T.C. M em o . 2 0 2 1 -3 0

UNITED STATES TAX COURT

CAYLOR LAND & DEVELOPM ENT, INC., ET AL., 1 Pet i t i o n ers v . COM M ISSIONER OF INTERNAL REVENUE, Res po n d en t

Do ck etNo s . 1 7 2 0 4 -1 3 , 1 7 20 5 -1 3 , Fi l edM arch 1 0 , 2 02 1
.

1 72 2 3 -1 3 , 1 9 2 3 8 -1 3 , 2 39 2 1 -1 3 , 2 3 9 2 2 -1 3 , 2 39 3 1 -1 3 , 1 1 3 4 8 -1 4 , 1 79 1 9 -1 4 , 1 7 9 2 0 -1 4 , 1 79 2 1 -1 4 , 1 7 9 2 2 -1 4
.

1 W e co n s o l i d at ed1 2 cas es fo r t ri al o n th e i ss u es we an al y ze i n t h i s o p i n i o n : Dat a W av e M an ag em en t , In c., d o ck etn u m b er 1 7 2 0 5 -1 3; Ib o r Co rp ., d ock et n u m b er 1 7 2 2 3 -1 3 ; Ro b ertC. Cay l o r, II an d M arg o D. Cay l o r, d o ck et n um b er 1 9 2 3 8 -1 3 ; Ro b ertCay l o r Co n s tru ct i o n Co m p an y , d o ck etn u m

b er 2 3 9 2 1 -1 3 ; Ro b ert C. Cay l o r II Ex em p t Tru s t , d o ck etn u m

b er 2 3 9 2 2 -1 3 ; Ro b ertC. Cay l o r an d Cl ara E. Cay l o r, d o ck et n u m b er 2 3 9 3 1 -1 3 ; Ban t am , LLC, Ro b ertC. Cay l o r, II Ex em p tTru s t , Tax M at t ers Part n er, d o ck etn u m b er 1 1 3 4 8 -1 4 ; La Pl ay a Cal i en t e, LLC, Ro b ertC. Cay l or II Ex em p t Tru s t , Tax M at t ers Part n er, d o ck etn u m b er 1 7 9 1 9 -1 4 ; Vi s t o s o LLC, Ro b ertC. Cay lo r II Ex em p tTru s t , Tax M at t ers Part n er, d o ck etn u m

b er 1 7 9 2 0 -1 4 ; Bav i s p e Li m i tedPart n ers h i p , Dat a W av e M an ag em en t In c., Tax M at t ers Part n er, d o ck etn u m b er 1 7 9 21 -1 4; an dM ay fai r Cres tLi m i t ed Part ners h i p , Ib o r Co rp ., Tax M at t ers Part n er, d o ck etn u m b er 1 7 9 22 -1 4
. Served 03/10/21- 2
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[* 2 ] DerekW . Kaczm arek , Dav i dR. J o j o l a, Gi sel l e C. Al ex an d er, J ay Ho ward Zi m b l er, an dJ o h n W . Treece, fo r p et i t i o n ers . M i ch ael R. Harrel , Do reen M ari e Su s i , W es l ey J . W o n g , an dJ o h n Ro b ert Go rd o n , fo r res p o n d en t
.

M EM ORANDUM FINDINGS OF FACT AND OPINION
HOLM ES, J u d g e: Bo b Cay l o r an dh i s s o n Ro b ert Cay l or II (Ro b ) are
en trep ren eu rs who b ui lta t h ri v i n g co n s tru ct i o n b u s in es s an d , i n a d i ffi cu l t i n du s try , h av e k ep tthe b u s i n es s g o i ng fo r m o re t han a h al f cen tu ry . Th ou g h i t b eg anas a s o l e p ro pri et o rs h i p, i th as s i n ce g ro wni n t o an em pi re o f m an y

s ep arat e
s ub s i d i ari es an daffi l i at es . An dl i k e al l b u s i n es s es , al l o f th e Cay l ors ’ co m p an i es
n eed edi ns u ran ce. Th ey

h av e l o n g h adtrad i t io n al i n su ran ce, wh i ch ty p i cal l y co s t th e g ro up aro u n d$ 6 0 ,0 0 0 each y ear. Beg i n n in g i n 2 0 0 7 , h o wev er, t h e Cay l o r
en t i t i es i n creas ed th ei r i ns u ran ce b i l l b y t ak i n g o u tp ol ici es fro m

a rel at ed
m i cro cap t i v e i n s u rer at a co s to f $ 1 .2 m i l li o n an nu al l y . Atth e s am e t i m e,
co n su l t i n g p aym en ts b et ween th e Cay l o r en t i t i es g rew b y ab o u t$ 1 .2 m il l i o n . Th es e d ev el o p m en ts were n o tu n rel at ed
.- 3
-

[* 3 ] In Av rah am i v . Co m m i s s i o n er, 1 49 T.C. 1 4 4 (2 0 1 7 ), we fo un dthata
m i cro cap t i v e d i dn ’ t actu al l y p ro v i d e i n s u ran ce b ecau s e i t fai l edt o d is tri bu t e ri s k
an d d i dn ’ tactas an i n su rer co m m o n l y wo u l d . In Res erv e M ech
. Co rp . v . Co m m i s s i o n er, T.C. M em o . 2 0 1 8 -8 6 , 1 1 5 T.C.M . (CCH) 1 4 7 5 (2 0 1 8 ), ap p eal fi led , No . 1 8 -9 0 1 1 (1 0 th Ci r. Dec. 2 0 , 2 0 1 8 ), we fo u n dth ata m i cro cap ti v e d i dn’ t actu al l y p ro v i d e i n s u ran ce b ecau se i tfai l edt o d is tri b u t e ri skan dd i dn ’ tactas an i n s u rer co m

m o n l y wo u l d . Th en i n Sy zy g y

In s . Co . v . Co m

m i s s i o n er, T.C. M em o . 2 0 1 9 -3 4 , 1 1 7 T.C.M . (CCH) 1 1 6 5 (2 0 1 9 ), we fo u n dth ata m icro cap t i v e d id n ’ t actu al l y p ro v i d e i n s u ran ce b ecau se i tfai l edt o d is tri b u t e ri skan dd i dn ’ tactas an i n s u rer co m

m o n l y wo u l d
. W e wi l l b reakn o n ew g ro u n dt o d ay .

FINDINGS OF FACT I. Back g ro u n d Th i s s to ry

b eg in s i n Ari zo n a b acki n 1 9 5 8 , wh en Bo b Cay l o r, wi th th e h el p
o f a l o an fro m

h i s wi fe Cl ara, s t art eda s m al l co ns tru ct i o n co m p an y wh i ch qu i ck l y g rew i n t o Ro b ertCay l o r Co n s tru ct i o n . Its t art edas a s ol e p ro p ri et o rs h i p , b u tBo b
ev en tu al l y

i n co rp orat edth e b u si n es s --h e o ffi ci al l y fo rm ed Ro b ertCay l o r Co n s tru ct i o n Co m

p an y (Cay lo r Co ns tru ct i o n ) i n 1 9 6 1. Cay lo r Co n s tru ct i o n was a
co m m erci al co ns tru ct i on co m p an y wi th ex p ert i s e as a g en eral b u i l d i n g co nt ract o r.- 4
-

[* 4 ] In an i n du s try kn o wnfo r i t s v o l at i l i ty , Bo b p ro v edt o b e a s t ead y l ead er an d
av o id ed o v erex t en d i n g i n g o odt i m es . Cay l o r Co n s tru ct i o n s u rv i v edth e b ad t i m es , an dBo b b ecam e reco g n izedi n h i s co m m un i ty as a s u cces s fu l b us i n es s m an . Bo b an dCl ara ev en tu al l y h adtwo ch i l dren , Ro b an dPau l a Cay l o r. Ro b an d h i s wi fe M arg o al s o h adtwo ch i l dren --Cas ey an d Carl y

Cay l o r. Ro b b eg an
wo rk i n g fo r h i s fat h er i n 1 9 7 3 wh en h e was ju s t n i ne. Ri g h t aft er g radu at i n g fro m h i g h s ch o o l , Ro b fo rm edh i s o wnco n s tru ct i o n co m pan y --Cay l or Lan d& Dev el o pm en tCo m

p an y (Cay l o r Lan d ). Cay l o r Lan dfo cu s edo n co m m erci al an d
res i den t ial co n tract i n g an dco n s u l t i n g . W it h h i s d ad ’ s h el p fu l ad v i ce t hro u g h o u t th e y ears , Ro b m an ag edt o b u i l dCay l o r Lan di n to a s u cces s fu l b us i n es s . In th e l at e 1 9 9 0s Ro b b o u g h tCay l o r Co n s tru ct i o n. As the co m p an i es g rew, th ey s p ro u t edm an y

o th er s ubs i d i ari es an daffi l i at es --n otatal l u n u s u al fo r an i n du s try wh ere l ev erag edfi n an ci n g i s co m m o n an dev ery

p ro jectcarri es s o m e ri s k
. Here t h ey are:
! RCM C, LLC: AnAri zo n a l i m it ed l iab i l i ty co m pan y wh ich i s s o l el y o wn edb y th e Ro b ert C. Cay l o r II Ex em p tTru s t . Itp ro v i d es m ai n ten an ce an d rep ai r s erv i ces , co n do m i n i u m -as s o ci at i on m an ag em en t s erv ices , b u i l d in g -m an ag em en ts erv i ces , an d l eas i n g s erv i ces . ! La Pl ay a Cal ien t e, LLC: AnAri zo n a LLC o wn edequ al l y b y Ro b ert C. Cay l o r II Ex em

p tTru s t an dM arg o . La Pl ay a d ev el o p s an do wn s real es tat e. Du ri n g th e y ears at i s su e i to wn edv ari o u s real es t at e- 5
- p ro p ert ies thro ug h a v ari et y o f s i n g le m em

b er LLCs . Th o s e are: Two Eas t LLC; 2 6 0 Pan t an o , LLC; Lo tOn e o n Haci en d a, LLC; 6 4 2 2 , LLC; Nex tDo o r, LLC; an d1 5 0 1 Ch erryLLC.
! Ban t am , LLC: AnAri zo n a LLC th ats p eci al i zes i n g o v ern an ce an d real -es t at e d ev el o pm en t i s s u es i n Pi m a Co u n ty . It s m em b ers are Ro b ertC. Cay l o r II Ex em p tTru s twi th a 4 7 .8 % i n t eres t , M arg o wi t h a 4 7.8 % i n t eres t , an dCh arl es Cu s h m anwi th a 4 .4 % i n t eres t . It o wn s two i n du st ri al b ui l d i n g s b u il t b y Cay lo r Co n s tru ct i on an dd ev el o p ed b y Cay l o r Lan d
. ! Vi s t o s o, LLC: AnAri zo na LLC wh o s e m em bers are Ro b ertC. Cay l o r II Ex em

p tTru s tan dM arg o --each wi th 5 0 % o wn ers h i p . Vi s t o s o d ev el o p s an dm an ag es o ffi ce s p ace. Ital s o o wn s o ne o ffi ce co n d o b ui l d i n g an dtwo co n do u n i t s b u i l t b y Cay l or Co n st ru ct i o n . ! 7 50 0 Bro ad way

LLC: AnAri zo n a LLC th ato wn s a s i ng l e, p art l y p av edp ark in g l ot . Bo b an dCl ara each o wn h al f. Th i s p ro p ert y was a fo rm er l an dfi l l b efo re Bo b b o u g hti t i n t h e 1 9 8 0 s.
! Ro b ertC. Cay l o r II Ex em p tTru s t : Ani rrev ocab l e t ru s to f wh i ch Ro b i s th e t ru s tee. Ito wn s s h ares o f rel at ed o perat in g co m p an i es an d i n t eres t s i n s om e o f t h e Cay lo r en t i ti es --1 0 0 % o f RCM C, 5 0 % o f La Pl ay a an d Vi s t os o , 4 7 .8 % o f Ban tam , 1 2 .5 % o f Cay l o r Co t l o w, an d 0
. 5 % o f Bav is p e.
! Dat a W av e M an ag em en t , In c.: AnAri zo n a C co rp o rat i o n that s p eci al i zes i n s m al l b u s i n es s es an d s t artup s. Ito wn s a 1 % g en eral p artn ers h i p i n t eres ti n Bav i s p e an di s res p o n s i b l e fo r m an ag in g Bav i s p e’ s as s et s . It s o n l y s h areh o ld er i s Bo b
. ! Ib o r Co rp .: AnAri zo n a C co rp o rat i o n o wn edb y Ro b an dM arg o i n equ al s h ares . Ito wn s a 1 % g en eral p art ners h i p i n t eres ti n M ay fai r Cres tan di s res p o n s i b l e fo r m an ag i n g th e d ay -t o -d ay o p erat i on s an d as s et s o f M ay fai r. [* 5 ]- 6
-

[* 6 ] ! M ay fai r Cres tLt d . Part n ers : A l i m i tedp art n ers h i p th at i s a fu n d i n g

m ech an i s m

fo r Cay l o r Co n s tru ct i o n th atfaci l i t at es l i n es o f cred i tan d d eb ti ns tru m en t s fo r t h e v ari o u s Cay l o r en t i t i es . Ib o r i s th e g en eral p artn er o f M ay fai r wi th a 1 % i nt eres t . It s l i m i tedp art n ers are Ro b (4 4 % i n t eres t ), M arg o (4 4 %), Cas ey A. Cay l o r GST Tru st(9 %), an d Carl y A. Cay l o r Ex em

p tTru st (2 %).
! Bav i s p e, LLP: AnAri zo n a l i m i tedp art n ers hi p th ati s a real -es t at e h ol di n g co m

p an y wi th a d i v ers e ran g e o f i n v es t m en t s . Dat a W av e i s a g en eral p art n er o f Bav i s p e wi th a 1 % i n t eres t
. Th e l i m i t edp art n ers are Ro b an dCl ara (9 8 .5 % i n teres t ) an dRo b ertC. Cay l o r II Ex em p t Tru s t(0 .5 %). W e wi l l co l l ect i v el y

refer t o al l th es e as the Cay lo r en t i t i es . An dwe fi n dth atRo b
ran th i s em

p i re p ri m ari l y

th ro u g h Cay l o r Co n s tru ct i on . Th e fo rtu n es o f al l th es e Cay l o r en t i t i es were cl o s el y t iedt o th e fo rtu n e o f Cay l o r Co ns tru ct i o n . In2 0 0 9 , fo r ex am p l e, Cay l o r Lan d h ad$ 1 .4 m i l l i o n i n g ro s s recei p t s, o f wh i ch $ 1 .2 m i l li o n was “ co n s u l t i ng fees ” recei v edfro m Cay lo r Co n s tru ct i o n . Cay l o r Lan d , aft er i trecei v edth i s “ co n su l t i n g fee,” t u rn edaro u n d
an d p ai d“ co n s u l t i n g fees ” t o s ev eral o f t h e o th er s ub s i d i ari es . An dth es e

“ co n s u l t i n g fees ” tu rn edo u tt o b e a s i g n i fi can t p arto f th e s ub s i d i ari es ’ rev en u es :- 7
-

