Third Circuit Denies Appeal Of The Delaware Department Of Insurance In Tax Shelter Captive Summons Case

The U.S. Third Circuit Court of Appeals has entered an opinion requiring the Delaware Department of Insurance (“DDOI”) to disclose information to the U.S. Internal Revenue Service in response to an IRS summons for information regarding Artex Risk Solutions, Inc., which is affiliated with Arthur J. Gallagher & Co. That the IRS won on its summons was easily predictable, but how the Third Circuit ruled was quite a surprise.

In what was easily its dumbest move ever, Artex purchased Tribeca Strategic Advisors, LLC. Tribeca was largely — if not purely — just a tax shelter shop that mass-produced 831(b) microcaptive tax shelters disguised as legitimate captive insurance companies. Some years later, Artex quite predictably because the object of an IRS tax shelter promoter examination, and the IRS began its discovery process by issuing various document production summons to Artex.

In responding to these summons, Artex was forced to disclose the existence of two e-mail chains between Artex employees and representatives of the DDOI. The first e-mail related to the issuance of a certificate of authority (read: captive insurance license) to be issued by the DDOI to an Artex client, and the second involved a breakfast meeting between Artex and six DDOI employees. However, the DDOI refused to produce the e-mails to the IRS, citing to § 6920 of the Delaware Insurance Code which requires that certain information regarding Delaware’s insurance companies be kept confidential.

To compel the DDOI to comply with its summons, the IRS filed a petition in the U.S. District Court for the District of Delaware. In response, the DDOI argued that the McCarran-Ferguson Act — by which Congress leaves the regulation of insurance largely to the states — operates to as to “reverse-preempt” other federal laws, such as the Internal Revenue Code. After the issue was briefed and argued, however, the U.S. Magistrate Judge who initially heard the case decided that there was no reverse-preemption because the business of insurance really was not involved (as opposed to tax shelter activity) and the DDOI should cough up the e-mails. The DDOI objected to this decision before the U.S. District Court, but it too held that the DDOI had to cough up the e-mails for the same reasons. Finally, the DDOI appealed to the Third Circuit, which issued its opinion in U.S. v. State of Delaware Department of Insurance, 2023 WL 3030247 (3rd Cir., April 21, 2023).

The first thing the Third Circuit needed to figure out was whether the McCarran-Ferguson Act even applied at all, which meant an inquiry into whether the DDOI’s activity constituted the “business of insurance”. Under U.S. Supreme Court precedent, the “business of insurance” essentially goes to activities of insurance companies in analyzing, underwriting, and issuing policies to transfer risks from the policyholder to the insurance company, and ancillary things necessarily related to the insuring function, but — very importantly — not everything that insurance companies do.

To this point, the DDOI argued to the effect that confidentiality of information (presumably contained in the e-mails at issue) allows the candid exchange of that information between captive insurance companies and the DDOI which furthers the DDOI’s insurance function. The Third Circuit flatly rejected this argument. First, captive insurance companies regulated by Delaware are required to respond with accurate information to the DDOI anyway and at the threat of losing their insurance license if they do not. Second, since the IRS could issue a summons directly to the captive insurance company for information that it submits to the DDOI anyway meant that there was no reason to believe that by protecting any such information it would somehow be more accurate.

With that, the Third Circuit affirmed the decision of the U.S. District Court to require the DDOI to turn over the e-mails to the IRS without the IRS having to sign any confidentiality agreement that might restrict their use.

ANALYSIS

This is more than just a dispute about a couple of e-mails. What is really at stake is the ability of the state insurance commissioners, including the DDOI here, to use the McCarran-Ferguson Act to stonewall an IRS tax shelter investigation regarding certain captive insurance companies and their managers.

