The aftermath

In August, the US Tax Court released its decision in the Avrahami case. The ruling marked the first case, which involved a captive that had made the election to be taxed solely on investment income under Section 831(b), also referred to as the micro captive strategy. For the reasons discussed below, the Tax Court ruled in favour of the Internal Revenue Service (IRS).

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:

  • The policies covered risks not considered to be insurance risks

  • The overall arrangement lacked the requisite distribution of risk

  • The arrangement failed to shift risks from the insureds due to the pricing of the underlying risks

  • The arrangements failed to follow the commonly-accepted notions of insurance

  • 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.

    Risk distribution

    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:

  • Pan American’s flow of funds was viewed as circular without any economic substance (a point disputed by the industry)

  • The premium pricing was unacceptably excessive for the risks being insured

  • It was questioned whether Pan American had the ability to pay claims

  • The compensation mechanism for Pan American did not follow the industry standard

  • The risks being insured were speculative at best, covering terrorism events in cities with populations of less than 1.5 million—had the taxpayers tried to submit a claim it would have been denied as they lived in Phoenix, which has a population well in excess of 1.5 million

  • 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:

  • 65 percent of the captive’s assets were in the form of illiquid investments that “only an unthinking insurance company would make”. The loans made to the related party entities called for neither interest nor principal payments for 10 years after entering into the loans

  • No approval was sought from the Department of Insurance for the aforementioned loans

  • The actuary’s explanations of the premium pricing structure were “often incomprehensible” and resulted in premiums that were “utterly unreasonable”

  • The taxpayers made no claims until the IRS examination began

  • Once claims were made, there was insufficient enforcement of policy terms (for example, claims were approved on 15 April 2013 for policies that expired on 15 December 2012)

  • 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.
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