

      The individual petitioners cannot deduct the purported premium payments

or any fees as payments for insurance because the payments were not for

insurance. Nevertheless, petitioners contend that the purported premium payments

are payments for indemnification that are deductible as ordinary and necessary

business expenses. Additionally, they contend that the Commissioner argues

against Rev. Rul. 2008-8, 2008-1 C.B. 340, and Rev. Rul. 2005-40, 2005-2 C.B. 4,

by disallowing deductions for the purported premium payments.

      A. Deductibility as Indemnification Payments

      There is little precedent addressing whether amounts paid for an invalid

insurance arrangement can nevertheless be deductible under section 162(a), and

neither party cites any cases. To be deductible under section 162 an expense must

be both ordinary and necessary. Welch v. Helvering, 290 U.S. at 113. An expense

is necessary if it is appropriate and helpful to the development of the taxpayer’s

business. Commissioner v. Tellier, 383 U.S. 687, 689 (1966); Welch v. Helvering,

290 U.S. at 113. In the context of captive insurance there may be instances where

noninsurance payments for indemnification protection might be appropriate and

helpful to the development of the insured. But, at the bare minimum, for such

payments to be considered appropriate and helpful, the indemnified party must
                                         - 47 -

[*47] intend to seek indemnification if a covered event occurs. Otherwise, there is

no valid purpose for making such payments. In these cases HT&A’s failure to file

claims that they thought were covered under the deductible reimbursement

policies leads us to find that there was no intent to seek indemnification for

covered losses. Accordingly, the payments are not deductible as ordinary and

necessary expenses.

      B. The Revenue Rulings

      Rev. Rul. 2005-40, 2005 2 C.B. at 5, states:28

      [A]n arrangement that purports to be an insurance contract but lacks
      the requisite risk distribution may instead be characterized as a
      deposit arrangement, a loan, a contribution to capital (to the extent of
      net value, if any), an indemnity arrangement that is not an insurance
      contract, or otherwise, based on the substance of the arrangement
      between the parties. The proper characterization of the arrangement
      may determine whether the issuer qualifies as an insurance company
      and whether amounts paid under the arrangement may be deductible.

      The Commissioner is required to follow his revenue rulings, and we have

treated revenue rulings as concessions by the Commissioner where those rulings

are relevant to the disposition of a case. Rauenhorst v. Commissioner, 119 T.C.

157, 171-172 (2002). For a taxpayer to rely on a revenue ruling, however, the

facts of the taxpayer’s transaction must be substantially the same as those in the


      28
           Rev. Rul. 2008-8, 2008-1 C.B. 340, 341, says nearly the same thing.
                                        - 48 -

[*48] ruling. Barnes Grp., Inc. & Subs. v. Commissioner, T.C. Memo. 2013-109,

at *37-*38, aff’d, 593 F. App’x 7 (2d Cir. 2014); sec. 601.601(d)(2)(v)(e),

Statement of Procedural Rules.

      Rev. Rul. 2008-8, supra, and Rev. Rul. 2005-40, supra, both describe

circumstances where the Commissioner determined that various transactions either

were or were not insurance. With respect to those transactions that were not

insurance, the Commissioner did not describe the precise characterization of the

arrangements that were not insurance or the precise tax treatment of each

characterization. Thus, it is unclear how petitioners can rely on the revenue

rulings to deduct the payments. The rulings do not have substantially similar facts

providing for a deduction for premium payments in relation to an arrangement that

is not insurance. Accordingly, petitioners cannot rely on the rulings to deduct the

purported premiums.

      Petitioners also argue that if the payments to Syzygy are not deductible they

should not be taxable to Syzygy. While the revenue rulings suggest the possibility

that an arrangement that purports to be an insurance contract may instead be

characterized as a deposit arrangement, a loan, a contribution to capital, or

otherwise, there is no evidence that any such recharacterization is appropriate. See

Reserve Mech. Corp. v. Commissioner, at *65-*66.
                                        - 49 -

[*49] IV. Penalties

      In the notices of deficiency the Commissioner determined that petitioners

were each liable for section 6662(a) accuracy-related penalties. Section 6662(a)

and (b)(1) and (2) authorizes a 20% penalty on the portion of an underpayment

attributable to “[n]egligence or disregard of rules or regulations” and “[a]ny

substantial understatement of income tax.” Negligence includes any failure to

make a reasonable attempt to comply with the revenue laws, and “disregard of

rules or regulations” includes any careless, reckless, or intentional disregard. Sec.

