In the past two years, the IRS has continued its oversight of the use and tax implications of captive insurance companies which make a “small captive” election pursuant to 26 U.S.C. §831(b). This election allows qualified captives to accept up to $2.2M in annual premiums free from federal income tax, instead only paying taxes on their investment income. Such “small captives” have come under IRS inquiry due to their rapid expansion and potential for tax-sheltering abuse.

Recently, the U.S. Tax Court recently decided Avrahami v. Commissioner, 149 T.C. No. 7 (2017). This matter came before the Tax Court after the IRS determined that two taxpayers, Benyamin and Orna Avrahami, could not deduct the premiums paid to a captive insurance company which provided them with terrorism insurance on their jewelry stores in Arizona. Following that decision, the Avrahamis brought suit in the tax court in order to have these premiums declared as deductions.

The Case

The IRS defended its decision and based its response on an analysis of both the formation and function of the captive. The IRS claimed that during the formation of the captive, the taxpayers made no effort to obtain terrorism insurance from the commercial market, demonstrated no concerns about their growing insurance cost (which had increased sixteen (16) times from what they had paid previously), never intended to replace their commercial coverage through the captive, and never requested a feasibility study, loss forecast, or actuarial study to determine the financial viability of the coverage. The IRS identified these factors as indicating that the captive was formed with the purpose of creating a tax shelter, not providing insurance.

Furthermore, the IRS claimed that the operation of the captive was irregular. According to the IRS, the captive never held board meetings, never prepared financial statements, did not have employees or contracts with any experienced insurance professionals, had no formal claim process, and was never appropriately capitalized. Critically, it was the absence of risk distribution or the shifting of risk from the taxpayers to the captive which was deemed fatal in the IRS’ analysis of the validity of the captive. Finally, the IRS contended that the premium funds flowed directly from the taxpayers to the captive and were returned to the taxpayers after intermediary steps. The flow of funds thus was more akin to a loan back then payment of a legitimate business expense. The IRS, therefore, concluded that these loans contained no profit potential and no business purpose other than tax avoidance.

The Decision

In a 105-page decision, Judge Holmes of the U.S. Tax Court provided a detailed and thorough analysis, addressing the various intricacies of the arguments presented by both sides. He held, in a fact-intensive analysis, that the captive’s structure failed to meet the appropriate definition of “insurance” for federal tax purposes. Such a conclusion is typically based on an analysis of four factors of a purported insurer’s business: risk shifting, risk distribution, the existence of insurance risk, and a determination whether the business meets the commonly accepted practices of the insurance business. The Court, however, limited its analysis to the captive’s risk distribution and whether its business met the commonly accepted practices of the insurance business. The captive failed both prongs of this analysis

First, the Court held that, even though captives may be small and limited in scope, they still must have a large enough pool of unrelated risks to have an adequate risk distribution. Experts relied upon by both sides varied in their evaluations of how many affiliated policyholders would be sufficient to meet this burden, the number ranging from twelve (12) to thirty-five (35). However, the captive in the instant case only insured risks for three (3) to four (4) affiliated entities, causing the Court to hold that it failed to adequately distribute risk. The Court’s decision was substantially premised upon the lack of a sufficient number of independent risk exposures, leading to the conclusion that the amount of independent risks is more important than the number of affiliated entities placing coverage through the captive. The captive in question only offered seven (7) types of direct policies, of which only eleven (11) total policies were issued.

While the Court indicated that the failure to distribute risk was enough to defeat the captive’s claim, it chose to further consider whether or not the business of the captive, and its relationship to its affiliate, functioned like traditional insurance in the commonly accepted sense. While a variety of factors contribute to such an analysis, the Court considered five (5): Operation, Capitalization, Validity of the Policies, Reasonableness of Premiums, and Payment of Claims. In particular, the Court indicated that the captive’s Operation dealt with claims on an “ad hoc” basis and only invested in illiquid, long-term loans, its Policies were filled with “unclear and contradictory” terminology, and the Premiums it charged were calculated to justify high premiums as opposed to support sound actuarial decisions. Accordingly, the captive failed this analysis as well.

The Bottom Line

Though the decision in Avrahami still left two factors (“Risk Shifting” and “Insurance Risk”) undiscussed, it provided a wealth of information which captives may use to review their business and establish more comprehensive best practices. In particular, appropriate risk distribution and actuarial decision making throughout all phases of a captive’s operation would support an organization’s ability to take valid tax deductions for premiums paid to its affiliated captive insurer.