Tax Court Issues Opinion Striking Down Captive Insurance Arrangement

by Fox Rothschild LLP
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The Tax Court has issued its long-awaited decision addressing captive insurance arrangements. In Avrahami v. Commissioner, 149 T.C. No. 7 (2017), the Tax Court held that payments made from a number of businesses owned by the Avrahamis to a microcaptive insurance company that was wholly-owned by Mrs. Avrahami were not for “insurance,” and thus were not deductible as insurance premiums paid. Here is what you need to know.

Captive Insurance Generally

Amounts paid for insurance are deductible as ordinary and necessary business expenses. Insurance companies are generally taxed on the insurance premiums they receive. However, small insurance companies that satisfy certain requirements are eligible to make a section 831(b) election, in which case they are only taxed on their taxable investment income (which does not include premiums received). For 2009 and 2010, an insurance company other than a life insurance company that had written premiums that did not exceed $1.2 million could elect to be taxed under section 831(b) as long as they met all other requirements.

A pure captive insurance company is one that only insures the risks of companies related to it by ownership. A captive insurance company that is eligible to make a section 831(b) election (referred to as a “microcaptive”) does not pay tax on the premiums it receives. Thus, if a business owner creates a microcaptive that insures only the risks of the business owner’s business, the business is able to deduct up to $1.2 million for insurance premiums paid to the related microcaptive while the microcaptive does not pay tax on the premiums received. However, the premiums are only deductible if the payments are for “insurance,” which begs the question: what is “insurance”? This is the question Avrahami addressed in the context of payments made to microcaptives.

Case Background

The Avrahamis owned jewelry stores and commercial real estate companies (the “Avrahami Entities”). In November 2007, they created an insurance company (the “Captive”) to insure the risks of the Avrahami entities. The Captive was wholly-owned by Mrs. Avrahami. In 2009 and 2010 – the years at issue in this case – the Avrahami entities paid the Captive premiums for direct insurance policies of approximately $730,000 and $810,000, respectively, for policies covering seven types of risk including: administrative actions, business risk indemnity, business income protection, employee fidelity, litigation expense, loss of key employee, and tax indemnity. In addition to its direct policies, the Captive participated in a risk distribution program with other small captive insurance companies through Pan American. Through Pan American’s risk distribution program, the Avrahami Entities paid approximately $360,000 to Pan American for terrorism coverage only. Pan American then reinsured all of the risk it had assumed and would make sure that the Captive received reinsurance premiums equal to the amount paid by the Avrahami Entities to Pan American ($360,000), and in exchange the Captive would reinsure a small percentage of Pan American’s total losses. In total, the Avrahamis deducted approximately $1.1 million and $1.3 million in 2009 and 2010, respectively, for insurance premiums paid from the Avrahami Entities to the Captive or Pan American for both direct policies and for the terrorism coverage obtained through the risk distribution program. Only the Avrahami Entities were covered by the direct policies while ## insured were included in the risk distribution program.

The IRS argued that neither the Captive nor Pan American sold “insurance”, meaning the premiums paid by the Avrahami Entities were not deductible as ordinary and necessary business expenses. The Tax Court agreed.

The Court’s Analysis

To be considered insurance, the arrangement must: (1) involve risk-shifting; (2) involve risk-distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance. The Tax Court analyzed only two of these elements: risk distribution and commonly accepted notions of insurance.

Risk distribution occurs when the insurer pools a large enough collection of unrelated risks. The Tax Court looked to the number of companies the Captive insured and the “number of independent risk exposures” (i.e., how many policies does the Captive issue and what do those policies cover). Ultimately, the Court determined that insuring 3 companies in 2009 and 4 in 2010, issuing 7 direct policies that covered 3 jewelry stores, 3 commercial real estate companies, 2 key employees, and 35 other employees did not cover a sufficient number of risk exposures to achieve risk distribution through the affiliated entities. The Court distinguished the facts present in this case from other cases where they have determined that insurers adequately distributed risk.

