About the Avrahamis
In this case, the taxpayers owned jewellery stores and shopping centres. They created a captive insurance company in St. Kitts, from which additional insurance was purchased. They also purchased terrorism insurance from an unrelated insurance company, Pan American, also domiciled in St. Kitts.
The taxpayers’ captive then reinsured risks from other participants in the pool with the taxpayers’ captive in an effort to obtain risk distribution. The taxpayers’ risks accounted for approximately 70 percent of the captive’s total risks, with the reinsured risks accounting for the remaining 30 percent.
A significant portion of the captive’s assets, approximately 65 percent, consisted of loans to a related party entity owned by the taxpayer’s children.
Of particular note is that the children all testified that they had no prior knowledge of their ownership in the entity. Under the terms of the loan agreements, no principal or interest payments were due for a 10-year period. Neither the taxpayers nor the captive manager sought regulatory approval for making these loans.
The IRS’s position was that the premiums paid by the taxpayers to the captive were not deductible, because the arrangements lacked all four criteria necessary to be considered insurance for Federal income tax purposes, specifically:
As the Tax Court agreed with the IRS that the arrangements failed to appropriately distribute risks and that the arrangements failed to respect the commonly accepted notions of insurance, as discussed below, the court deemed it unnecessary to rule on the other two criteria.
The Tax Court determined that the taxpayers’ captive and overall arrangement lacked risk distribution. In reaching this conclusion, it was determined that Pan American did not qualify as an insurance company for Federal income tax purposes for the following reasons:
As Pan American failed to qualify as an insurance company, it was determined that there were no unrelated insureds, and the three or four entities owned by the taxpayers insured by their captive were insufficient to properly distribute risk.
Commonly accepted notions of insurance
The Tax Court also found that the taxpayers’ captive failed to operate as an insurance company. In reaching this conclusion the court found the following factors problematic:
As the taxpayers’ captive lacked risk distribution and was not operated in accordance with the commonly-accepted notions of insurance, the Tax Court ruled in favour of the IRS, denying the taxpayers’ deductions for the premiums paid to the captive.
How should taxpayers proceed now?
Between the Avrahami decision and additional scrutiny of the micro captive strategy by the IRS, many are concerned about their participation/involvement. In the past several months we have been asked many times how those using the micro captive strategy should proceed.
Our consistent response is that, if there is a legitimate, not-tax business reason for utilising the captive, and the captive is properly run, there is no reason to change direction.
We do believe it is prudent to review current captive operations in light of the Tax Court findings in Avrahami. First, the non-tax business reason should be well documented and pressure tested to determine whether it will withstand IRS scrutiny. An example would be taxpayers purchasing insurance from their captive for coverage that is unavailable in the marketplace. In Avrahami, the Tax Court pointed to some duplication of coverages between that purchased in the commercial marketplace and purchased from the captive.
It is also imperative that the regulatory nature of the captive entity be respected. This includes submitting for regulatory approval for changes in the captive’s business plan, certain investments (especially when making loans to related parties), or making distributions to the captive’s owners. It is also important to make sure the captive has sufficient capital and liquidity to be able to address claims as they may come due.
This would also be a good time to review the captive’s premium pricing. A certified actuary should be part of the process in order to ensure that sound, actuarial principles are part of the pricing model. Where applicable, premiums should be consistent with those obtainable in the commercial marketplace. It’s critically important to make sure that premiums are not calculated simply to reach the premium limitation of Section 831(b). If a captive has several years without significant claims activity, this may support a reduction in the pricing. In summary, the pricing should be commensurate with the risk taken on by the captive.
The policies written by captives need to be comparable to those offered by commercial carriers and need to cover real rather than illusory risks.
Avrahami provides a clear reminder that a captive’s processes for handling claims should be documented and followed. If the insureds have losses, they should be submitted to the captive within the timeframe specified in the policies, rather than being borne by the insureds. Late claims or claims otherwise not covered by the policies should not be paid by the captive.
It is also prudent to ensure that the captive has an investment policy statement, which is approved by the regulators and adhered to. The policy should ensure that the investments are conservative enough to provide sufficient liquidity in the event of significant claims.
It’s likely that the IRS will continue its scrutiny of micro captives for the foreseeable future. Nevertheless, the micro captive strategy remains viable, but now more than ever it is important to make sure it’s being done correctly.