[* 7]
Reci p i en t To t al rev en u es Co n s u l t i n g fees recei v edth ro u gh Cay lo r Lan d Percen t ag e o f

rev en u e recei v ed th ro u g h Cay l o r L an d 7 5 0 0 Bro ad way $ 3 7 ,8 3 0 $3 6 , 1 8 0 9 5 .6 % Ban t am 9 5 ,5 2 0 3 6 ,1 8 0 2 3 7 .9 3 Bav i s p e 8 6 ,0 0 6 4 2 , 2 1 0 49 .1 Dat a W av e 4 2 ,7 9 8 3 6 , 1 8 0 84 .5 Ib or 1 4 4 ,9 7 2 14 4 , 7 2 0 99 .8 La Pl ay a 1 , 9 0 9 ,7 5 7 15 6 , 7 8 0 8 .2 M ay fai r 1 9 8 ,0 8 0 15 6 , 7 8 0 79 .1 RCM C 3 5 2 ,0 9 0 27 1 , 6 9 5 77 .2 Cay l or Tru s t 2 0 4 ,4 7 8 6 0 , 3 0 0 29 .5 Vi s t o s o 3 8 ,9 8 0 3 6 , 1 8 0 92 .8 Th i s rev en u e b reak d own s h o ws th atCay l o r Co n s tru ct i o n was th e d ri v er o f th e s u cces s o r fai l u re o f al l th e o t h er Cay l or en t i t ies --i n a ro o m fu ll o f m i ce, i twas th e 8 0 0-p o u n dg o ri ll a. Fro m 2 0 0 5 t o 2 0 0 8 Cay l o r Co n s tru ct i o n rep o rt edg ro s s recei p t s o f $ 1 1 m i l l i o n , $ 15 .2 m i l l i o n , $ 2 6
. 1 m i l l i on , an d$ 2 0 .6 m i l li o n , res p ect i vel y . Wh en th e Great Reces s i o n h it , Cay l o r Co n s tru ct i o n d i dn o tes cap e

2 Ban t am al s o recei vedco n s ul t i n g fees fro m RCM C o f $ 4 1 , 8 20 fo r t ax y ear 2 0 0 9 , wh i ch m ean s th at i trecei v eda t o t al o f $ 7 8 , 0 0 0 i n co n s u l t i n g fees fro m rel at ed co m

p an i es . 3 If o n e i n cl u d es th e RCM C p aym en t , th en 8 1 .6 6 % o f Ban tam ’ s cam e fro m rel at ed co m

p an i es .- 8
-

[* 8 ] u n s cat h ed . It s rev en u es fel l i n 2 0 09 an d2 0 10 , fi rs tt o $ 8 m i l l i o n an dth en t o $ 6 .2 m i l l i o n . II. Th e M ov e t o a M i cro cap t i v e 4 A. Th e Pi t ch Fo r n earl y

th ree d ecad es Cay l o r Co n s tru ct i o n b o u g h t trad i t i o n al thi rd -p art y
co m m erci al p ro p ert y , cas ual ty , an dl i ab i l it y i n s u ran ce t h ro u g h i t s l o ng t im e i n s u ran ce b ro k er, To m

m y Gee. Fo r t h e p as t1 5 y ears Gee h adb ro k eredCay l o r Co n s tru ct i o n ’ s trad i t io n al i ns u ran ce fro m th e Ci nci n n at i In s u ran ce Co . Cay l o r Co n s tru ct i o n d i dn ’ ts k im p o n th i s trad it i o n al i n s u ran ce--i th adth e b ro ad es t p o l i ci es av ai l ab l e i n th e co m m erci al -i n s u ran ce m ark etp l ace co v eri n g :
! co m

m erci al p ro p ert y , ! g en eral l i ab i l i ty , ! u m b rel l a/ ex ces s l i ab i l i ty , ! el ect ro n i c d at a p ro ces s i n g , ! co n tract o rs equ i p m en t ,

4 A qu i ck v o cab u l ary

l es s o n m ay

b e h el pfu l atth i s p o in t . A “ cap t i v e i n s u ran ce co m

p an y ” i s a co rp o rat i o n wh o s e s t o ck i s o wn ed b y o n e o r a s m al l n u m b er o f co m

p an i es an dwh i ch h an d l es al l o r a p arto f t h e i n s u ran ce n eed s o f i t s s h areh o ld ers o r th ei r affi l i at es . Harp er Grp
. v . Co m m i s s i o n er, 9 6 T.C. 4 5 , 4 6 n .3 (1 9 9 1), aff’ d , 9 7 9 F.2 d1 3 4 1 (9 th Ci r. 1 9 92 ). A “ m i cro cap t i v e” i s a s m al l cap t i v e i n s u ran ce co m

p an y . Av rah am i v . Co m

m i ss i o ner, 1 49 T.C. 1 4 4 , 1 7 9 (2 0 1 7 ). To b e “ s m al l ”, t h e cap ti v e m us tt ak e i n l es s th an $ 1 .2 m i l l i o n i n p rem i u m s . Id
.- 9
-

[* 9 ] ! i n s t al l at i o n fl o at er,
! co m

m erci al au to , an d
! t erro ri sm . Th es e p o l i ci es n o to n l y

i n s u redCay l or Co n st ru ct io n , b u t al so o th er Cay l o r en t i t i es
an d Ro b ’ s fam i l y :
! Cay l o r Lan dDev el o p m en t ;
! Bo b an dCl ara Cay l o r;
! Ro b an dM arg o Cay l o r;
! Cl ara Cay l o r LLC;
! Fi d el i ty

Nat i on al Ti t l e Tru s tNo . 1 0 2 7 0 ;
! Ro b ertCay l o r DBA Cay l o r Co m m erci al Dev el o p ers ;
! Ro b ertCay l o r II DBA Ro b ertCay lo r In v es t m en t ;
! Cay l o r Co t l o w, LLC;
! Bav i s p e;
! M ay fai r;
! Ib o r;
! Cay l o r Tru s t ;
! 6 19 1 E. M i ram ar, LLC;
! La Pl ay a;- 1 0 -

[* 1 0 ] ! Dat a W av e;
! 7 50 0 Bro ad way ;
! Cay l o r Co n s tru ct i o n ;
! Two Eas t ;
! 6 42 2 Sp eed way ;
! Lean dro , LLC;
! Lo tOn e o n Haci en d a;
! Carl y

Cay l o r;
! Cas ey

Cay l o r;
! Cas ey

A. Cay l or GST Tru s t;
! Carl y

A. Cay l o r Ex em

p tTru st ;
! Lap l at a No rt e, LLC;
! RCM C;
! Nex t Do o r;
! 1 50 1 Ch erry ;
! 2 60 Pan t an o;
! Ban t am ; an d
! Vi s t o s o.- 1 1 -

[* 1 1 ] Fro m

2 0 05 -1 4 , Cay lo r Co n s tru ct i o n p ai d the fo ll o wi n g p rem i u m s fo r i t s el f
an d al l the Cay l or en t i t i es :

Co v erag e p eri o d Am o u n t Au g . 1 , 2 0 0 5 t o Au g . 1 , 2 0 0 6 $ 6 1 ,6 0 8 Au g . 1 , 2 0 0 6 t o Au g . 1 , 2 0 0 7 5 8 ,8 0 0 Au g . 1 , 2 0 0 7 t o Au g . 1 , 2 0 0 8 5 9 ,9 1 7 Au g . 1 , 2 0 0 8 t o Au g . 1 , 2 0 0 9 5 8 ,1 2 1 Au g . 1 , 2 0 0 9 t o Au g . 1 , 2 0 1 0 5 4 ,8 9 8 Au g . 1 , 2 0 1 0 t o Au g . 1 , 2 0 1 1 5 2 ,2 6 9 Au g . 1 , 2 0 1 1 t o Au g . 1 , 2 0 1 2 6 4 ,3 3 0 Au g . 1 , 2 0 1 2 t o Au g . 1 , 2 0 1 3 6 9 ,8 3 0 Au g . 1 , 2 0 1 3 t o Au g . 1 , 2 0 1 4 6 3 ,2 5 4 Bu tth i s trad it i o n al i n s uran ce d i dn ’ tco v er ever y l o ss th atth e Cay l o r en t i t i es faced o v er th e y ears . Fro m 1 9 97 -2 0 0 7 , th e Cay l o r en t i t i es h ad$ 5 0 0 ,0 0 0 o f l o s s es th atwere n o tco vered b y

th ei r trad i t i o n al i ns u ran ce--ro u g hl y $ 5 0,0 0 0 a y ear. Th i s g ap i n co verag e i rri t at edRo b . Inearl y 2 0 0 7 an acq u ai n tan ce i n tro du cedh i m

t o th e i d ea o f a cap t i v e i n s u ran ce co m p an y . Ro b , al o ng wi th h i s fat h er an d Ri ch ardKen n ed y , h i s l o n g t im e acco u n t an t , wen tt o a l u n ch p res en t at i o n
o n cap t i v e i n su ran ce atth e Tu cs o n Co u n try Cl ub . Th i s p res en t at i o n was p u to n b y Tri b eca--an i n s u ran ce-m an ag em en tco m pan y l ocat edi n Ari zo n a t hats p eci al i zedi n- 1 2 -

[* 1 2 ] m an ag i n g cap t iv e i ns u ran ce co m p an i es . 5 Th e p res en t at i o n was a p ri m er o n cap t i ve i n s u ran ce an dem ph as i zedm i cro cap t i v es an dth ei r p o ten t i al t ax b en efi t s . Ro b was co n v i n cedaft er t h e p res en t at i o n th atth e Cay l o r en t i t i es co u l d b en efi tfro m

s uch an arran g em en t --b utKen n ed y was l es s co nv i n ced , an d p res ci en t l y

tho u g h tth e p i t ch fo r a m i cro cap ti v e “ t o o g o o dt o b e t ru e.” Ro b as k ed Ken ned y t o l o oki n to Tri b eca t o s ee i f t h ere was an yth i ng b adab o u t th e co m p an y
an d t o po k e aro u n dcap t i v e i n s u ran ce g en eral ly , t o s ee i f i twas l eg it i m at e fro m a t ax s t an dp o i n t . Ken n ed y m ad e cl ear t h at thi s area was o ut s i d e o f h is ex p ert i s e, b u t h e s earch edth e i n t ern etfo r i n fo rm at i o n ab o u t cap t iv e i n s u ran ce co m pan i es an d ch eck edwi th a fri en dat th e St at e Bo ard o f Acco u n tan cy t o s ee i f t here were an y
co m p l ai n t s ag ai n s tTri b eca. He co n cl u d edth atcap t i v e i n s uran ce, i f d o n e
co rrect ly , h adp ot en t i al . Bu tKen n ed y al s o t o l d Ro b t h ath e h i m s el f co u l dn o t d et erm i n e i f Tri b eca’ s s p eci fi c p ro g ram s at i s fi edth e Co d e’ s req u i rem en t s , an d we
s p eci fi cal l y

fi n dth atth i s m ean th e t o l dRo b th ath e was u n s u re i f Tri beca’ s p ro g ram wo u l db e ab l e t o d el i v er o n th e p ro m i s edt ax b en efi ts
. Ro b al s o as k edGreg Gad ari an , h i s l o n g t i m e t ax an db u s in es s at t o rn ey , t o l o o ki n t o cap ti v e i n s uran ce. Gad ari an h adal read y co n du ct eds o m e res earch fo r

5 In Decem

b er 2 01 0 Tri beca was p u rch as edb y Art ex Ri s kSo l u t i o n s , In c. Si n ce t h e co m

p an y was kno wnas Tri b eca fo r al m o stal l th e y ears at i s su e, we wi l l refer t o i tas Tri b eca t h ro u g h o u t
.- 1 3 -

[* 1 3 ] o th er cl ien t s , b u t h e al s o ackn o wl ed g ed th ath e was n o ex p ert i n th e area. Aft er Ro b as k edh i m , h e read s o m e art i cl es o n th e s ubject an dt al k edt o an o th er at t o rn ey wh o was m o re fam i l i ar wi th thi s area o f l aw. Aft er t h i s b ri ef i n qu i ry , Gad ari an cam e t o th e s am e co n cl u s io n th atKen n ed y d i d --t h atcap t i ve i ns u ran ce
was a l eg i t im at e co ncep t , s o l o ng as i twas “ es t ab l i sh edco rrect l y an d o p erat ed
co rrect ly .” An dal s o l i k e Ken n ed y , Gad ari an d i dn ’ t(o r co u l dn ’ t ) ad v i s e Ro b o n wh et h er Tri b eca’ s s p eci fi c p ro g ram wo u l ds at i s fy th e req u i rem en t s l ai d o u ti n th e Co d e. W e al s o no t e t h atRo b n ev er as k edGee, h i s l o n g ti m e i n s u ran ce ad v i s er, ab o utwh et h er t o go fo rwardwi th a cap t iv e an dTri b eca. B. Fo rm at i o n Th es e g en eral co m

m en t s fro m Ken ned y

an d Gad ari anwere g o oden o u g h fo r Ro b , an dh e d eci d ed t o g o fo rwardi n s et t i n g up a cap t i v e i n s uran ce co m p an y wi t h Tri b eca as i t s th i rd -p arty

m an ag er. He b eg an th e p ro ces s b y an s weri n g a g en eral qu es ti o n n ai re t h atTri b eca s en t h i m . He s ig n edan en g ag em en tl et t er wi th Tri b eca i n Sep tem

b er 2 0 0 7 . Th e l et t er s t at ed th atth e cap t i v e n eed edt o m eetcert ai n “ ri s k
s h i ft i n g ” an d“ ri s k d i s tri bu t i o n ” t es t s . 6 Th i n g s m o v edqui ck l y . W i th in a m o n t h ,

6 To en s u re ad equ at e ri s kd i st ri b u t i o n , Tri b eca req u i redth e cap t iv es i t m an ag edt o p art i ci p at e i n a ri s kp o o l . Cay l o r’ s cap t iv e n ev er p art i ci p at edi n th i s p o o l
.- 1 4 -

[* 1 4 ] Tri b eca p rep areda feas ab i l i ty s tu dy fo r Cay l o r Co n st ru ct io n . Th e s tu dy
co n cl u d ed th at Cay l o r Co ns tru ct i o n was s u i t ab l e fo r a cap t i v e i n s u ran ce co m p an y . Th e Cay l o rs ’ cap t i v e i ns u ran ce co m p an y , n am edCo ns o li d at ed , In c., was i n co rp o rat edu nd er t h e l aws o f An g ui l l a 7 an dl i cen s edas an An g u i l l a i n s u ran ce
co m p an y . Itwas o wn edb y

Ro b . Tri b eca fi ledth e art i cl es o f i nco rp o rat io n fo r Co n s o l i dat edo n Decem

b er 2 0, 2 0 0 7
. OnDecem b er 2 1 , Co n s ol i d at edel ect ed
u n d er s ect i o n 9 5 3 (d ) 8 t o b e t reat edas a d o m es t i c U.S. co rp orat i o n fo r t ax p u rp os es , as wel l as an el ect i o n u n d er s ect i on 8 3 1 (b )(2 )(A)(i i ) t o b e t ax ed s o l el y
o n i n v es t m en ti n co m e s o l o ng as i t s an nu al p rem i u m s d i dn o tex ceed $ 1 .2
m i l l io n --wh i ch i s wh atm ad e Co n s o l i d at eda mi cr o cap t i v e. Th ats am e d ay Cay l o r Co n s tru ct i o n p ai dCo n s o l i d at ed$ 1.2 m i l l i o n , wh i ch i td edu ct edas an i n su ran ce
ex p en s e o n i t s 2 0 07 t ax retu rn . 9 Th i s was atl eas t a b i to dd , s i n ce Cay l o r Co n st ru ct io n h adn o ty etco m p l et ed
an y u n d erwri t i n g qu es t i o n n ai res , an dp erh ap s ev en o dd er b ecau s e Co n s o l i d at ed

