They’re more like guidelines anyway

Few disputes will garner the kind of attention that Avrahami v the Internal Revenue Service (IRS) has over the past few weeks. Put forward as a potential Holy Grail that will allow small captives to forever endure, the US Tax Court’s ruling in favour of the IRS has somewhat soured the industry’s mood, although, as it will become clear, a healthy dose of realism might have been necessary, anyway.

In reaction to the Tax Court’s 21 August decision to block Benyamin and Orna Avrahami’s captive, Feedback, from electing 831(b) of the Internal Revenue Code for certain financial years, Jeffrey Simpson, director at the Delaware law firm of Gordon, Fournaris & Mammarella, suggested that although the captive insurance industry did not get the win it was hoping for, “this is an important first step toward the industry’s getting the guidance it needs to move forward constructively”.

Simpson said: “It doesn’t address all of the pieces of the puzzle, and I don’t think anyone imagined it would, but it does give us something concrete to work with.”

According to Simpson, the decision is “unequivocally good news” for the industry because it helps to see where the lines will be drawn.

Simpson said: “The resulting clarity is good for us all. Unfortunately, some operators who may have thought they were doing the right things are learning that they may have to change their ways or exit the industry. But there are many operators who can comfortably say the structures they work on have very few facts in common with the negative facts spotlighted by the court.”

“In any event, I am looking forward to seeing the industry use this case to refine its practices and advance the dialogue with the IRS as we seek more complete guidance regarding micro captives.”

Charles Lavelle, senior partner and member of the tax and employee benefits department at Bingham Greenebaum Doll, suggested that this opinion should “incentivise those involved in captive insurance arrangements to assure that the premiums are appropriately computed, and that the policies are properly drafted”.

Lavelle added: “The pooling mechanism must also be valid. Conducting insurance operations in the same manner as commercial companies will assist taxpayers in satisfying the court’s tax tests.”

The Avrahamis argued that their captive, Feedback, is a valid insurance company that qualified to be elected under Section 831(b), all of its policies covered insurable risks, and premiums were actuarially determined, and the captive distributed risk.

Feedback’s risk exposures fell short of meeting the threshold for insurable risk, according to Judge Mark Holmes. He ruled: “While we recognise that Feedback is a micro captive and must operate on a smaller scale than [other insurance companies the Tax Court has examined], we can’t find that it covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities.”

In particular, Judge Holmes held that the pooling entity, Pan American Reinsurance Company, used in 2009 and 2010, was not a bona fide insurance company, and that the captive did not operate like an insurance company because it issued policies with unclear and contradictory terms, and charged wholly unreasonable premiums.

Stewart Feldman, CEO and general counsel of Capstone Associated Services weighed in, noting that the terrorism policy was the sole pooled policy and was excessively priced under any reasonable measure.

Feldman explained: “There was insufficient risk distribution under what most tax practitioners consider existing law and there was essentially no pooling or other third-party insurance so as to achieve risk distribution.”

“The taxpayer’s actuary himself admitted that the risks covered by the sole pooled policy were never experienced in the long history of the world. The policies were poorly manuscripted. The actuary couldn’t articulate the basis of the policies’ pricing and the lawyer directed the actuary to arrive at a dollar specific premium desired by the client. It appears there was no shortage of inadequacies.”

Although Judge Holmes ruled that the pooling entity was not a bona fide insurance company, Simpson stated: “This definitely does not spell the end of risk pools.”

Simpson expects those who currently use risk pools to take what they can from this case, even though the features of the pooling facility used in Avrahami are not present in many other pool designs.

Simpson added: “Perhaps more importantly, the court’s analysis seemed to focus more on how the coverages were priced. In my view, pricing is independent of pool design, and pricing is the real concern. I anticipate seeing continued use of pools but with much more focus on process and documentation in pricing.”

As part of the ruling, the Tax Court imposed penalties on the Avrahamis based on amounts related to distributions from Feedback that the taxpayers classified as loans, but that the IRS reclassified as dividends or interest.

However, Judge Holmes didn’t impose penalties on the taxpayers for improperly deducted captive insurance premiums that were paid to Feedback. Instead, Judge Holmes found that the Avrahamis “acted with reasonable cause and in good faith” because they relied on the professional advice of Craig McEntee, a certified public accountant, Neil Hiller, a lawyer who practices in estate planning, employee benefits and tax, and Celia Clark, who practices in the areas of taxation and estate planning.

Jay Adkisson, partner at Riser Adkisson, described the opinion of Judge Holmes as the “predictable conclusion to a bad set of facts”.

Adkisson said: “The Avrahamis got the idea and started their captive through tax professionals, and were much more interested in generating a deduction than obtaining insurance at affordable rates. Their captive manager apparently made little or no effort to conform insurance coverages with the Avrahamis existing policies, and the actuary came up with premium numbers that were not only not in the ballpark, but not in the same time zone.”

The risk pool in which the Avrahamis participated was little more than a “glorified account through which money passed”, according to Adkisson. Put all these ingredients together and the result is a “predictable disaster”.

However, Adkisson did praise Judge Holmes, crediting him for giving “substantial guidance” to other captive practitioners as to what to do, and, more importantly, what not to do.

“Unfortunately, fact patterns like those of the Avrahamis are probably all too common, and we will likely see more opinions like this,” Adkisson explained.

Tax attorney Tim Tarter of Woolston & Tarter, which represented the Avrahamis, said: “The Avrahamis are very disappointed with the US Tax Court’s disallowance of their claimed deductions for captive insurance premiums, but appreciate that the court did not find their captive was a sham nor did the court determine that they were negligent in claiming the deductions at issue. The taxpayers are currently considering their options going forward.”

The ruling comes as the IRS has increased its scrutiny and audits of micro captives in the belief that small businesses are using them to insure against improbable risks that they never pay claims on, and the surplus returns to the business owners or heirs with little to no tax.

The IRS escalated that scrutiny last year with the release of Notice 2016-66, which formally labelled micro captives as ‘transactions of interest’ and required them to report to the federal agency by 1 May 2017 due to their potential for tax avoidance or evasion.

The Avrahami opinion will “likely encourage” the IRS to continue its audit programme for small captive insurance companies, according to Lavelle, although Feldman argued that the US Tax Court’s ruling might not be the victory that everyone thinks it is.

The IRS might have difficulty applying the Avrahami facts to the usual captive situation, he said, concluding: “Bad facts make bad law. If a captive is operated as the personal chequebook of its owner, no one should be surprised that the captive is disregarded.”

Avrahami: The Facts

  • Feedback insured the Avrahamis’ Arizona jewellery stores and shopping centres against chemical and biological terrorist attacks

  • But the IRS believed that the micro captive was organised to provide tax deductions under Section 831(b) of the Internal Revenue Code and lacked insurance risk, and that risk was not shifted to the captive

  • There were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis and their various entities’ returns

  • Feedback accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which was transferred back to the Avrahamis, as loans and loan repayments, or as distributions

  • Judge Holmes agreed with the IRS in his 105-page opinion, finding that certain amounts paid by Feedback were not insurance premiums for federal income tax purposes

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