HIGHLIGHTS:

  • The U.S. Tax Court recently ruled in Avrahami v. Commissioner, the first litigated Tax Court case involving an 831(b) captive insurance company.
  • The Tax Court held that two of the key factors that define "insurance" for federal income tax purposes – risk distribution and meeting commonly accepted notions of insurance – were not satisfied. Therefore, the risk purported to be insured was deemed not to be insurance.
  • On its face, the long-awaited Tax Court opinion was a victory for the IRS, although the Court seemed, at least implicitly, to approve of the use of risk pools. But taxpayers and their advisors should review a few key action items in regards to their captive insurance arrangements.

The U.S. Tax Court recently ruled in Avrahami v. Commissioner, the first litigated Tax Court case involving a captive insurance company under Section 831(b) of the Internal Revenue Code (IRC). On its face, the long-awaited Tax Court opinion was a victory for the IRS, stating that the arrangement at issue did not involve "insurance" for federal income tax purposes and therefore denying any income tax deduction for the insured business in connection with its payment of insurance premiums to the "micro captive" insurance company.

For federal income tax purposes, "insurance" is defined by the following four factors: 1) risk shifting,2) risk distribution,3) insurance risk and 4) meeting commonlyacceptednotions of insurance. The Tax Court held that the second and fourth factors – risk distribution (essentially, the law of large numbers as it relates to insurance risk, where the insurer does not have all of its "eggs," i.e., risk, in one basket) and the commonly accepted notions of insurance, respectively – were not satisfied. Therefore, the risk purported to be insured was deemed not to be insurance.

The Court determined that risk distribution was not satisfied since the number of insureds (primarily brother-sister companies owned by a common parent) was not sufficient to satisfy the concept of risk distribution. In addition, the Court also held that risk distribution in this case was not satisfied through a so-called "pooling arrangement," since the funds that were used to fund the premiums ended up, eventually, being loaned back to the owners of the parent company/insured (i.e., the taxpayers, through a "circular flow of funds"), and because the premiums paid for the insurance that was pooled were deemed to be unreasonable. A pooling arrangement is designed to allow an insurance company that does not have sufficient third-party premium/risk on its own to "share" risk with other insurance companies and therefore distribute its risk among sufficient third parties.

Although it could have stopped there, the Tax Court decided to go further by determining that the commonly accepted notion of insurance was not present. In explaining this part of its holding, the Court determined that the captive insurance company did not operate like a typical insurance company, since, among other things, no claims were made for many years (at least, not until after the IRS audited the taxpayer and related entities), the claims adjudication process was very informal, the terms of the insurance policies were unclear and the insurance company invested – almost immediately – all of its funds in a highly illiquid investment (e.g., a loan to the taxpayers). In addition, the Court also took the taxpayers' actuary to task, finding him at times to be "incomprehensible" and finding his premium calculations "utterly unreasonable."

Takeaways 

Although the Avrahami case was a clear "win" for the IRS, all is not lost for captive insurance companies. First and foremost, there were a host of "bad facts" as described above that, taken together, made the Court's decision rather easy. Second, the Court seemed, at least implicitly, to approve of the use of risk pools, since in its discussion of risk pooling arrangements, the Court could have determined that risk pools are not suitable for achieving risk distribution but instead went to great lengths to explain why in this particular case the pooling arrangement did not work. If risk pools were per se prohibited, the Court could very well have said so, but it didn't.

Action Items

  • Taxpayers and their advisors should: 1) ensure that the risks to be covered are risks to which the insured business are proper risks for coverage and 2) review all insurance policy language to make sure it is clear and unambiguous.
  • Taxpayers and their advisors should review the risk distribution model of their current arrangement to make sure there is adequate third-party risk.
  • Taxpayers and their advisors should ensure that there is a clear and respected claims procedure, and also that claims are made and – if legitimate – approved on a timely basis.
  • Lastly, taxpayers and their advisors should review their actuarial analyses to make absolutely certain that the methodology is sound.

It is likely that more IRC 831(b) Tax Court cases will be determined in the next few months. Holland & Knight will keep you apprised of key developments.