7 An g u i l l a i s an i s l an d o f t h e Bri t i sh W es tIn d i es . See M o n ah anv . Co m m i s s i o n er, 1 0 9 T.C. 2 3 5 , 2 3 6 (1 9 9 7).
8 Al l s ect i o n referen ces are t o th e In t ern al Rev enu e Co de an dreg u l at i o n s i n effect fo r t h e y ears ati s s u e, an dal l Ru l e referen ces are t o t h e Tax Co u rtRu l es o f Pract i ce an d Pro cedu re, u n l es s we s ay o therwi s e. 9 Cay l or Co n s tru ct i o n fi les i t s retu rn s o n a cal en d ar-y ear b as i s .- 1 5 -

[* 1 5 ] h adn o t y etu n derwri t t en o r i s s u edan y p o l i ci es t o an y

o f t h e Cay l o r en t i t i es . Th e reco rds h o ws , an dwe fi n d , th at Cay l o r Co n s tru ct i o n d i dev en tu al l y fi l l o u tan
u n d erwri t i ng qu es t i o nn ai re fo r 2 0 0 7 b y th e en do f M ay 2 0 0 8 . An dCay l o r Co n s tru ct i o n d i dev en tu al l y g etp ol i ci es thatco v eredi t s el f an ds ev eral o th er Cay l o r en t i t i es : 7 5 0 0 Bro ad way , Bav i s p e, Carl y A. Cay l o r Ex em

ptTru s t , Cas ey A. Cay l o r GST Tru s t , Cay l or Lan d , Dat a W av e, Ib or, La Pl ay a, M ay fai r, RCM C, Cay l o r Tru s t , an dCay lo r Co n s tru ct i o n . Bu twh atreal l y m ad e t h i s fi rs ty ear
rem ark ab l e was th atth e 2 0 0 7 p o l i ci es thatCo n s o li d at edfi n al ly g o taro u n dt o i s su i ng i n 2 0 08 were “ cl ai m s-m ad e” p o l i ci es , wh i ch m ean s th at an y cl ai m h adt o b e rep o rt eddu ri ng th e ap pl i cab l e p ol i cy p eri o d(o r an ex t en d edrep o rt i n g p eri o do f
n o m o re t h an 6 0 d ay s ). So wh en Cay l o r Co ns tru ct i o n p ai d$ 1 .2 m i l l i o n atth e en d
o f 2 0 07 t o Co n s o li d at ed --t h e s am e am o u n ti two u ldb e p ay i n g du ri n g t h e y ears at i s su e fo r a y ear’ s wo rt h o f co v erag e--i n real it y i twas recei v i n g atm o st1 0 d ay s o f
co v erag e an dp o s s i b l y n o n e atal l
. Th e p ro ces s b ecam e l es s h urri edi n 2 0 08 . Th e Cay l o r en t i t i es s t art edt o b u y th ei r o wn co v erag e fro m

Co n s ol i d at ed , an deach en t i ty p ai di t s o wnp rem i um s . Bu t as in 2 0 07 th e u n d erwri t i n g p ro ces s fo r 2 00 8 d i dn o tb eg i n u n ti l aft er t h e 2 0 0 8
co v erag e p eri o dh adal read y cl os ed
.- 1 6 -

[* 1 6 ] C. Ex ecu t i on Th es e o d di ti es i n th e 2 00 7 an d2 00 8 p o li ci es are n o to ur fo cu s b ecau s e t h e t ax y ears b efo re u s are 2 0 09 an d2 01 0 . Duri n g b o th tho s e y ears th e Cay l o r en t i t i es al s o carri edtrad i ti o nal co m m erci al i n s uran ce. Fro m Au g us t2 0 0 8 t o Au g u s t2 0 1 1 , Cay l o r Co ns tru ct i o n p ai da t o tal o f $ 1 6 5 ,2 8 8 --o r ro u g h l y $ 5 5 ,0 0 0 p er y ear--fo r th i s trad i t i o n al i n s u ran ce. An dju s tas i n 2 00 7 an d2 00 8 , o n p ap er th e Cay l o r
en t i t i es s up p l em en t edth ei r i n s u ran ce th ro ug h Co n so l i d at edi n 2 0 0 9 an d2 0 1 0
.

1
. 2 00 9 Co n so li d at ed ’ s co v erag e ch an g ed s li g h tl y i n 2 0 0 9. Ro b wan tedtwo ad d it i o n al en t i ti es t o g ets up p l em en t al i ns u ran ce th ro u g h Co n s o l id at ed --Vi s t o s o
an d Ban t am . He co m

p l et edth e u n d erwri ti n g qu es t i o n n ai res fo r t h es e t wo
co m p an i es an dretu rn ed th em t o Tri b eca i n M arch 2 0 0 9
. Bu tth i s ad d i t i o n was co up l edwi th a s ub tract i on . Th e Carl y Cay l or an d Cas ey Cay l o r Tru s t s were rem o v edfro m Co n so l i d at ed ’ s p ro g ram i n J u l y 2 0 0 9 , o n th e ad v i ce o f t he Cay l o rs ’ CPA wh o s u g ges t edth atth e Cay l o rs “ no t* * * p ay i n s u ran ce p rem i u m s th ro ug h Cas ey ’ s an d Carl y ’ s Tru s t.” W i th th es e ch an g es n o w i n p l ace, 1 2 Cay l o r en ti t i es p ai dp rem i um s th at ad d edup t o $ 1 .2 m i l l i on t o Co n s o l i d at ed :- 1 7 -

[* 17 ] En ti ty Prem i u m p aym en tt o Co ns o li d at ed Cay l or Co n s tru ct i o n $ 1 79 ,8 8 0 Cay l or Lan d 1 68 ,0 0 0 7 5 0 0 Bro ad way 36 ,0 0 0 Ban t am 78 ,0 0 0 Bav i s p e 42 ,0 0 0 Dat a W av e 36 ,0 0 0 Ib or 1 44 ,0 0 0 La Pl ay a 1 68 ,0 0 0 M ay fai r 1 56 ,0 0 0 RCM C 96 ,0 0 0 Cay l or Tru s t 60 ,0 0 0 Vi s t o s o 36 ,0 0 0 To t al 1 ,1 99 ,8 8 0 Th ere was a p ro bl em . Th e Carl y an dCas ey Cay l or Tru s t s h adal read y each p ai d$ 21 ,0 0 0 t o Co n s o l i d at ed . Aft er t h e Cay l ors ’ CPA s u g g es tedth atthe p rem i u m s s h o ul dn ’ t be p ai dth ro u g h th es e t ru st s, Pau l a s u g g es t ed th atth e tru s t s b e

“ refu n ded ” an dth ei r p rem i u m b e “ re[l o cat ed ] * * * am o n gs tth e rem ai n i n g
co m p an i es .” An dth at ’ s ju stwh ath ap p en ed
. Co n s o l i d at ed refu n d edth e p rem i u m s p ai db y th e t ru s ts
. Wh atp ro tect i o n s an y

o f t h es e en t i t i es --t h e t ru st s o r t he co rp o rat i o ns o r t he p art n ers hi p s --were p ay i n g fo r was n’ tactu al l y kn o wni n 2 0 09 , s i n ce th e 2 0 0 9- 1 8 -

[* 1 8 ] p o l i ci es , fo ll o wi n g th e p at t ern o f p rev i o us y ears , were n o tp rep ared u n t i l 2 0 1 0 . Go rd o n Go t zi n g er, Tri b eca’ s d i rect o r o f ri s km an ag em en tu n d erwri t i n g , d i dn ’ ts i g n th e d ecl arat i on s u n t i l Au g u s t2 0 1 0 , an d Co ns o li d at edd i dn’ td el i v er t h e p o l i ci es t o Ro b u n t i l Decem b er 2 0 1 0
. W e d o fi n dthatCo n s o l i d at edd i d ev en tu al l y p ro duce p o l i ci es fo r t hes e
en t i t i es --ev en i f t h ey

were cl ai m s -m ad e p o l i ci es d el i v ered wel l aft er t h e p ol i cy p eri o d s . Co ns ol i d at ed , h o wev er, wro t e p o l i ci es fo r o n ly th ree o f t h e en t i t i es : Cay l o r Co ns tru ct i o n , Cay lo r Lan d, an d RCM C. Th e n i n e o th er en t it i es --M ay fai r, Ib o r, La Pl ay a, Cay l o r Tru s t , Bav i s p e, Dat a W av e, 7 5 0 0 Bro ad way , Ban t am , an d Vi s t o s o --were n am ed“ ad d i t i on al i ns u red s ” u n der RCM C’ s p ol i ci es . Here are t h e p o l i ci es :- 1 9 -

[* 19 ] In su red Po l i cy Cay l or Co n s tru ct i o n Ad m i n i s trat i ve act i on s Leg al ex p en s e rei m

bu rs em en t Cay l or Lan d Ad m i n i s trat i ve act i on s Leg al ex p en s e rei m

bu rs em en t Lo ss o f k ey

co n tract

RCM C, etal
. Ad m i n i s trat i ve act i on s Cy b er l i ab il i ty Leg al ex p en s e rei m

bu rs em en t Lo ss o f k ey

co n tract M i s cel l an eo u s p ro fes s i o n al l i ab i l i ty Pro fes s i o n al s erv i ces rei m b u rs em en t 2
. 2 01 0 2 0 1 0 l o ok edm

u ch l i ke 2 0 0 9 . Th e s am e Cay l o r en t it i es p ai dCo n s o l i d at ed p rem i u m s t h att ot al ed$ 1 .2 m i l l i o n . Th es e p aym en t s were m ad e t hro u g h o u t2 0 1 0
. Here i s th e b reak d o wn :

En t i ty Prem i u m p aym en tt o Co ns o li d at ed Cay l or Co n s tru ct i o n $ 1 7 9 ,8 8 0 Cay l or Lan d 1 6 8 ,0 0 0 7 5 0 0 Bro ad way 3 6 ,0 0 0 Ban t am 7 8 ,0 0 0 Bav i s p e 4 2 ,0 0 0- 2 0 -

[* 20 ] Dat a W av e 3 6 ,0 0 0 Ib or 1 4 4 ,0 0 0 La Pl ay a 1 6 8 ,0 0 0 M ay fai r 1 5 6 ,0 0 0 RCM C 9 6 ,0 0 0 Cay l or Tru s t 6 0 ,0 0 0 Vi s t o s o 3 6 ,0 0 0 To t al 1 ,1 9 9 ,8 8 0 Th es e were ex act l y th e s am e p rem i u m s as th e Cay lo r en t i ti es h adp ai di n 2 0 0 9
. An d ag ai n, as i n 2 0 0 9, the Cay l o r en ti t ies p ai dth es e p rem i u m s wi th o u t kn o wi n g wh at p o l i ci es th ey were p ay i n g fo r o r th e t o t al p rem i u m am o u n t s . Th e
wo rk s h eetu sedt o ren ew t h e p o l i ci es was n ’ t retu rn edt o Tri b eca u nt i l J u n e 2 0 1 0
. Ro b d i dn ’ ts i g n an dretu rn th e co v erag e accep tan ce fo rm s t o Tri beca u n ti l No v em b er 2 0 10
. Go t zi n ger d i dn ’ t en d o rs e t h e d ecl arat i on p ag es u n ti l l at e J an u ary 2 0 1 1 , an dth ey

weren ’ td el i v eredt o Ro b u n t i l Ap ri l 2 01 1 . An dth es e were ag ai n p o l i ci es th atco v eredo n ly cl ai m s m ad e b efo re th ey were d el iv ered
. Th e p o l i ci es thatwere ev en tu al ly p ro du cedwere s i m i l ar t o 2 0 09 ’ s :- 2 1 -

[* 21 ] In su red Po l i cy Cay l or Co n s tru ct i o n Ad m i n i s trat i ve act i on s Ex ten d edwarran ty Leg al ex p en s e rei m

bu rs em en t Cay l or Lan d Ad m i n i s trat i ve act i on s Leg al ex p en s e rei m

bu rs em en t Lo ss o f k ey

co n tract

RCM C, etal
. Ad m i n i s trat i ve act i on s Cy b er l i ab il i ty Leg al ex p en s e rei m

bu rs em en t Lo ss o f k ey

co n tract M i s cel l an eo u s p ro fes s i o n al l i ab i l i ty Pro fes s i o n al s erv i ces rei m b u rs em en t D. Th e Fl o w o f Fu nd s An o th er n o t ewo rt h y

as p ecto f t h es e cas es i s h o w m o n ey fo u n di t s way fro m Cay l o r Co ns tru ct i o n t o Co n s o li d at edduri n g th es e y ears .

1
. 2 00 9 Th e p aym en to f Co n so l id at ed ’ s 2 0 0 9 p rem i u m s b eg an o n Decem b er 3 0 , 2 0 0 8 wh en Cay l o r Co ns tru ct io n p ai dCay lo r Lan d$ 1 ,2 2 4 , 1 6 0 fo r “ co ns u l t i n g ”. Cay l o r Lan d ’ s o n ly

wo rk ers i n 2 0 0 9 were Ro b an dPau l a, an dCarl y an dCas ey -- wh o atth e t i m e were o n ly 1 1 an d1 8 y ears o l d . Th es e co n s u l t in g p aym en t s were- 2 2 -

[* 2 2 ] m ad e wi tho utan y

co n tract b etween Cay l o r Co ns tru ct i o n an dCay l o r Lan d , an d i n deed wi th ou tan y

reco rd s t h atd es cri b edwh en the co n s u l t at i on t o okp l ace, wh atad v i ce was recei ved , o r ev en wh ats ub ject s were d i s cu s s ed . Wh en p res s edat tri al , Bo b d es cri b edwh atap p ears t o b e a m o rn i n g ro u t in e fo r h im an dRo b t o h av e b reak fas tt o g et h er an dd is cu s s th e b u s i n es s . Itwas du ri n g th es e co n v ers at i o n s th at
m o sto f t h e “ co n s u l t i n g” s eem s t o h av e t ak en p l ace. Aft er Cay l o r Co n st ru ct i on s en t s o m uch m o n ey t o Cay lo r Lan dfo r
co n su l t i n g atth e en d o f 2 0 08 , Cay l o r Lan dm ad e t wo p aym en t s th att o tal ed $ 1 6 8 ,0 0 0 t o Co n s o l i dat edi n 2 0 0 9 . Itth enp ai dan o th er $ 1 .1 m i l l i o n fo r

“p ro fes s i o n al -co n s u lt i ng fees ” 1 0 t o th e o th er Cay l o r en t i t i es th atwere co vered
u n d er Co n s o l i dat ed ’ s p ro gram . As th es e en t i t i es g o tthi s “ co ns u l ti n g ” rev en u e, th ey s p en ti to n i n s u ran ce fro m Co n so l i d at ed
. 1 1 W e m ad e a t ab l e:

1 0 Th i s i n cl ud es p aym en t s o f $ 4 2 , 0 0 0 t o b o th the Carl y an d Cas ey Tru s t s . 1 1 Wh en Co n so l i d at edrefu n dedth e p rem i u m s fro m th e Carl y Tru s t an d Cas ey Tru s t , th e t ru s t s refu n d edCay l o r Lan d fo r t he “ co n s u l t i n g” p aym en t s th at th ey h adrecei vedearl ier t h aty ear.- 2 3 -