The Avrahamis argued that they adequately distributed risk because, in addition to the Captive insuring the Avrahami Entities, the Captive participated in the Pan American risk distribution program and reinsured third-party risk. The Court determined that Pan American was not a bona fide insurance company in the first place, meaning the policies it issued were not “insurance” and the Captive could not have distributed risk by reinsuring policies that were not insurance to begin with. The Court looked to a number of factors to determine whether Pan American was a bona fide insurance company, ultimately concluding that it was not for the following reasons:

  • There was a circular flow of funds. Avrahami Entities paid Pan American, Pan American turned around and reinsured all of the risk it had assumed, making sure that the Captive received reinsurance premiums equal to those paid by the Avrahami Entities. Thus, money was effectively transferred from an entity owned by the Avrahamis (one of the Avrahami Entities) to an entity wholly-owned by Mrs. Avrahami (the Captive).
  • The premiums charged for terrorism coverage were “grossly excessive”. The only policy Pan American issued was for terrorism coverage, and the policy was worded in a way that it was highly unlikely that the triggering event would ever occur.
  • Pan American charged high premiums for an event that was unlikely to ever occur (and had never occurred in the past), and if the event did occur Pan American may have not been able to pay the claims.
  • Because the risk distribution program was not recognized by the Court, when the Court reviewed the direct policies it determined that on a stand-alone basis they also did not adequately distribute risk because the direct policies only covered the Avrahami Entities and the combination of risks and entities covered by the direct policies did not distribute risk among an adequate number of independent insurance risks.

For these reasons, the Court concluded that the Captive did not adequately distribute risk.

The Tax Court then analyzed whether the Captive met commonly accepted notions of insurance, which required the Court to work through a number of factors. The Court determined that the Captive was not selling insurance in the commonly accepted sense. The Court explained:

  • The Captive did not operate like an insurance company. No claims were filed until the IRS began its audit. The Captive only invested in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them.
  • The Captive returned substantial portions of its surpluses to the insureds and owners of the insured through various loans and distributions.
  • The Captive policies were questionable because they were unclear and contradictory.
  • The Captive charged unreasonable premiums even though an actuary priced the policies. The Court did not find the actuary’s pricing methodology at all persuasive, noting that the actuary consistently chose inputs that would generate higher premiums. The Court noted that before creating the Captive, the Avrahami Entities paid $150,000 for commercial insurance policies. After creating the Captive, the Avrahami Entities paid $1.1 million and $1.3 million in 2009 and 2010, and paid $90,000 for a commercial insurance policy.

As a result, the Court concluded that payments made from the Avrahami Entities to the Captive and Pan American were not for insurance, and thus were not deductible as ordinary and necessary business expenses.

It is worth noting that the Captive was incorporated under the laws of the Caribbean nation of Saint Christopher and Nevis (St. Kitts). The Captive made a section 953(d) election to be treated as a domestic corporation for federal income tax purposes, and also made an election to be taxed as a small insurance company under section 831(b). However, since the Captive’s policies were not for “insurance”, both elections were invalid, and it was thus treated as a foreign corporation for federal income tax purposes. The parties stipulated that the taxable premiums earned by the Captive were not subject to U.S. Federal income tax.

Impact on Continuing IRS Scrutiny of Captive Insurance Arrangements

For several years, the IRS has devoted significant resources to examinations of captive insurance arrangements and numerous cases are the subject of Tax Court petitions.  There are several cases pending in the Tax Court post-trial.  The IRS increased its scrutiny of microcaptives when it issued Notice 2016-66, requiring self-reporting by taxpayers engaging in captive insurance arrangements where there has been a low incidence of claims or where significant loans have been made to related parties. In light of the Avrahami decision, the IRS is likely to continue devoting resources to scrutinizing and challenging captive insurance arrangements it believes are abusive.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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