That Delaware is involved is utterly no surprise, since Delaware is one of several states (North Carolina and Tennessee are not far behind) who aggressively marketed itself as welcoming tax shelter captives with open arms. Such jurisdictions have routinely licensed captives that are objectively ridiculous from a traditional risk-management viewpoint, but these jurisdictions got to collect license and other fees — and trumpet their growing captive numbers to their state legislators for bigger budgets. Or, to put it even more bluntly, several of the captive jurisdictions have openly colluded with tax shelter promoters dressed as captive managers to facilitate their creation of abusive tax shelters to cheat Uncle Sam. This is the information that the IRS is really looking for in its discovery summons, since that evidence would be very strong evidence supporting the assessment of promoter penalties.

Putting together a tax shelter captive is not easy, but requires several players who are willing to overlook economic reality. The first is the captive manager who is willing to organize and do the paperwork for an insurance company that lacks any real economic purpose. The second is the actuary who dummies up thick folder of highly questionable information to support the premiums that will be charged. The third consists of the state insurance regulators who will overlook rather obvious flaws in how the captive will operate (mostly how the captive prices its policies or allows its owner to take moneys tax-free out the backdoor through loans or similar arrangements). Finally, the fourth consists of the captive’s auditors who will sign off on tax returns that are utterly detached from any economic reality. Take away any of these, and no tax shelter captive.

Delaware is a case in point. The DDOI’s captive deputy commissioner made clearly early and often at various industry meetings that Delaware would be friendly to tax shelter captives. Delaware next allowed microcaptives to be formed as Delaware Series LLCs to further expedite the process for tax shelter participants, and seemingly gave the insurance license applications for these deals only a cursory review. Towards the end, Delaware might simply have set up a kiosk somewhere to allow captive managers to obtain licenses for tax shelter captives on a self-service basis, as that wasn’t too different from what went on. Again, see also North Carolina and Tennessee.

What this has resulted in is that these states (and a few others) have developed a reputation within the captive industry of being lax regulators, which may be good for the tax shelter promoters, but is just the sort of thing that those in the legitimate captive industry will want to steer away from to avoid guilt by association with the tax shelter folks. At the complete other end of the spectrum is Vermont, by way of contrast, which is perceived by many as the gold standard for captive insurance worldwide and which was not willing to accept this kind of gutter captive business. There is a reason that the major U.S. corporations are domiciling their captives in Delaware and other states with good reputations, and not these other tax shelter friendly states.

What must be remembered is that not only to the state insurance departments regulate captive insurance companies, but they also ― effectively ― regulate the captive insurance managers by allowing them to qualify to act as such in those states. For lay persons, what this means is that every state maintains a list of captive managers who have been deemed qualified to act as such, and every captive insurance company must have a captive insurance manager who is approved to be on that list. As a best practice, a state should require that if a captive manager is under an IRS promoter examination, that fact should immediately be disclosed to the state so that the state can then be apprised that the particular captive manager may be putting together shoddy tax shelter captives as opposed to real captives. This would also, of course, give the insurance department the opportunity to go back and revisit the most current reporting of the captives being managed by the particular captive managers to see what is really going on with the operation of the captive (usually a near total absence of the predicted claims over several years) as opposed to what was presented in the captive’s original licensing application.

Terminating the approval of a predominantly tax shelter captive manager will almost immediately weed out the bad captives. The good captives will simply move to a new manager, but the tax shelter captives will have difficulty finding a new captive manager (if they can find one at all willing to accept that kind of business), and then will either redomicile elsewhere or just shut the tax shelter captive down, which ends the insurance department’s problem right there.

It is possible that Delaware and these other states may be able to fix their reputations within the legitimate captive industry someday, but that will take both time and strong medicine in terms of clearing out the tax shelter captives. These states should do what Arizona had to do a decade ago, which is to start aggressively flushing out the tax shelter captives. At the present moment, however, there doesn’t appear to be any reason to believe that these states are even trying to do that, and we’ll probably see more of these IRS summons cases directed to them in the coming years.

So stay tuned.