[* 23 ]
Reci p i en t Co n su l ti n g fees

recei v edfro m Cay l o r Lan d Am ou n tp ai dt o

Co n s ol i d at ed Co n s u l t i n g

i n co m e as a p ercen t ag e o f i n s u ran ce 7 5 0 0 Bro ad way $ 3 6 ,1 8 0 $3 6 , 0 0 0 1 0 0 .5 % Ban t am 3 6 ,1 8 0 7 8 , 0 0 0 4 6 .4 Bav i s p e 4 2 ,2 1 0 4 2 , 0 0 0 1 0 0 .5 Dat a W av e 3 6 ,1 8 0 3 6 , 0 0 0 1 0 0 .5 Ib or 1 4 4 ,7 2 0 14 4 , 0 0 0 1 0 0 .5 La Pl ay a 1 5 6 ,7 8 0 16 8 , 0 0 0 9 3 .3 M ay fai r 1 5 6 ,7 8 0 15 6 , 0 0 0 1 0 0 .5 RCM C 2 7 1 ,6 9 5 9 6 , 0 0 0 2 8 3 .0 Cay l or Tru s t 6 0 ,3 0 0 6 0 , 0 0 0 1 0 0 .5 Vi s t o s o 3 6 ,1 8 0 3 6 , 0 0 0 1 0 0 .5 It is n o tb y

ch an ce t h atthe co ns u lt i ng p aym en t s m at ch th e p rem i u m s s o cl o s el y . Wh en Ro b b eg an m ak i n g th es e p aym en t s i n 2 0 0 8 , h e m ad e s u re th e
co n su l t i n g p aym en ts were s l ig h t l y m o re t h an th e p rem i um p aym en t s s o , as h e p u t i t in an em ai l , “ th e p ay i n s d o n o tm at ch the p ay o u ts ex act l y . ”

2
. 2 01 0 Th e n ex ty ear was v ery si m i l ar. On Decem b er 3 0 , 2 0 09 Cay l o r Co n s tru ct i o n p ai dCay l or Lan d$ 1 .7 m i l li o n fo r co n s u l t i ng . Th ere were n o
co n su l t i n g ag reem en t s b et ween Cay l o r Co n s tru ct i on an dCay l o r Lan d , an dn o- 2 4 -

[* 2 4 ] reco rd s o f wh en the co ns u l t i n g t o o k p l ace, wh atad v i ce was recei v ed , o r wh ats ub ject s were d i s cu s s ed . Cay l o r Lan d’ s em p l o y ees were s t i l l o n l y

Ro b , Pau la, an dRo b ’ s n o w s l i g h t l y o l d er ch i l dren . Cay l o r Lan dth en p ai dCo n s o l i d at ed $ 1 6 8 ,0 0 0 . Itp ai do th er Cay l o r en t i t i es th atwere p arto f Co n s o li d at ed ’ s i n s u ran ce p ro g ram $ 1 .5 m i l l i o n fo r co n su l t i n g . As i n 2 00 9 , th es e co n su l t i n g p aym en t s m ad e up the b u l ko f t he rev en u e fo r m an y
o f t h es e en ti t ies
. Th es e o th er en t i t i es th en p ai dp rem i u m s t o Co n s o l i d at ed . Here’ s th e b reak d o wn :

Reci p i en t To t al

rev en u e Co n s u l t i n g

fees recei v ed f r om Cay l o r Lan d Percen tag e

o f t o t al rev en u e fro m co n s ul ti n g A m ou n t p ai d

t o Co n s ol i d at ed Co n s u l t i n g

i n co m e as a p ercen t ag e o f i n s u ran ce 7 5 0 0 Bro ad way $ 37 ,1 08 $ 3 6 ,0 1 8 9 7 .1 % $ 3 6 ,0 0 0 1 00 .0 5 % Ban t am 1 86 ,7 23 7 8 ,0 3 9 4 1 .8 7 8 ,0 0 0 1 0 0 .0 5 Bav i s p e 61 ,0 04 4 2 ,0 2 1 6 8 .9 4 2 ,0 0 0 1 0 0 .0 5 Dat a W av e 46 ,5 42 3 6 ,0 1 8 7 7 .4 3 6 ,0 0 0 1 0 0 .0 5 Ib or 1 45 ,1 87 1 4 4 ,0 7 2 9 9 .2 1 4 4 ,0 0 0 1 0 0 .0 5 La Pl ay a 1 ,9 61 ,9 62 2 6 8 ,0 8 4 1 3 .7 1 6 8 ,0 0 0 1 5 9 .6 M ay fai r 2 87 ,2 60 2 0 6 ,0 7 8 7 1 .7 1 5 6 ,0 0 0 1 3 2 .1 RCM C 5 55 ,3 08 5 4 6 ,0 4 8 9 8 .3 9 6 ,0 0 0 5 6 8 .8- 2 5 -

[* 25 ] Cay l or Tru s t 1 73 ,5 28 6 0 ,0 3 0 3 4 .6 6 0 ,0 0 0 1 0 0 .0 5 Vi s t o s o 53 ,5 23 3 6 ,0 1 8 6 7 .3 3 6 ,0 0 0 1 0 0 .0 5 E. Cl ai m s Pai d Al l th es e p rem i u m s , fo r al l th es e y ears , fro m al l th es e Cay l o r en t i t i es b eg an p i l i n g up --fro m 2 0 0 7 t o 2 01 0 , Co n s o l i d at edco l l ect ed$ 4 .8 m i l li o n . Iti s th erefo re i n t eres t i n g t o o b s erv e t h ati n al l th att im e, Co n s o li dat edp ai d o nl y fo u r cl ai m s --t wo i n 2 0 0 8 an dtwo i n 2 0 0 9 --t h at t o g et her am o u nt edt o o n l y $ 4 3 ,0 0 0
. 1 2 An d , i n as m u ch as th es e cl ai m s were m ad e o n cl ai m s-m ad e p o l i ci es th atCo n s ol id at ed d i dn ’ ti s s u e u n t i l aft er t h e p o l i cy y ears h adcl o s ed , o n e m i g h tex pect th ere t o b e
s o m et h in g o ddab o utth em . On e wo u l d b e ri g ht . Let ’ s t ak e a l o o kat th e cl ai m s fro m 2 0 09 (t h e o n l y y ear b efo re u s th ath adcl ai m s fi l edwi th Co n s o l id at ed ). Th e fi rs tcl ai m

i n 2 0 09 was fo r $ 1 3 ,0 0 0 i n l eg al fees th atCay l or Co n s tru ct i o n i n cu rred t o co l l ecta d eb t. Tri beca req u es t edad d i ti o nal s up p o rtfo r t h e cl ai m --s u ch as an i n v o i ce o r p ro o f o f p aym en t --b u tn o n e was ev er s ubm i t t ed . In s t eadRo b an dPau l a i n thei r cap aci t i es as Co n so l i dat ed ’ s o wn ers o v erru l edth e cap t i v e m an ag ers at Tri b eca an do rd eredth atth e cl ai m b e p ai d . Co n s ol id at edi s s u eda $ 1 3 ,0 0 0 ch eck
.

1 2 No cl ai m s were fi l edi n 2 0 0 7 o r 2 0 1 0
.- 2 6 -

[* 2 6 ] Th e s eco n dcl ai m was fi l edb y La Pl ay a fo r s ev eral s ep arat e l o ss es th at i n cl u d edth e s et tl em en t of s ev eral co m p lai n t s an ds o m e l eg al fees . Tri b eca ag ai n req u es t edad d i ti o n al d o cu m en t at i o n fo r th es e cl ai m s --p erh ap s an i n vo i ce o r p ro o f
o f p aym en t . Itag ai n recei v edn o n e. Ro b an dPau l a ag ai n s i m p ly o rd ered Co n s o l i dat edt o p ay th e cl ai m . W e h av e t h e $ 1 0 , 0 0 0 ch ecki n th e reco rd . An d b o th th es e cl ai m s were fi l edb efo re Co n s o l i dat edi s s u edth e p o l i ci es u n d er wh i ch th ey were m ad e--i n deed , b efo re t h e p o l i ci es were ev enu n d erwri t t en . III. Retu rn s , Au d i t, an dTri al Fo r b o th 2 00 9 an d 2 0 1 0 , Cay l o r Co n s tru ct i on d edu ct edth e p aym en t s th ati t
m ad e t o Cay l o r Lan d as co ns u lt i n g ex p en s es . Al l th e o th er en ti t i es rep o rt edth ei r p aym en t s t o Co ns o l i dat edas a co m b i n at i o n o f d edu ct i b l e i n s u ran ce ex p en ses , l eg al fees , acco u n t i n g fees , an d m an ag em en tfees
. 1 3 Co n so l i d at edrep o rt edi t s el f
as a m icro cap t iv e, an dth erefo re d i d n o ti n cl u d e t h e $ 1 .2 m il l i o n i n p rem i u m s as t ax ab l e i n co m e fo r ei th er y ear. Fo r b o th 2 00 9 an d 2 0 1 0 Ken ned y --wh o i s a l i cen s edCPA i n Ari zo n a--p rep aredth e t ax retu rn s fo r al m os tal l o f t h e Cay lo r en t it i es . Th e t ax p ay ers p ro v i dedan yth i n g t h at was req u es t ed . W e s p eci fi cal l y fi n dth at

1 3 Des p it e t h i s o ddrep o rt i n g b y th e Cay l o r en ti t i es , Co ns o l i d at edi t s el f reco rd edal l th es e p aym en t s as “ i n s u ran ce p rem i u m s .”- 2 7 -

[* 2 7 ] Ken n ed y

was u n ab l e t o ad v is e t h e Cay l o rs ab o u twh et h er Co n s o li d at edwas p ro p erl y o p erat edas an i n s u ran ce co m p an y . He n ev er p ro v i d eda t ax o p i n i o n o r
m em o ran du m

ab o u tth e requ i rem en t s fo r a m icro cap t i ve i n s u ran ce co m p an y t o
wo rku n d er t h e Co de. Th e Cay l o rs d i dn’ tp ro v id e, an d Ken n ed y d i dn o tas kfo r,
an y d o cu m en t s t o s up p o rtthe l arg e co n s ul t i n g fees b et ween Cay l o r Co n st ru ct i o n
an d Cay l o r Lan d --h e s im p l y rep o rt edthe i n fo rm at i o n th at was g i v en t o h i m . He
was u naware t h at m an y

o f t h e Cay l o r en t i t i es were p ay i ng n earl y 1 0 0% o f t h ei r g ro s s recei p ts fro m

co ns u lt in g o n i n s u ran ce p rem i u m s t o Co n s o l i d at ed
. Th o u g h Ro b h ad as k edGad ari an t o l o oki n to cap t i v es g en eral l y , Gad ari an
n ev er p ro v i d edh i m

an y wri t ten o p i n i o n o r m em o ran du m . Gad ari an n ev er
rev i ewedan y

o f th e p ap erwo rkth atcreat edCo n s ol i d at edo r an y o f t h e t ax retu rn s . An dap artfro m

h is g en eral s t at em en t s ab o u t cap t iv e i n s u ran ce, we fi n di tm o re l i kel y th an n o tth atGad ari an g av e n o o ral ad v ice t o Ro b ab o u t Co n so l i d at ed
. Th i s m i cro cap t i ve s eto ff s o m e al arm s , an dth e Co m m i s s i o ner b eg an t o i n v es t i g at e. He ev en tu al l y i s s u edm an y n o t i ces o f d efi ci en cy

t o t h e Cay l o rs an d- 2 8 -

[* 2 8 ] m an y

o f t h e Cay l or en t i t i es . 1 4 He al s o ch al l en gedth e d edu ct i b il i ty o f t h e
co n su l t i n g p aym en ts fro m Cay l o r Co n s tru ct i o n t o Cay l o r Lan d
. 1 5 Th e Co m m is s i o n er al s o as s ert s s ect i o n 6 6 6 2 (a) accu racy -rel at ed p en al t i es fo r s ub s t an t i al u n d ers t at em en tu n d er s ect i o n 6 6 6 2 (b )(2 ) o r n eg l i g en ce u n d er
s ect i on 6 6 6 2 (b )(1 ). W e t ri edth es e cas es i n Ari zo n a. 1 6 W e are l eftt o d eci de:
! wh et her t h e “ co n s u l t i ng p aym en t s ” m ad e b et ween Cay l o r Co n s tru ct io n an dCay l o r Lan d were o rd in ary an dn eces s ary b us i n es s es ex p en s es ;
! wh et her t h e p aym en t s fro m th e Cay l o r en ti t ies t o Co n so l i d at edwere “ i ns u ran ce ex p en s es ; ” an d
! wh et her an y

p en al t i es are o wed
. W i th o u r fo u n d at io n l ai d, we can g ett o wo rk
.

1 4 Th o u g h we d o n ot e th atth e Co m m i s s i o n er d o es n o t ch al l en ge Co n s o l i dat ed ’ s o wnreturn s i n th e cas es th atwe tri ed
. Cf. Av rah am i , 1 4 9 T.C. at1 7 2 ; Sy zy gy , 1 1 7 T.C.M . (CCH) at 1 17 1
.

