Captive insurer fails to shake IRS challenge to $239,773 in tax deductions

A captive insurance firm tried to end a tax fight with the Internal Revenue Service before trial. A federal court said not so fast. 

The US Court of Federal Claims on September 25 denied summary judgment to Capstone Associated Services, a Texas-based firm that set up and ran captive insurance companies for closely held businesses. The ruling keeps alive the IRS's challenge to $239,773 in insurance premium deductions Capstone claimed for the 2016 tax year - along with 20 percent accuracy-related penalties. 

The dispute centers on whether payments Capstone made to two affiliated insurers - FinServ Casualty Corporation and PoolRe Insurance Corporation, both based in Anguilla, British West Indies - were real insurance premiums or just money circling between related entities. 

Here is how the arrangement worked. Capstone paid $147,595 in premiums to FinServ across 10 policies and $92,178 to PoolRe for stop-loss coverage on nine of them. Losses above a threshold were split between FinServ at 20 percent and PoolRe at 80 percent. PoolRe then redistributed its share to a quota-share pool of 79 insurance companies - including FinServ itself. 

The tax advantage flows from Internal Revenue Code Section 831(b), which lets small insurers exclude up to $1.2 million in premiums from taxable income. The Supreme Court has noted that such arrangements carry "potential for tax evasion," as the opinion cited from CIC Services, LLC v. Internal Revenue Service. 

Judge Kathryn C. Davis found too many unresolved facts to decide the case without trial. 

Capstone relied on a controller's declaration to prove it paid premiums, but the government's expert read the underlying ledger differently. A memorandum establishing the premium allocation was written during litigation - not when the transactions happened - and the controller conceded the original allocations were "determined prior to his being there." 

Claims handling raised questions too. Capstone pointed to written procedures, but those documents were drafted by Capstone itself as captive insurance manager. A government expert described the processing as "flawed and inconsistent" with the firm's own policies. 

PoolRe's independence drew the sharpest scrutiny. Although a third party formally owned it, PoolRe's own conflict-of-interest policy called it "a wholly owned subsidiary of Capstone." A services agreement gave Capstone power to dissolve it. One director testified he provided overlapping consulting services to both companies, and could not recall PoolRe ever paying a claim before 2016. 

The case now heads to trial. The parties must propose a schedule by October 16, 2026. 

The ruling is not a final determination. But for advisors whose clients use microcaptive insurance, it signals that the IRS is pressing these cases past the paper, into how the arrangements actually operated day to day.