6662(c). Negligence is determined by testing a taxpayer’s conduct against that of

a reasonable, prudent person. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), aff’g 79 T.C. 714 (1982). For individual taxpayers there is a

substantial understatement of income tax if the amount of the understatement for

the taxable year exceeds the greater of 10% of the tax required to be shown on the

return or $5,000. Sec. 6662(d)(1)(A). For corporations there is an understatement

of income tax if the amount of the understatement for the taxable year exceeds the

lesser of 10% of the tax required to be shown on the return for the taxable year (or,

if greater, $10,000) or $10 million. Sec. 6662(d)(1)(B).

      Under section 7491(c) the Commissioners bears the “burden of production”

for penalties related to individual petitioners but not corporations. NT, Inc. v.
                                       - 50 -

[*50] Commissioner, 126 T.C. 191 (2006); Higbee v. Commissioner, 116 T.C.

438, 446 (2001). Once the Commissioner meets his “burden of production”,

however, the “burden of proof” remains with the taxpayer, including the burden of

proving the penalty is inappropriate because of reasonable cause under section

6664. See Rule 142(a); Higbee v. Commissioner 116 T.C. at 446, 448. We need

not decide whether the Commissioner met his burden for the individual petitioners

because they have established reasonable cause through good faith reliance on Mr.

DiNatale’s professional advice.

      Section 6664(c)(1) provides that the penalty under section 6662(a) shall not

apply to any portion of an underpayment if it is shown that there was reasonable

cause for the taxpayer’s position and he acted in good faith. See Higbee v.

Commissioner, 116 T.C. at 448. This determination is made on a case-by-case

basis, taking into account all of the pertinent facts and circumstances. Sec.

1.6664-4(b)(1), Income Tax Regs. For underpayments related to passthrough

items we look at all pertinent facts and circumstances, including the taxpayer’s

own actions, as well as the actions of the passthrough entity. Sec. 1.6664-4(e),

Income Tax Regs. Reliance on professional advice may constitute reasonable

cause and good faith, but only if considering all the circumstances such reliance

was reasonable. Freytag v. Commissioner, 89 T.C. 849, 888 (1987), aff’d, 904
                                         - 51 -

[*51] F.2d 1011 (5th Cir. 1990), aff’d, 501 U.S. 868 (1991); sec. 1.6664-4(b)(1),

Income Tax Regs.

      Reasonable cause exists if a taxpayer relies in good faith on the advice of a

qualified tax adviser where the following three elements are present: (1) the

adviser was a competent professional who had sufficient expertise to justify the

reliance, (2) the taxpayer provided necessary and accurate information to the

adviser, and (3) the taxpayer actually relied in good faith on the adviser’s

judgment. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000),

aff’d, 299 F.3d 221 (3d Cir. 2002). Reliance may be unreasonable if the adviser is

a promoter of the transaction. Id. at 98. A promoter is “an adviser who

participated in structuring the transaction or is otherwise related to, has an interest

in, or profits from the transaction.” 106 Ltd. v. Commissioner, 136 T.C. 67, 79

(2011) (quoting Tigers Eye Trading, LLC v. Commissioner, T.C. Memo. 2009-

121, slip op. at 47-48), aff’d, 684 F.3d 84 (D.C. Cir. 2012).

      We find that Mr. DiNatale was a competent professional with sufficient

expertise. He is a C.P.A. who advises HT&A on tax and business matters. His

testimony strongly indicates that he familiarized himself with relevant captive

insurance law when advising HT&A, and we credit his testimony. Accordingly,

we find that Mr. DiNatale was a competent professional with sufficient expertise.
                                        - 52 -

[*52] We find that Mr. DiNatale was provided with all of the necessary and

accurate information. He sat through meetings with John W. Jacob and Alta and

was familiar with HT&A’s business.

      We find petitioners relied on Mr. DiNatale in good faith. Mr. DiNatale was

not a promoter. In the context of microcaptive insurance, we have found a

taxpayer’s reliance on professional advice coupled with the lack of precedent in

the area to be indicative of good faith. See Avrahami v. Commissioner, 149 T.C.

at 207. Taking into account all of the facts and circumstances, the good faith

reliance extends to all petitioners in these cases. Accordingly, petitioners are not

liable for the accuracy-related penalties.

      In reaching our decision, we have considered all arguments made by the

parties, and to the extent not mentioned or addressed, they are irrelevant or

without merit.

      To reflect the foregoing,


                                                 Decisions will be entered for

                                        respondent as to the deficiencies and for

                                        petitioners as to the accuracy-related

                                        penalties under section 6662(a).