1 5 In h i s am en d edan s wer t h e Co m m is s i o n er d o es n o t

d en y th e s ub s equ en t d educt i o n s fro m

Cay l or Lan dt o th e o th er Cay l o r en t i t i es . Rat h er, h e u s es th es e d educt i o n s as an al t ern at i v e arg u m en t th atth e p aym en t s fro m Cay l o r Co n s tru ct i o n t o Cay l o r Lan dare n oto rd i n ary b u s i n es s ex p en s es . 1 6 Th e Cay l o rs were an drem ai n Ari zo nan s ; th e Cay lo r en t i ti es al l h adth ei r p ri n ci p al p l ace o f b u s i n es s o r p ri n ci p al o ffi ces i n Ari zo na, s o al l o f t he t ax p ay ers i n thes e cas es w ere i n Ari zo n a. An y ap p eal s wo u l d p res um

p t i v el y g o t o th e Ni n th Ci rcu i t . See s ec. 7 4 8 2 (b )(1 ).- 2 9 -

[* 2 9 ] OPINION I. Co n su lt i n g Paym en t s Sect io n 1 6 2 al l o w s the d edu ct i o n o f al l o rd i naryan d n eces s ary b u s in es s
ex p en s es . Th e cas es t el l u s t o b e m o re s k ep t ical ab ou tex p en s es b et w een rel at ed p art i es . See, e.g ., Harwo o dv . Co m m i s s io n er, 8 2 T.C. 2 3 9, 2 5 8 (1 9 8 4), aff’ d wi th o u tp ub l i s hedo p i n i o n , 7 8 6 F.2 d 1 17 4 (9 th Ci r. 1 9 8 6 ). Th e reas o n i s t h at

“ ex p en s es ” fro m

o n e rel at edp art y

t o an o ther are m ore l i k el y t o b e d i s tri b u ti o n s o f p ro fi ts , wh ich are n o td edu ct i b le. See El li ot t s, In c. v . Co m m i s s i o n er, 7 1 6 F.2 d 1 2 4 1 , 1 2 4 3 (9 th Ci r. 1 9 8 3 ), rev ’ g an drem an d i ng o n o th er g ro u n d s T.C. M em o . 1 9 8 0 -2 8 2 ; Ho m e In t eri o rs & Gi ft s , In c. v . Co m m i ss i o n er, 7 3 T.C. 1 1 4 2 , 1 1 5 6 (1 9 8 0). St i l l, i t ’ s en t i rel y p o s s i b l e fo r o ne co m

p an y l eg it i m at el y

t o i n cu r o r p ay b u s i n es s ex p en s es t o a rel at edco m p an y . See Ch ap m an v . Co m m i s s io n er, T.C. M em o. 2 0 1 4 -8 2 , 1 0 7 T.C.M . (CCH) 1 4 33 , 1 43 5 (2 01 4 ). To al l ay o u r s u s p i ci o n s , we l o okt o s ee i f t h ere i s an y co rro b orat i n g ev i d en ce rel at edt o th es e ex pen s es -- i n v o i ces , reco rd s, d at es , h o u rs wo rk ed , o r p ro ject s wo rk edo n . See ASAT, In c. v . Co m m i s s i o n er, 1 0 8 T.C. 1 4 7 , 1 7 4 -7 5 (1 9 9 7 ) (n o d edu ct i o n fo r co ns u l t i ng fees wh ere n o ev i d en ce o f h o w fees are d et erm i n ed , n o wri t t en co n tract , n o d et ai l ed i n v o i ces , an dn o ev id en ce o f wh atm i g h twarran t co n s u l t i n g fees ); Fu h rm an v . Co m m i s s i o n er, T.C. M em o . 2 0 1 1 -2 3 6 , 1 0 2 T.C.M . (CCH) 3 4 7 , 3 4 8 (2 0 1 1 );- 3 0 -

[* 3 0 ] W eek en dW arri or Trai l ers , In c. v . Co m m i s s i o n er, T.C. M em o . 2 0 1 1 -1 0 5 , 1 0 1 T.C.M . (CCH) 1 5 0 6 , 1 5 19 -2 0 (2 0 1 1 ) (n o d edu ct io n o f m an ag em en tfees t o rel at ed co rp o rat i o n wi th o utp ro o f o f s p eci fi c s erv i ces p erfo rm ed ); Ki m m v . Co m m i s s i o n er, T.C. M em o . 2 0 0 3 -2 1 5 , 8 6 T.C.M . (CCH) 1 0 1 , 1 03 (2 0 0 3 ). Th e Co m m is s i o n er fi rs tch al l en g es th e d edu ct i b i li ty o f t h es e “ co n s ul t i n g ” p aym en t s t hatCay l o r Co n s tru ct i o n m ad e t o Cay lo r Lan datth e en do f 2 0 0 8 an d 2 0 0 9 . Th e t es t i m o n y

an d ex hi bi t s we h av e i n th e reco rdcau se u s t o fi n di tm o re l i kel y th an n o tth atth i s “ co n su l t i n g ” co n s i s t edo f co nv ers at i o n s th atRo b an dh i s d ad h ado v er b reak fas t. Nei th er o n e co u lds ay wh atth i s co ns u lt i n g co n cern ed , wh ats ub ject s th ey d i s cu s s ed , o r t h e am o un to f t i m e t hey s p en t t al k i ng b u s i n es s i n s t eado f t h e o rd i n ary

s ubject s fat h ers an ds o n s t al k ab o u t . Fo r a fat h er an ds o n t o h av e a warm

an dl o v i n g rel at i o n s h i p th at h el p s s u st ai n an dg ro w th e fam il y b u s i n es s i s ad m i rab l e. Bu ti t ’ s n o td edu ct i b l e. II. In s u ran ce In s u ran ce p rem i um s are d edu ct i b l e u n d er s ect io n 1 62 (a) as o rd i n ary an d
n eces s ary ex p en ses i f p ai do r i n cu rredi n co n n ect i o n wi th a t rad e o r b us i n es s . Sec. 1 .1 62 -1 (a), In co m e Tax Reg s . In s u ran ce p rem i u m s are al s o i n cl u d ed i n i n co m e wh en recei v edb y i n s u ran ce co m p an i es . See s ec. 6 1; Av rah am i , 1 4 9 T.C. at1 7 4
. In s u ran ce co m

p an i es are g en eral l y

t ax edo n th ei r i n co m e i n the s am e m an n er as- 3 1 -

[* 3 1 ] o th er co rp o rat i o ns . See s ec. 8 3 1 (a). An dth at ’ s wh at m ad e t h e $ 1
. 2 m i l l io n i n co n su l t i n g d edu ct i o n s an dp rem i u m s s o l i k el y t o rai s e t h e IRS’ s b u reau crat i c ey eb ro ws --t hat ’ s th e l i m i t o n p rem i u m s t hatan i n s u rer can recei v e wi th o u to wi n g t ax . See s ecs . 5 0 1 (c)(1 5 ), 8 3 1 (b ). Ani n s uran ce co m p an y wi th p rem iu m s th at d o n ’ tex ceed $ 1 .2 m i l l i o n fo r t h e y ear can el ectu n der s ect i o n 8 3 1 (b ) t o b e t ax ed
o n l y o n i t s i n v es t m en ti nco m e. Sec. 8 3 1 (b )(1 ) an d(2 ). 1 7 Th es e ru l es are m ore co m p l i cat ed wh en th e i n s u rer an dth e i n s ured s are rel at ed
. Th i s i s b ecau se wh i l e i n s u ran ce i s d edu ct i b l e, am o un t s s et as i d e i n a l o s s
res erv e as a fo rm o f s el f-i n su ran ce are n o t . See, e.g ., Harp er Grp . v . Co m m i s s i o n er, 9 6 T.C. 4 5, 4 6 (1 9 9 1 ), aff’ d , 9 7 9 F.2 d1 3 41 (9 th Ci r. 1 9 9 2 ); s ee al s o St eere Tan kLi nes , In c. v . Un i t edSt at es , 5 7 7 F.2 d2 7 9 , 2 8 0 (5 th Ci r. 1 9 7 8 ); Sp ri n g Can y o n Co al Co . v . Co m m i s si o n er, 4 3 F.2 d7 8 , 8 0 (1 0 th Ci r. 1 9 3 0 ). Bu t
n ei th er t h e Co d e n or t h e reg ul at i o n s act u al l y d efi n es “ i n s u ran ce.” Secu ri t as Ho l di n g s , In c. v . Co m

m i s s i o n er, T.C. M em o . 2 0 1 4-2 2 5 , 1 0 8 T.C.M
. (CCH) 4 9 0 , 4 9 4 (2 01 4 ). As wi th an yth in g th atl ack s a co d i fi ed d efi n i ti o n , we l o o kt o cas el aw. Th e Sup rem e Co u rth as s t at edth ati n s u ran ce i s a t ran s act i on th ati n v o l v es

“ an actu al ‘ i ns uran ce ri sk ’ ” an dth at“ [h ] is t ori cal l y an dco m m o n l y i n s u ran ce

1 7 W e rev iewedth e h i s t o ry o f t h es e p ro v i s i o n s i n Av rah am i , 1 4 9 T.C. at1 7 5 -7 6
.- 3 2 -

[* 3 2 ] i n v o l v es ri s k -s h ift i n g an dri s k -d is tri b u t i n g . ” Hel v eri n g v . Le Gi ers e, 3 1 2 U.S. 5 3 1 , 5 3 9 (1 9 4 1 ). Th e l i n e b et ween n o n dedu ct ib l e s el f-i n su ran ce an d d educt i b l e i n s u ran ce i s b l u rry , an dwe try t o cl ari fy i tb y l oo k in g t o fo ur
n o n ex cl us i v e b u t rarel y

s up p l em en t edcri t eri a:
! ri s k -s h i ft i n g ;
! ri s k -d i st ri b u ti o n ;
! i n s u ran ce ri s k ; an d
! wh et her an arran g em en tl o ok s l i k e co m m o n l y accep t ed n o t i o n s o f i n s u ran ce. See Av rah am i , 1 4 9 T.C. at1 7 7 ; Ren t -A-Cen t er, In c. v . Co m m is si o n er, 1 4 2 T.C. 1 , 1 3 (2 01 4 ); s ee al s o R.V.I. Gu ar. Co
. v . Co m m i s s i o n er, 1 45 T.C. 2 0 9, 2 2 5 (2 0 1 5 ); Harp er Grp ., 9 6 T.C. at5 8 ; AM ERCO & Su b s . v . Co m m i s s i o n er, 9 6 T.C. 1 8 , 3 8 (1 9 9 1), aff’ d9 7 9 F.2 d 1 6 2 (9 th Ci r. 1 9 9 2 ); Secu ri t as , 1 08 T.C.M . (CCH) at 4 9 4
. To d et erm i n e wh et her Co n s o l i dat ed ’ s p o l i ci es were i n su ran ce, we wi l l u s e th e s am e fo u r-p artt es tthatwe h av e i n th e p as t . Ino u r t h ree p ri o r m i cro cap t i v e
cas es , we h av e fo cu s edo n th e el em en t s o f ri s kd i s tri b u t i o n an d“ co m m o n l y accep t edn o t i o ns o f i n s u ran ce.” See Av rah am i , 1 4 9 T.C. at1 8 1-9 7 ; Sy zy g y , 1 1 7 T.C.M . (CCH) at 1 17 2 -7 6 ; Res erv e M ech , 1 1 5 T.C.M . (CCH) at 1 4 8 3-9 0
. W e wi l l d o s o ag ai n h ere.- 3 3 -

[* 3 3 ] A. Ri s kDi s tri b u t io n Ri s kd i s tri b u t i o n is o n e o f t h e co m m o n ch aract eri s t i cs o f i n s u ran ce i d en t i fi edb y

the Sup rem e Co u rt , s ee Le Gi ers e, 3 1 2 U.S. at 5 39 , an d co u rt s wi l l fi ndi twh en an i n s u rer p o o l s a l arg e en o u gh co l l ect i o n o f u n rel at edri s ks , Av rah am i , 1 49 T.C. at1 81 ; s ee al s o Ren t -A-Cen t er, 1 4 2 T.C. at2 4 . “ By as s u m i n g
n u m ero u s rel at i v el y

s m al l , i n d ep en d en tri s k s th ato ccu r ran do m l y o v er t i m e, t h e i n s u rer s m o o th es o u tl o s s es t o m at ch m ore cl o s el y i ts recei p to f p rem i u m s . ” Cl o ug h ert y

Pack i n g Co
. v . Co m

m is s i o n er, 8 1 1 F.2 d1 2 9 7, 1 3 0 0 (9 th Ci r. 1 9 8 7 ), aff’ g 8 4 T.C. 9 4 8 (1 9 8 5 ). In each o f o u r p rev i o u s m i cro cap t i v e-i n s u ran ce cas es th e cap t i v e tri edt o
s h o w ri s k d i s tri b u t io n b y i n v es t i n g i n an “ i n s u ran ce p oo l ”--a wayt o rei ns u re a l arg e n u m

b er o f g eo g rap h ical l y

d i v ers e t h i rdp art i es . See, e.g
. , Av rah am i, 1 4 9 T.C. at1 6 3 . Ineach cas e, we fo u n dth at th e “ in s u ran ce p o o l ” was n ’ t actu al l y i n s u ran ce s o i td i dn ’ t s uffi ce t o s h o w ri s kd is tri b u t i o n . See i d ., 1 4 9 T.C. at1 9 0 ; Sy zy g y , 1 1 7 T.C.M . (CCH) at 1 1 7 2-7 4 ; Res erv e, 1 1 5 T.C.M (CCH) at 1 4 8 4 -8 5
. Tri b eca t ol d i t s cl ien t s th atth ey h adt o p art ici p at e i n s u ch a p oo l t o h av e ad equ at e ri skd i st ri b u t i o n . Co n so l i d at edn o n et h el es s ch o se n o tt o . Th at ’ s n o t th e en do f t h i s cas e, h o wev er. Th e o th er way th atm i cro cap t i v e i n s u rers i n o u r fi rs tth ree cas es tri edt o s ho w th at th ey m etth e ri s k -d i s tri b ut i o n- 3 4 -

[* 3 4 ] req u i rem en twas b y i s s u in g p o l i ci es t o i t s o wnb ro ther an d s i s t er en t i t i es . See Av rah am i , 1 4 9 T.C. at1 8 2 ; Sy zy g y , 1 1 7 T.C.M . (CCH) at 1 1 73 ; Res erv e, 1 1 5 T.C.M (CCH) at 1 4 8 4-8 5
. W e as k edi n th o s e cas es : “ [W ] as th ere a l arg e en o u g h p o o l o f un rel at edri s k ? ” See, e.g ., Av rah am i , 1 4 9 T.C. at1 82 . Th e qu es t i o n i s n o t
s o l el y ab ou t th e n u mb er

o f b ro th er-s i s t er en t i t i es i n s ured , b u t th e nu m b er o f i n d ep en den t r is k exp o s u r es . Id . at1 8 3
. Th i s was a p ro b l em i n al l th ree o f t h o s e
recen tcas es . Ineach we fo u ndth ere was n ’ ta l arg e en ou g h p o o l o f u n rel at edri s k fro m th e p o l i ci es i s su ed t o th e rel at eden t i t i es . See i d . at1 8 4 (s ev en ty p es o f p o l i ci es t o fo ur en t i t ies fel l s ho rt ); Sy zy g y , 1 1 7 T.C.M . (CCH) at 1 1 6 9 (ei g h t p o l i ci es t o o n e en t i ty fel l s h o rt ); Res erv e, 1 15 T.C.M . (CCH) at 1 4 7 9 -8 0 (el ev en
o r t h i rt een p o l i ci es fo r t h ree en t i t i es fel l s h ort ). Th e Co m m is s i o n er arg u es , rel y in g h eav i l y o n h is ex p ert Dr. Dav i dBab b el , th atCo n s o l i d at ed d i dn ’ th av e en o u g h i n d ep en den tri s k s . InBab b el ’ s o p i n i o n , th e ri sk s faced b y

Co n s o l i d at ed --t h e 1 2 i n d ep en d en tex po s ures fo r adm i n i s trat i v e act i on , 1 1 i n d ep en d en tex p o su res fo r l o s s o f k ey co n tract , 1 0 fo r cy

b erl iab i l i ty , an d 1 fo r ex t en d edwarran ty --m ad e fo r m u ch t o o s m al l a ri s k p o ol . Bu ta l o w
n u m b er o f i n d ep en d en tri s k s was n ’ tth e o n l y reas o n fo r Bab b el ’ s o pi n i o n . He
o b s erv edth atal l o f t h e ri s k s th atCo n s o l i d at edfaced were h eav i l y t i ed t o o n e
en t i ty --Cay l or Co n s tru ct i o n . Th i s i s i t s el f a p ro b l em . Th e s tro n g co rrel at i o n o f- 3 5 -

