While many were captivated by the solar eclipse on August 21st, the US Tax Court, in Avrahami v. Commissioner, shed judicial light on the tax treatment of what is known as a “microcaptive” insurance company. More specifically, the Tax Court’s guidance, measuring just over 100 pages, was the first Tax Court opinion to address the deductibility of premiums paid to a microcaptive insurance company. Although the decision resulted in an IRS victory, the Court provided key points to consider for businesses currently utilizing a microcaptive or those considering forming one.
Briefly, a captive insurance company is an insurance company formed by a business owner to cover certain risks of the business. The captive provides business owners an opportunity to cover exposures that might be unavailable or too costly in the commercial market. A “microcaptive” is an insurance company that has made a tax election under Section 831(b) of the Internal Revenue Code to exclude the premiums it receives from its income. Thus, a business owner may deduct premiums paid to its own insurance company and the insurance company can exclude such premium from income. Captive insurance companies continue to grow in popularity, as more states adopt their own captive insurance laws. Captives are also utilized by a majority of Fortune 500 companies as well as many mid-size businesses, providing a mechanism for business owners to capture profits as a result of strong risk management practices.
Notwithstanding the legitimate use of microcaptives (also acknowledged by the Court), the potential for abuse arose, where policies were utilized that would purposefully never pay claims so as to funnel the premiums back to the captive owners, or to a trust for descendants of the business owner (thereby completely avoiding gift, estate and GST tax.) In some cases, the microcaptive’s surplus could be used to purchase life insurance or make loans to related parties. The IRS began investigating these particular arrangements, and the microcaptive subsequently became a “transaction of interest,” requiring Federal (and applicable state) tax filings on an annual basis to disclose certain facts.
In Avrahami, the Tax Court ruled in favor of the IRS where the microcaptive at issue exhibited many of the characteristics the IRS found abusive as set forth in IRS Notice 2016-66. The Court closely scrutinized the entire microcaptive structure, including the insurance policy forms, premium calculations, flow of funds, risk pool structure, as well as the use and investment of captive funds. The Court held the captive did not distribute risk nor issue insurance in the commonly accepted sense. Consequently, the deductions taken for the payment of premiums were denied, resulting in a large tax liability.
Those who utilize a microcaptive should have their structure reviewed by an independent advisor to assess the health of the structure in light of Avrahami. For those considering a captive, Avrahami provides key points that should be considered when deciding whether to form a captive insurance company.