[* 3 5 ] ri s kb et ween th e s m al l er Cay lo r en ti ti es an dCay l o r Co ns tru ct i o n p rev en t ed Co n s o l i dat ed , i n h i s o pi ni o n , fro m h av i n g ad equat e ri s kd i s tri b u ti o n . Th e t ax p ay ers d i s ag ree an darg u e t hatri s kd i s tri b ut i o n can b e ach i ev edo n e o f t h ree way s :
! i n s u ri n g a n u m b er o f u n rel at edri s k s s u ffi ci en tt o al l o w th e l aw o f l arg e n u m

b ers t o p red i ctex p ect ed l o s s es ;
! h av i n g ri s k s o f at l eas t1 2 affi l iat edco m p an i es , n o n e o f wh i ch h as l i ab i l i ty co v erag e o f l es s th an 5 % n o r m o re t h an 1 5 % o f t he t o t al ri s k i n s u redb y

th e i ns u ran ce; o r
! arran g i n g fo r atl eas t 3 0 % o f t h e ri s k s as s u m ed b y th e i n s u ran ce co m p an y t o b e t h os e o f u n rel at edp art i es . Go i n g i n rev ers e o rd er, Co n s o l i d at edd i dn ’ t as su m e atl eas t3 0 % ri s k s fro m
u n rel at edp art i es . Co n s o l i d at edh ad zer o ri s ks fro m u n rel at edp art i es . Th is o n e fai l s . Nex t , Co n s ol i d at ed d i dn o t i n s u re atl eas t1 2 affi l i at edco m p an i es , n o n e o

f wh i ch h a d

l i a b i l i t y co ver a g e f

o r l es s th a n 5 % n o r

mo r e th a n 1 5% o

f th e t o ta l r is k b y Co n s o l i d

a t ed . Ev en wi th t h e i n cl u s i o n o f s ep arat e Cay l o r en t i t i es , th e ri s k i n s u red --as d et erm i n edb y th e t ax p ay ers ’ o wnex p ert --was ex trem el y co n cen trat ed i n ju s t two co m

p an i es , wh i l e t he res th ado n l y m i n i m al ri s k . Acco rd i ng t o th e t ax p ay ers ’ o wnex p ert , two co m p an i es --Cay l o r Co n s tru ct io n an dLa Pl ay a Cal i en t e--each h ad m o re t h an 3 0 % o f t h e g ro up ’ s t ot al ri s k ex p o s u re, wh i l e s ev en- 3 6 -

[* 3 6 ] co m

pan i es --Cay l o r Lan d , RCM C, Ib or, Dat a W av e, 7 5 0 0 Bro adway , Ban tam , an dVi s t o s o --each h adl es s th an 5 %. W e fi n dth e t ax p ay er’ s ex pert
en t i rel y cred i b l e i n h i s ex pl an at i o n o f t h es e nu m b ers . Ital i g ns h i m , h o wev er, wi t h Bab bel ’ s t es ti m on y

thatth e h i gh co n cen trat i o n o f ri s k m ean s there i s n’ ts u ffi ci en t ri skd i st ri b u t i o n h ere. Th i s al s o fai l s . Th e t h ird way

th atCay l o r arg u es th atCo n s o l i d at ed ad equ at el y d i s tri b u t ed ri ski s th e l aw o f l arg e n u m bers --t h atCo n s o li dat edi n s ures a s u ffi ci en tn um b er o f
u n rel at edri s k s t o al l o w th e l aw o f l arg e n u m b ers t o p red ictl o ss es . Th i s i s n o t
en t i rel y o ff b as e--we s tat edi n Av rah am i th ati n d ep en den tri s k ex p o s u re i s th e k ey . Av rah am i , 1 49 T.C. at1 83 . Bu tth i s i s cal ledth e l aw o f la r g e n u m b ers --n o t
s ma ll n u m b ers o r s ome n u m

b ers . Our cas el aw d em o n s trat es h o w v ery l arg e t h es e
n u m b ers m u s t b e. In Harp er Gro up , th e cap t i v e i n s ured7 , 5 0 0 cu s t o m ers co v eri n g
m o re th an 3 0,0 0 0 d i fferen ts h i p m en t s an d6 ,7 2 2 s peci al carg o p o l i ci es . Harp er Grp
. , 9 6 T.C. at5 1
. Th i s m ean tm o re t h an 2 6 0 ,0 0 0 ai r s h i p m en t s ; 1 8 ,0 0 0 ai r fl ig h ts ; an d4 0 ,0 0 0 s h i p m en t s o n m o re t h an3 ,0 0 0 o cean v o y ag es were co v ered
. Id . InRen t -A-Cen t er, t h e cap t i v e i n s u red th ree t y p es o f ri s k s --wo rk ers ’
co m p en s at i o n , au to m o b i l e, an d g en eral l i ab i l i ty . Ren t -A-Cen t er, 1 4 2 T.C. at2 . It i n s u red1 4 ,0 0 0 em

p l o y ees ; 7 ,0 0 0 v eh icl es ; an d 2 ,6 00 s t o res . Id . at 2 . An di n R.V.I. Gu aran ty , th e i n s uran ce co m p an y i ns u red o ne t

yp e o f ri s k, the res idu al- 3 7 -

[* 3 7 ] v al u e o f as s et s . R.V.I. Gu ar., 1 45 T.C. at2 1 2 . Bu tev en th ere, t h e i n s u ran ce
co m p an y i s s u ed 9 5 1 p o l i ci es co v eri n g 7 1 4 d ifferen ti n su redp art i es wi th m o re t h an 7 5 4 ,0 0 0 p as s en g er v eh i cl es ; m o re t h an 2 ,0 0 0 i nd i vi du al real -es tat e p ro p ert i es ; an d
m o re th an 1
. 3 m il l i o n co m m erci al -eq u i p m en tas set s . Id
. at2 1 4
. Th ere i s n o p reci s e n um

ber o f i n d ep en den tri s k s t h atm u s tex i s t fo r ri s kt o b e s u ffi ci en t l y

d i s tri b u tedt o m eetth i s el em en t --we’ re n o ta l eg i s l atu re o r reg u l at o r, an dthat ’ s n o t th e way co m m o n -l aw co n cep t s b eco m e cl earer o v er t i m e. Th e p ro b l em fo r Co n s o l i d at edi s th ati tfaces a n um b er o f i nd ep en d en tri s k s th at are at l eas t a co up l e o rd ers o f m ag n i tud e s m al l er t h an th e cap t iv es i n cas es wh ere we’ v e fo u n ds uffi ci en td i st ri b u t i o n o f ri s k . Duri n g t h e y ears ati s s u e t h ere were a t
mo s t 12 i n dep en d en tex po s ures fo r ad m i n i s trat i v e-act i o n an dl eg al -ex p en s e rei m b u rs em en t ; 1 1 i n d ep en den tex p o s u res fo r l os s o f k ey co n tract s ; 1 0 fo r cy b erl iab i l it y , m i s cel l an eo u s p ro fes s i o n al l i ab i l i ty , an dp ro fes s i on al -s erv i ces rei m b u rs em en t ; an d1 fo r ex ten d edwarran ty . W e fi n d o n th e b as i s o f t h i s reco rd th atth e l aw o f l arg e n um b ers d o es n ’ tap p l y

t o s u ch s m al l n u m

b ers . Onth is i s s u e Bab bel i s t he m ore cred i b l e wi tn es s . W e al s o fi n d i n th e al t ern at i v e th atth e m ajo ri ty o f t h e ri s ks Co n s o l i d at ed faced weren ’ t in d

ep en d en t ri sk s . Duri n g tri al , b o th p art i es p l ay edwi th th e
m et ap h o r o f a t eet er-t o t t er. Bab b el t es t i fi edth atth e Cay l o r en t i t i es were al l s o- 3 8 -

[* 3 8 ] d ep en den to n Cay l o r Co ns t ru ct i o n th at i twas l i k e h av i n g a b u n ch o f m i ce o n
o n e s id e an dan 8 0 0 -p ou n dg o ri l l a o n t h e o th er wi th n o way fo r Co n s o l i d at edt o b al an ce t h e ri s kth atCay l o r Co n s tru ct i o n carri edco m p aredt o th e o th er en ti t i es . Th e t ax p ay ers t o o k ex cep t i o n t o th e an al og y an d arg u edth atth e i n su red ’ s rev en u e
earn edd oes n ’ tco rrel at e t o th e ri s kCo n so l i d at ed n eed ed t o d i s tri b u te. Tri b eca, h o wev er, cal cu lat ed p rem i um s fo r t he Cay lo r en t i t i es b as edo n
rev en u e, wh i ch s u g g es t s thatrev en u e i s s o m e i n d i cat o r o f t h e ri s kCo n s o l i d at ed
was p urp o rt i n g t o i n s u re. Ev en i f rev en u e i s n ’ tth e o n l y m eas ure o f ri s k , we d o fi ndas a m at ter o f fact thateach o f t h e Cay l o r en t it i es was h i gh l y d ep en d en to n Cay l o r Co ns tru ct i o n . M an y of t h e en t i t i es recei vedal l o r m os to f th ei r rev enu e fro m Cay l o r Co ns tru ct i o n . M an y h adn o cl ien t s o th er t h an Cay l or Co n s tru ct i o n . An di f s o m et h i n g were t o h ap p en t o Cay lo r Co n s tru ct i on o r a p o l i cy fo ll o w edb y Cay l o r Co ns tru ct i o n was fo u ndt o b e fau l ty , i two ul d h av e a s ev ere effect o n al l o f th e o th er en t i t i es . W e al s o th i n ki ti m p ort an tth atal th o u g h the Cay l o r en t i t i es are a b i g p l ay er i n th e Tu cs o n real -es t at e m ark et , th e g ro up i s al m o s ten t i rel y l i m i t ed t o th atm ark et . Th i s m ean s t hatthere was n o g eo grap h i c d i vers i ty o r i n du st ry d i v ers i ty i n th e en t i t i es th atCo n s o l i d at edi n s u red . Al l th e en t i t i es i n o n e way o r
an o th er were a p arto f th e real -es t at e i n du s try . An dal l th e en t i t i es were i n Tu cs o n .- 3 9 -

[* 3 9 ] Th is l acko f d i v ers i ty al s o s up p ort s o u r fi n di n g t h atth e ri s k s i n su redb y Co n s o l i dat edwere n o t s uffi ci en t l y d i s tri b u t ed
. An d ab s en ts u ffi ci en tri skd i s tri b ut i o n, wh atCo ns o li d at edwas p ro v id i n g
was n oti n s u ran ce. B. Co m

m on l y Accep t edSen s e Wh i l e t h e ab s en ce o f ri s kd i s tri b u t i o n i s en o u g h t o d em o l i s h thi s s ch em e, AM E RCO, 9 6 T.C. at4 0 , we wi l l as an al t ern at i v e g ro u n dl o okt o s ee i f wh at Co n s o l i dat edwas s el l i n g was an arran g em en tthatl o o ks l i k e co m m o n l y accep t ed
n o t i o n s o f i n s u ran ce, s ee Av rah am i , 1 4 9 T.C. at1 9 0 -9 1 . Th ere i s a h i n to f qu es ti o n b eg g i n g h ere--we s ay s o m et h in g ’ s n o ti n su ran ce b ecau s e i td o es n ’ tl o o k
en o ug h l i k e s o m et h i n g we d o s ay i s i n s u ran ce--b u ti ti s o n e o f t h e fo ur cri t eri a p reced en tt el l s u s t o l o o k fo r. An do n e can v i ew i tas s i m p l y a co m m an dt o en g ag e i n an al o g i cal reas o ni n g --t here i s an o rd in ary p ub l i c m ean i n g o f t h e wo rd

“ i n su ran ce” wi d es p readi n s o ci et y th at p eo p l e as cri b e t o co n tract s wi th o u tm u ch th o u g h t . A co u rtcan th en l o o k at n o v el arran g em en t s thatm ig h t o r m i g h tn o tl o o k l i ke t h os e co n tract s i n v ari o u s way s an dp ro n o un ce wh et h er t h ei r d i fferen ces wi t h
co m m o n ly h el dn o t i o n s o f i n s u ran ce are i m p o rt an ti n an y p art i cu l ar cas e. Preced en ts u g g es t s th atwe l o o kat :- 4 0 -

[* 4 0 ] ! wh et her t h e co m p an y was o rg an i zed , o p erat ed , an d reg u l at edas an i n s u ran ce co m

p an y ;
! wh et her t h e i n s u rer was ad equ at el y cap i tal i zed ;
! wh et her t h e p o l i ci es were v al i d an db in d i n g ;
! wh et her t h e p rem iu m s were reas o n ab l e an dth e res u l to f an arm ’ s l en gt h tran sact io n ; an d
! wh et her cl ai m s were p ai d
. See, e.g
. , Av rah am i , 1 4 9 T.C. at1 9 1 ; R.V.I., 1 4 5 T.C. at2 3 1 . W e h av e al so l o o k edatwh et h er th e p o l i ci es co v eredri s k s p eo p l e ty p i cal l y i n s u re an d i f t h ere
was a l eg i t im at e b u si n es s reas o n fo r b u y i n g i n s uran ce t hro u gh a cap t i v e. See Ho s p. Co rp . o f Am . v . Co m m i s s i o ner, T.C. M em o . 1 9 9 7-4 8 2, 7 4 T.C.M
. (CCH) 1 0 2 0 , 1 0 3 8 (1 99 7 ). Th e Cay l o rs arg u e t h atCo n s o l i d at edi s ju s tl i k e ev ery o th er ru n -o f-t he-m i ll i n s u ran ce co m

p an y . Th ey

s ay i twas p ro p erl y

reg u l at edan dh adad equ at e cap i t al i zat io n . Itp ai di t s cl ai m s wh en th ey were fi l ed . Ith adp rem i u m s th atwere actu ari al l y

d et erm i n ed b y a t hi rd -p art y cap t i v e-m an ag em en tco m p an y an dth o s e p rem i u m s were act u al ly

p ai db y th e Cay l o r en t i t i es . Bu t th e Co m m i s s io ner i s n ’ t
co n vi n ced
. He h as fo u r m ai n i s s u es wi th Co n s o l i d at ed --wh en i ti s s u edi t s p o l i ci es , h o w i t cal cu l at edthe p rem i u m s i tch arg ed , h o wi t p ro ces s edcl ai m s , an d wh atth e Co m m i s s i o n er s ay s were t h e s h eer ex ub eran t ex ces s o f t h o s e p rem i u m s .- 4 1 -

[* 4 1 ] 1
. Org an i zat i o n , Op erat io n , an dReg u l at i o n Th e p art i es ag ree t h atCo n s o l i d at edwas i nco rp o rat edi n An g ui l l a an dfi l eda req u es tth ere t o b e reg ul at ed as an i n s u ran ce ag en cy . Th ey d i s ag ree a b i tab o u t wh et h er An g u i l la ev er g ran t edCo n s o l i d at ed ’ s req u es tan dwh et her Co n so l i d at ed al s o n eed edt o fo l lo w Ari zo n a’ s i n s uran ce reg u lat i o n s . Th e qu es t io n o f wh et h er Ari zo n a reg u l at io ns ap p l y t o an al i en i n s u ran ce co rp o rat i o n tu rn s o u t t o b e an
es p eci al ly th o rn y l eg al i s s u e. W e d o n ’ tthi n kei th er o f t h ei r d i s ag reem en ts m at t ers t o the o u t co m e, s o we wi l l l eav e t h em fo r an o th er d ay . See LTV Co rp . v . Co m m i s s i o n er, 6 4 T.C. 5 89 , 5 9 5 (1 9 7 5 ). Th e m o re t el l i n g qu es t i o n i s wh et h er Co ns o li d at edo p erat edas an i n s u ran ce
co m p an y . Nan cy

Harm an 1 8 an dBab b el b o th cred i b l y t es t i fi edth atCo n s ol i d at ed
was n oto p erat edl i k e a n o rm al i n s u ran ce co m p an y . Harm ant es t i fi edth at th e p ro ces s o f p ri ci n g p o li ci es was “ v ery d i fferen t ” fro m th e p ro ces s ev erywh ere el s e
s h e h adwo rk ed --n o o th er co m pan y b ack edi n to th e p rem i u m am o u n tth e way Co n s o l i dat edan d Tri b eca d i d . An d Bab b l e t es t i fi edth at h e h adn ev er s een a real i n s u ran ce co m

p an y i ss u e p o l i ci es aft er t h e p eri o d b ei n g i ns u red --a p ract i ce t h at

1 8 Harm an i s an i n s uran ce u n d erwri ter wh o h as wo rk edi n s ev eral areas o f i n s u ran ce--fro m

p ers o nal t o co m

m erci al --an dfo r s ev eral co m p an i es . Sh e al s o wo rk edfo r Tri beca fro m

2 0 0 6 t o 2 0 09 as a cap t i v e m an ag er. W e fi n d h er t es t i m o ny en ti rel y cred i b l e.- 4 2 -

[* 4 2 ] ap peared t o b e s tan d ardo p erat i n g p ro cedu re fo r Co ns o li d at edan dTri b eca. 1 9 He s t at ed“ [t ] h i s i s n ’ th o w i n s u ran ce co m p an i es ty p i cal l y o p erat e l etal o n e fo u r y ears i n a ro w.” To an s wer t h i s qu es t io n o u rs el v es , we “ m us tl o o kb ey o ndth e fo rm al i t i es
an d co n s i d er t h e real it i es o f t h e p u rp ort edi n s u ran ce t ran s act i o n.” Ho sp . Co rp . o f Am ., 7 4 T.C.M . (CCH) at 1 0 3 7. Th e real i ti es d o n o th el p Co n s o l i d at edh ere. W e fi ndHarm an was cred i b le i n h er t es t i m o n y th atCo n s ol i d at ed ’ s p ri ci ng o f i t s p o l i ci es was ab n o rm al . W e al s o fi n dBab b el cred i b l e th atCo n s o l i d at ed ’ s
o p erat i o n was en t i rel y

ab n o rm al
. W e o u rs el v es fi n dth atCo n s o l i dat ed ’ s h an d l i n g o f cl ai m s was ab n o rm al
. Th e cl ai m s thatth e Cay l o rs an d t h e Cay l o r en t it i es m ad e du ri n g th e y ears ati s s u e were h an d l edqu i te d i fferen t l y fro m h o w ty p i cal i n s u ran ce co m

p an i es res po n dt o th ei r p ol i cy

h o l d ers . It ’ s co m

m o n en o u g h fo r an i n s u ran ce co m p an y t o as kfo r

1 9 Bab b el al s o g av e h is o p i n i o n th atthe p aym en to f $ 1
. 2 m i ll i on fro m Cay l o r Co n s tru ct i o n t o Co ns o l i dat edfo r o n l y 1 0 d ay s o f co v erag e was n otty pi cal i n th e i n s u ran ce i n du st ry . W e reco gn i ze t h at thi s m o n s t er p aym en tfo r 1 0 d ay s o f co v erag e th atwas n earl y

th e s am e as th e Cay l o rs p ai d fo r a fu l l y ear’ s wo rt h o f co v erag e d i dn o t i t s el f o ccu r i n a t ax y ear b efo re u s . Bu t we co ns i d er fact s fro m y ears n o tb efo re u s t o m ak e fi n d i ng s fo r y ears th at are. Sec. 6 2 1 4 (b ); s ee, e.g ., Ch ag an t i v . Co m

m i s s i on er, T.C. M em o . 2 0 16 -2 2 2 , 1 1 2 T.C.M . (CCH) 6 2 9 , 6 3 4 (2 0 1 6), aff’ dp er cu ri am , 7 4 5 F. Ap p ’ x 2 59 (8 th Ci r. 2 01 8 ). Th i s p art i cu l ar fact s h o ws h o w m

u ch m o re l i k el y

i ti s th atCo ns o li d at edi s s el f-i n s u ran ce, i f n otju s ta t ax -av o i d an ce s ch em e.- 4 3 -

[* 4 3 ] m ore i n fo rm at i o n fro m i t s cl i en t wh en i trecei v es a cl ai m . An dTri b eca o n b eh al f o f Co n s o li d at edd i d d o th ath ere; b u ti n s t eado f g iv i n g th ati nfo rm at i o n , th e p o l i cy h o l d ers ju s tt o l dCo n s o l i d at edt o p ay , an dCo n s o l id at edo b ey ed . See Av rah am i , 1 49 T.C. at1 92 (ap p ro v i n g cl ai m s wi tho u ts up p o rti s ab n orm al ). Ev en i f Co n s o l i d at edwas o rg an i zedan dreg u l at edas an i ns u ran ce co m p an y , we fi n di twas n o to p erat edl i k e o n e.

2
. Cap i t al izat i o n W e n ex tl o okat cap i tal i zat i on . Th e p art ies ag ree t h atCo n s o l i d at edm etth e
m i n i m u m cap i tal i zat io n req u irem en t s o f An gu i l l a. Th i s i s th e s am e as ad equ at e cap i t al i zat io n . See i d . at1 9 3 . No i s s u e h ere.

3
. Val i d an dBi n d in g Po l ici es In Secu ri tas , we fo u n dv al i dan db i n d i ng p o l i ci es wh en “ [e] ach i n su ran ce p o l i cy i d en t i fi edth e i n s ured , co n t ai n ed an effect i v e p eri odfo r t h e p o l icy , s p eci fi ed wh atwas co v ered b y

th e p o l i cy , s t at edth e p rem i u m am o un t , an d was s ig n edb y an
au th o ri zedrep res en t at i v e o f t h e co m p an y . ” Secu ri t as , 1 0 8 T.C.M . (CCH) at 4 9 7 ;
s ee al so Av rah am i , 1 4 9 T.C. at1 9 4 ; R.V.I., 1 4 5 T.C. at2 3 1
. Th e “ p o l i ci es ” p ro v i d ed b y Co n s o l i d at edare t h e m o s tg lari n g ev i d en ce i t
was n’ tan i n s u ran ce co m

p an y . Duri n g th e y ears ati s s u e (as wel l as i n 2 0 0 7 an d 2 0 0 8 ) Co n s o l i dat ed , wi th th e h el p o f Tri b eca, d i dn ’ tp ro v i de p o l i ci es fo r th e- 4 4 -

[* 4 4 ] Cay l o r en t i t i es u n ti l a f ter th e cl ai m s p eri o d s en d ed . Fo r 2 0 0 9 , th e p o l i ci es
were n o t p rep aredu n t il 2 0 10
. Th e d ecl arat i o n s weren ’ ts i g n edb y Go t zi n ger u n t i l Au g u s t2 0 1 0 , an d th ey

weren ’ td el i vered t o Ro b u n t i l Decem ber 2 01 0 . Th e Cay l o r
en t i t i es p ai dp rem i u m s t o Co n so l i d at edwi th ou tkno wi ng th e t o tal p rem i u m s fo r each an d wi th ou tkn o wi ng wh atth o se p ol i ci es wo u ldb e fo r t haty ear. Two cl ai m s
were ev enp ai do n p o l i ci es thath adn o t y etb een wri t t en . M u ch th e s am e o ccu rredfo r 2 0 10 . Ro b d i dn ’ ts i g n an dretu rn co v erag e accep t an ce fo rm s t o Tri beca u n t i l No vem ber 2 01 0 . Go t zi ng er d id n ’ ten d o rs e t h e d ecl arat io n p ag e u n t i l J an u ary 2 0 1 1 , an dth es e p o l i ci es weren ’ td el i v eredt o Ro b
u n t i l Ap ri l 2 0 1 1
. Wri t i n g an dd el i v eri n g “ cl ai m s m ad e” i n s uran ce p o l i ci es a f t er the cl ai m p eri o di s , we fi n d , ab n o rm al an di s t o an y reas o n ab l e o b s erv er ju s tp l ai n s il l y . In s u ran ce p ro t ect s ag ai n s t th e ri s ko f l o s s . See St ev en Pl i ttetal ., 1 Co u ch o n In s ., s ec. 1 .6 n .2 (3 ded . 2 0 2 0 ). A p o l i cy wri t t en a f t er th e cl ai m s p eri odi s b ei n g wri t t en aft er t h ere i s n o l o n g er a ri s k o f l o s s , wh i ch d efeat s th e wh ol e p u rp o s e o f i n s u ran ce. An dthe ex pert s b acku s up o n o u r i n tu i t i o n. As we s t at edab o v e, Bab bel cred i b l y t es t i fi edth atwri t i n g th e p o l i ci es aft er t h e cl ai m s p eri o d i s n o t
n o rm al fo r an i n su ran ce co m pan y . See s up ra p . 4 2 . An dHarm an t es ti fi ed th at t h e p ri ci ng o f p o li ci es aft er t h e p eri o d h adcl o s ed , wh i l e co m m o n at Tri b eca an d- 4 5 -

[* 4 5 ] Co n s o l i d at ed , was ab n o rm al i n t h e i n s uran ce i ndu st ry . W e fi n d--i n s tro n g t erm s --t h atth i s i s n o t n orm al b eh av i o r. 2 0

4
. Reas on ab l e Prem i u m s Th e n ex tques ti o n i s wh et h er Co n s o l i dat ed ’ s p rem i u m s were reas o n ab l e an d th e res u l to f an arm ’ s -l en g th tran s act i o n. See Av rah am i , 1 4 9 T.C. at1 9 4 -9 5 . W e h av e two i s s u es wi th th e p rem i u m s h ere--o n e m acro an do ne m i cro . Ou r m acro i s s u e i s th atCo n so l i d at edch arg ed , an dth e Cay l o r en t i t i es p ai d , a t o t al o f $ 1
. 2 m il l i o n per y ear i n p rem i u m s. Th at ’ s n o tb y i t s el f a s i g n th at
s o m et h in g i s n ’ t l i k e t h e co m m o n l y accep tedn o t io n s o f i n s uran ce. Bu tRo b t es t i fi edth atth i s i n s u ran ce was v i ewedas ad d i ti o n al p ro t ect i o n fro m u n co vered cl ai m s i n t h e p as t . An d i n the 1 0 y ears l ead i n g up t o Co n so l i d at ed ’ s fo rm at i o n , the Cay l o r en t i t i es h adi n cu rredo n l y $ 5 0 0 ,0 0 0 i n wh atth e Cay l o rs cal l edu n co v ered cl ai m s --ro u g h l y

$ 5 0 ,0 0 0 p er y ear. Wh i l e we d o n ’ tth in k th atan y p rem i u m o v er $ 5 0 ,0 0 0 p er y ear wo u l d b e per s e u nreas o n ab l e, 2 1 a p rem i u m th ati s s o m

u ch

2 0 Th ere i s o n e o th er m i n o r p o i n t o f ab n o rm al i ty we m u stp o i nto u t. Th e Cay l o rs n ev er co n s u l t edGee, t h ei r l o n gt i m e i n s u ran ce ad vi s er, ab o u t th e p o l i ci es th ey were recei v i n g fro m

Co n s o l i d at ed an dTri b eca. If t h is was tru ly i n su ran ce, we wo n der wh y th e Cay l o rs n ev er ev en as kedGee wh atk i n d o f p o l i ci es th ey s h o u ldo b t ai n t o s upp l em en tth ei r t rad i t io n al i n s uran ce.

2 1 Fo r ex am

p l e, a co m

p an y m ay b e wi l l i n g t o p ay

a s l i g h tl y h ig h er p rem i u m t o fi x i t s co s t s .- 4 6 -

[* 4 6 ] h i g h er--$ 1 ,1 5 0 ,0 0 0 h i g h er t o b e s p eci fi c--l o o k s u n reas o n ab l e an dth u s l i k el y t o b e fo r s o m et h in g o th er t h an “ i n s u ran ce” as th att erm i s co m m on l y u n d ers t o o d
. 2 2 Onth e m icro s i d e we al s o t ak e i s su e wi th h o w th e p rem i u m s were cal cu l at ed
. 2 3 Rat h er t h an s t art i n g wi th th e Cay l o r en t i t i es ’ h i s t o ri cal l o s ses --wh i ch cred i b l e t es t i m o ny

s h o wed wo u l d h av e b een s t an d ardp ract i ce i n th e i n du s try --Tri b eca s tart edwi th th e t o t al p rem i u m am o u n tthe Cay l o r en t i t i es as a wh o l e wi s h edt o p ay , an dthen creat edan dp ri ced p ol i ci es th atwo ul dfi t wi th i n th i s l i m i t . W e ack n o wl ed g e t h atTri b eca m ay h av e feared th at a t en -y ear l o s s h i s t o ry wo u l dn o th av e en o u g h d at a, b u ti gn o ri n g i tco m p let el y d o es n ’ tm ak e
s en s e ei th er. Nei th er d o es i g n o ri n g n ew i n fo rm at i on du ri n g al l fo u r y ears Co n s o l i dat edp ro v i d edi n s u ran ce--Co n s o l i d at ed(t h ro u g h Tri b eca) n ev er ad ju s t ed i t s p rem i um s b as edo n th e l o s s h i s to ry o f th e Cay l or en ti t ies
. Th e cal cu l at io ns o f t h e p rem i u m s al s o m ad e l i t t l e s en s e. Go t zi n ger, i n cal cu l at in g th e p rem i u m s , s t art edi n a n o rm al p l ace--t h e ISO (In s u ran ce Serv i ces

2 2 An o th er m i n o r m i cro ab n o rm al i ty i s fo u ndi n wh o p ai d fo r t h e i n s u ran ce. Cay l o r Co ns tru ct i o n p ai dth e p rem i u m s fo r i t s trad i t i o n al i ns u ran ce th at co v ered al l th e en t i t i es . Bu twi th Co n s o l i d at ed , th e co v ereden t i t i es each p ai dth ei r o wn p rem i u m s--a d ep artu re fro m wh atap p ears t o b e t h e l o n g t i m e s t an d ardp ract i ce wi th i t s t rad i t i o n al i n s u ran ce.

2 3 W e n o t e t h atth e actu al u n d erwri t er o f t h e p o li ci es h add i edb efo re t ri al an d l eftn o t es t i m o ny

b eh i n d
.- 4 7 -

[* 4 7 ] Offi ce) b as e rat e. 2 4 Bu tth e cal cu l at i on s s o o n t o o k a d et o u r t o crazyt o wn . Sev eral ad

ju s t m en t s were m ad e t o th es e b as e rat es wh i ch h adth e effect o f rai s i n g th e p rem i u m s fo r each p o li cy --wh ich m ak es s en s e o n l y as an effo rtt o i n creas e t h e t o t al p rem i u m t o th e d es i red$ 1 .2 m i l l i o n . Th e m o stg lari ng ex am

p l e o f t h es e ad

j u s t m en t s was s o m et h in g cal l eda

“ cap t i v e ri s kfact o r” ad

ju st m en t . Tri b eca s ai dth is ad ju st m en t ’ s p u rp os e was t o i n fl at e p rem i u m s t o al l o w cap t i v es t o g ro w i n fi n an ci al s tren g th . Itd idi n factd o th i s --fi d d l i n g wi th t h i s fact o r i ncreas edp rem iu m s b y 3 0 0 %. Bu tth i s fact or i s
co m p l et el y u n kn o wni n th e co n v en t i o n al i ns u ran ce i n du s try . Ro b ert a Garl an d , an actu ary wh o s e t es ti m o n y

we fi n dcred i b l e, cri t i ci zedth e u s e o f t h i s fact o r. Sh e
s t at edi ti s n o twi d el y

u s edi n the i ndu s try . Or p erh ap s we s h o u l dfi n dthats h e
u n d er s t at edth is --as far as s h e kn ew o n l y Tri b eca u s edth i s fact or. Sh e co ncl u d ed th atTri b eca’ s p rem i u m s were ex ces s i ve. Bab b el cred i b l y cri t i ci zed the u s e o f t h i s fact or as wel l , arg ui n g th ati t s u s e i s “ eco n o m i cal l y fu t i le” an d“ co n traryt o
co m m o n i n s u ran ce i n du st ry

p ract i ce.” W e fi n dth atth e p rem iu m s weren ’ tactuari al l y d et erm i n ed , an d t h ei r p aram et ers an das s u m

p t i o n s were n o tp ro p erl y

d o cu m en t ed
.

2 4 ISO i s an i n dus try

d at a co l l ect i o n an d rat i n g ag en cy . ISO b as e rat e at t em p t s t o cap tu re th e “ p u re l o s s co s t s ” p er ex p o s u re u n it (s u ch as rev en u e) b y s t at e.- 4 8 -

[* 4 8 ] 5
. Paym en to f Cl ai m s Fi n al l y we l o o katwh et her Co n s o l i d at edp ai di t s cl ai m s . Th e s i m pl e an s wer i s y es . Bu twe al read y d i s cu s s edth e ab n o rm al way thes e cl ai m s were p ai d
. See s up ra p . 4 4
. Do es al l th is ad dup t o “ i n s u ran ce i n the co m m o nl y accep t eds en s e? ” W e fi ndi tm o re l ik el y

th an n o tth atth e an s wer i s “ n o ”. Co n so l i d at ed m ay h av e b een
o rg an i zedan dreg u lat edas an i n s u ran ce co m pan y , p ai dth e cl ai m s fi l edag ai n s t i t , an d m et th e m in i m al cap i t al i zat i o n req ui rem en t s o f An g u i l l a. Bu ti t al so cal cu l at edp rem i u m s i n a fan ci fu l way i n en t i rel y

u n reas o n ab l e am o u n t s, i ss u ed cl ai m s -m ad e p o l i ci es aft er t h e t i m e t o m ak e cl ai m s h ad ex p i red , an dp ai d t h e few cl ai m s thati td i d o n th e s ay -s o o f i t s cl ien t s. W e fi n dth ati td i d n o to p erat e l i k e an i n s u ran ce co m p an y . C. No tIn su ran ce Becau s e we fi ndth atCo n s o l i d at edfai l edt o d i s tri b u t e ri s kan d was n o t
s el l i n g i n s u ran ce i n the co m m on l y accep t ed s en s e, we n eedn o t d eci de wh et h er i t s tran s act io n s i n v o lv edi n su ran ce ri s ko r ri s ks h i ft i n g. See, e.g ., Cl o u g h erty , 8 1 1 F.2 dat 1 30 0 n .5 . Des p i te t h e at t em p t s o f Co ns o l i d at edt o m ak e i t s tran s act i o n s l o o kl i k e t rad i t i on al i n su ran ce an dt ak e ad v an t ag e o f t h e ap paren tl o o ph o l e atth e i n t ers ect i o n o f s ect io n 8 31 an dcap t i v e-i n s u ran ce cas el aw, th e p rem i u m s p ai dt o- 4 9 -

[* 4 9 ] Co n s o l i d at edan d d edu ct edb y th e Cay l o r en ti ti es are n o t “ i n s u ran ce” fo r fed eral t ax p u rp os es . See, e.g ., Av rah am i , 1 4 9 T.C. at1 9 7 . As i n Av rah am i , as i n Sy zy g y , an das i n Res erv e, we fi n d th atth e m i cro cap t i ve d i dn ’ tactu al l y p ro v i d e i n s u ran ce b ecau s e i tfai l edt o d i s t ri b u t e ri s kan dd i dn ’ t actas an i n s urer co m m o n l y
wo u l d
. III. Pen al t i es Ou r l as ti s s u e i s wh et h er an y o f t h i s ju s t i fi es accu racy -rel at edp en al t i es
u n d er s ect i o n 6 6 6 2 (a). W e n o wkn o w th ati f t h e Co m m i s s i on er wan t s p en al t i es , h e h i m s el f m

u s th av e l ai dth e fo u n d at i o n b y co m p l y i n g wi th s ect i o n 6 7 51 . Th e p art i es h av e s et t ledthi s i s s u e h ere wi th a s t i p u l at i on th atth e Co m m i s s i o n er
co m p l iedwi th s ect i o n 6 7 51 (b ) i n o n l y s ev en o f t h es e cas es . W i th th ati n p l ace, we can p u tup a fram ewo rkfo r t h e m eri t s . Sect i on 6 6 6 2 (a) i m

p o s es a 2 0 % p en al ty

o n th e p o rt io n o f anu n d erp aym en to f t ax at tri b u t ab l e t o an y

s ub s t an t ial u n d ers t at em en t o f i n co m e t ax , s ec. 6 6 6 2 (b )(2 ), o r
n eg li g en ce o r d i sreg ardo f ru les o r reg u l at i o ns , s ec. 6 6 6 2 (b )(1 ). An
u n d ers t at em en ti s s ubs t an ti al i f i tex ceed s th e g reat er o f $ 1 0 m i ll i on o r “ 10 p ercen t
o f t h e t ax req u i red to b e s ho wno n th e retu rn fo r t h e t ax ab l e y ear (o r, i f g reat er, $ 1 0 ,0 0 0 ).” Sec. 6 6 6 2 (d )(1 )(B). Neg l i gen ce i n cl u des an y fai l u re t o m ak e a- 5 0 -

[* 5 0 ] reas o n ab l e at tem

p tt o co m p l y wi th the p ro v i si o n s o f t h e Co d e; an dd i s reg ard i n cl u d es an y

carel es s , reck l es s , o r i n t en t i o n al d i s reg ard . Sec. 6 6 6 2 (c). Al m o stal l th e t ax p ay ers --as a m at t er o f ari th m et i c--s ub s t an t i al l y
u n d ers t at edth ei r t ax l i ab i l i t i es . 2 5 An d we fi ndi n th e al t ern at i v e th atth e t ax p ay ers were al s o n eg l ig en t . Neg li g en ce i n cl ud es fai l u re t o k eep ad equat e b o o k s an d
reco rd s . See s ec. 6 6 62 (c); s ec. 1 .6 6 62 -3 (b )(1 ), In co m e Tax Reg s . It al s o i n cl u d es fai l u re t o d o wh ata reas o n ab l e an dp ru den tp ers o n wo u l dd o u n d er t h e ci rcu m s t an ces . See s ec. 1 .6 6 6 2 -3 (b )(1 ), In co m e Tax Reg s .; Neel y v . Co m m i s s i o n er, 8 5 T.C. 9 34 , 9 4 7 (1 9 8 5 ). Neg l i g en ce i s s tro ng l y i n d i cat edwh en a t ax p ay er fai l s t o reas o n ab ly at tem p tt o “ as cert ai n th e co rrect n es s o f a d edu ct i o n
* * * o n a retu rn wh i ch wo u l d s eem t o a reas o n ab l e an d p ru d en t p ers on t o b e ‘ t o o g o o dt o b e t ru e’ u n der t h e ci rcu m s t an ces .” Sec. 1 .6 6 6 2 -3 (b )(1 )(i i ), In co m e Tax Reg s. Ro b was p i tch edth e i d ea o f a m i cro cap ti v e as a “ tax p l an n i n g s ol u t i o n ” an d a “ t ax p l an n i n g t o o l .” Th e p res en t at i o n h e at t en d eds t at edth atth i s s ch em e wo ul d p ro v id e “ a t ax d edu ct i o n o f up t o $ 1 ,2 0 0 ,0 0 0 * * * p er y ear.” A s o p h i st i cat ed b u s i n es s m an l i k e Ro b s h ou ldh av e s een th i s as “ t oo g o o d t o b e t ru e.” Ken ned y

2 5 Th e Co m

m i s s i o n er co n ced es th ere are n o s ub st an t i al u n ders t at em en t s fo r Cay l o r Lan dfo r 2 0 10 an dDat a W av e fo r 2 0 0 9 an d2 0 1 0
.- 5 1 -

[* 5 1 ] ev ent o l dRo b th atth is s ch em e s eem ed“ t o o g o o d t o b e t ru e.” Th i s i m p el s u s t o fi n dthatRo b d i dn ’ tm ak e reas o n ab l e at tem pt s t o en su re h i s an d h i s b u si n es s es ’
en t i t l em en t s t o th es e d educt i o n s . W e d o fi n dth atKen n ed y an d Gad ari an d i ds o m e
res earch i n t o cap t i v e i n s uran ce fo r Ro b , an d we d o fi n d th atb o th t o l dRo b th ata
m i cro cap t i v e i n s u ran ce co m p an y i s a l eg i t i m at e co n cep t
. Th ey ’ re ri g h tab o u tth at
. Bu t th ey ’ re al s o ri g htth ati t ’ s a l eg i t i m at e co n cep to n l y i f “ es t ab l i s h edco rrect l y
an d o p erat edco rrect ly .” Nei ther ad v i s edRo b th at th is m icro cap t i v e was
es t ab l i s h edan d o p erat edco rrect l y . An d o th er t h an Tri beca--wh ich i s u n ab l e t o
o ffer an u nb i as edo p i n i o n --Ro b n ev er i n ves t i g at edi f t h i s s ch em e was o p erat ed
co rrect ly . Ro b d i dn ’ t ev en fo l l o w Tri beca’ s ad v ice--wh i ch was t o i n v es ti n th e i n s u ran ce p o o l t o en s u re ri s k d i s tri b u t i o n --wh i ch i ts el f i s u nreas o n ab le. An dap art fro m th e d edu ct i o n s o f Co n s o l i d at ed ’ s p rem i um s , Cay l o r Co ns tru ct i o n fai l edt o k eep ad equ at e reco rd s o f i t s d edu ct io n s fo r “ co n s ul ti n g ” p aym en t s . Th o s e were
n eg li g en tt o o . See s ec. 6 6 6 2 (c). Th e Cay l o rs try

t o s h o re up th i s p o s i t i o n wi th s ect i on 6 6 6 4(c)--t he
reas on ab l e-cau s e-an d -g o o d -fai th d efen s e. See s ec. 1 .6 6 6 4-4 (a), In co m e Tax Reg s. W e m ak e o u r d et erm i n at i o n s ab o u tth i s d efen s e o n a cas e-b y -cas e b as i s . Sec. 1 .6 66 4 -4 (b ), In co m e Tax Reg s . An dh ere we l o o kt o s ee i f i tap pl i es t o ei ther t h e
co n su l t i n g p aym en ts o r t h e m i cro cap t i v e s ch em e. Th e Cay l o rs arg u e t hatth ey- 5 2 -

[* 5 2 ] rel i edo n p ro fes s i o n al s t o ad v i s e t hem o n h o w t o rep o rtth es e i t em s o n th ei r retu rn s . Th e Cay l o rs arg u e t h atth ey can es t ab l i s h th i s d efen s e t h ro ug h th e ad v i ce
o f Gad ari an an dKen n edy . W e m u s tfi rs t d et erm i n e i f t h es e p art ies g av e t h e Cay l o r en t i t i es an y

“ ad v i ce”. Ad v i ce i s “ an y co m m u n i cat i on * * * s et t i n g fo rt h th e an al y si s o r
co n cl u s i o n o f a p ers o n * * * p ro v i dedt o (o r fo r t he b en efi to f) t h e t ax pay er an do n wh i ch th e t ax p ay er rel i es .” Sec. 1 .6 6 6 4 -4 (c)(2 ), In co m e Tax Reg s . W e s p eci fi cal l y

fi n dth atth e Cay l o r en ti t i es recei vedn o ad v i ce fro m Gad ari an o r Ken n edy

reg ard i n g Co n s o l i d at ed o r i t s i n su ran ce s ch em e. Gad ari an cred i b l y t es t ifi edth ath e n ev er o ffered an y ad v i ce ab o u tth e o rg an izat i o n an d
o p erat i o n o f Co n s o l i d at ed . Ken n ed y cred i b ly t es t i fi edth ath e n ev er o fferedan y ad v ice ab o u t th e o rg an i zat i on o r o perat io n o f Co n s ol id at ed . Th i s fi n d i ng i s d i fferen t fro m

th o se we m ad e i n o u r o th er m i cro cap t i v e cas es . InAv rah am i , 1 4 9 T.C. at2 0 7 , th e t ax p ay ers recei v edactu al ad v ice fro m a t ax p ro fes s i o n al wh o m th ey rel i edo n i n g o o dfai th
. InSy zy g y , 1 1 7 T.C.M . (CCH) at 1 1 7 7 , th e t ax p ay ers ag ai n recei v edactu al ad v i ce fro m a t ax p ro fes s i o n al thatth ey rel i edo n i n g o o d fai th
. Th e Cay l or en t i t i es can , i n co n tras t , n o trel y o n ad v i ce t h atwas n otg i v en . W e fi n dth atth ey

h ad no reas o n ab l e cau s e an dd i dn o tt ak e th ei r p o s i t i on i n g o o d fai th
.- 5 3 -

[* 5 3 ] Cay l o r Co n s tru ct i o n al s o can no ts h el t er i n p l ace b eh i nds ect i o n 6 6 6 4 (c) fo r th e co n s u l t i n g p aym en t s . Ag ai n , the t ax p ay ers arg u e t h atKen n ed y p rep aredth ei r retu rn s an dth erefo re t h e d efen s e ap p l i es . Em p l oy i n g a t ax retu rn p rep arer, h o wev er, d o es n’ tal l o w t ax pay ers t o av o i dp en al t i es . Neo n at o l og y As so cs ., P.A.
v . Co m m i s s i o n er, 1 1 5 T.C. 4 3, 1 0 0 (2 0 0 0 ), aff’ d , 2 9 9 F.3 d2 2 1 (3 dCi r. 2 0 0 2 ). Ken ned y s i m p ly co pi edi n fo rm at io n h an d edt o h i m o n a g en eral l ed g er o n t o a t ax retu rn . Ken n ed y an dthe Cay l o rs n ev er d i scu s s edthes e p aym en t s , wh i ch m ean s th e Cay l o rs d i dn o tg etad v ice o r a p ro fes s i o n al ’ s ju d g m en tth atth ey co u l d h av e
reas on ab l y

rel i edup on . See Fl u m e v . Co m m i s s i o ner, T.C. M em o . 2 0 20 -8 0 , 1 1 9 T.C.M . (CCH) 1 5 4 5 (2 0 2 0 ); Yap p v . Co m m i ss i o ner, T.C. M em o. 2 0 18 -1 4 7 , 1 1 6 T.C.M . (CCH) 2 7 0 (2 0 1 8 ), aff’ d , 8 1 8 F. Ap p ’ x 7 4 3 (9 th Ci r. 2 0 2 0 ). Pen al t i es ap pl y

acro s s th e b o ard . Th ere wi ll b e s o m e cal cu l at io n s n eed ed fro m th e p art i es , an db ecau s e t hi s i n v o l ves s o m e TEFRA cas es , Ap p ro p ri at e o rd ers wi l l b e i ss u ed
.