On August 21, 2017, the United States Tax Court, in Avrahami v. Commissioner, 149 T.C. No. 7 (2017), issued its opinion in the first case involving a captive insurance company electing to be taxed as a small insurance company under section 831(b) of the Internal Revenue Code of 1986, as amended (Code). This election allows the captive insurance company not to be taxed on premiums paid to it, while at the same time permitting the insureds to deduct the amount of those premiums. The Court held that the Taxpayers were not entitled to deduct premiums paid to their captive insurance company because they did not enter into a valid insurance transaction. However, the Court did not impose any accuracy-related penalties on account of the disallowed deduction because the Taxpayers received independent advice and there was a lack of clear authority to guide the Taxpayers.
The Facts: The Taxpayers owned entities that operated jewelry stores and shopping centers (Insureds). One of the Taxpayers established a captive insurance company named Feedback Insurance Company, Ltd. (Feedback), in St. Kitts. The Insureds purchased insurance from Feedback. The Insureds also purchased terrorism coverage from an unrelated insurance company risk pool named Pan American Insurance Company, Ltd. (Pan American), which also provided coverage to other insureds that were not affiliates of the Taxpayers. Pan American, in turn, reinsured a pro-rata share of those risks to the insurance companies that were affiliated with Pan American’s insureds, including Feedback. Feedback’s direct insurance of its related parties was roughly 70% of the total risks and its reinsurance of Pan American (unrelated party insurance) was roughly 30% of Feedback’s total risk. Feedback loaned $2,530,000 (about 65% of its assets) to an entity owned by the Taxpayers’ children; however, neither principal nor interest was due for several years.
Only entities considered “insurance companies” under the Code qualify for section 831(b) small captive treatment. Risk distribution is a necessary element for any company to be treated as an insurance company for Federal income tax purposes. In a 105-page opinion, the Court ultimately found that there was insufficient risk distribution because there were not enough exposure units with which to share risk, looking only at those from the affiliates. In Harper Group v. Commissioner, 979 F.2d 1341 (9th Cir. 1992), the Court found insurance present where there was 29%-33% unrelated business. The Taxpayers argued that the insurance arrangement possessed risk distribution because it had roughly 30% unrelated business through the Pan American pool. The Court ruled that Pan American was not a bona fide insurance company, meaning that there was no unrelated insurance, and, thus, no risk distribution. The Court found that the arrangement looked suspiciously like a circular flow of funds, the premiums were grossly excessive, the policies were not marketable absent tax benefits (exorbitantly high premiums for coverage that has a very low chance of being triggered, combined with a questionable ability to pay), and the pool manager was compensated by a fixed fee rather than a percentage of the premium.
In addition to lack of risk distribution, an arrangement must also be insurance in its commonly accepted sense to be treated as insurance for tax purposes. The Court found that Feedback did not meet this requirement by analyzing five factors:
1) Organized, operated and regulated as an insurance company. The Court found that even though Feedback was organized and regulated as an insurance company in St. Kitts, it was not operated as one. Feedback invested in illiquid, long-terms loans to related parties and failed to timely receive regulatory approval for them. Additionally the loans consisted of 65% of Feedback’s assets, investments that “only an unthinking insurance company would make,” according to the Court. Failure to have claims from Feedback’s 2007 inception until March 2013, two months after the Insureds’ income tax audits commenced, suggested to the Court that Feedback was not operating as an insurance company. The Court also questioned the processing of the claims.
2) Adequate Capitalization. The Court noted that that prior case law implied that meeting the domicile’s minimum capitalization requirements was being adequately capitalized. The Court found Feedback was adequately capitalized.
3) Valid and Binding Policies. The Court questioned the claims-made policies, because it viewed them as having elements of both claims-made and occurrence policies.
4) Reasonable, Arm’s-length Premiums. The Court found that the premium-pricing explanations by the Taxpayer’s actuary were “often incomprehensible” and not persuasive. The amounts of premiums were “utterly unreasonable,” in the words of the Court. The Court recognized that the actuary started with commercial insurance rates, but consistently adjusted them higher by selecting what the Court found to be inappropriate adjustment factors.
5) Payment of Claims. Feedback satisfied this factor, it paid claims, albeit only after the IRS commenced its exam of the Insureds.
The Court concluded that the arrangement was not insurance in the commonly accepted sense because Feedback was not operated like an insurance company, the policies had “unclear and contradictory terms” and the premiums were “wholly unreasonable.”
Despite the concerns the Court found with the arrangement, the Court declined to impose an accuracy-related penalty on the Taxpayers on account of the nondeductibility of the premiums. The Court found that the Taxpayers had reasonable cause to rely on the advice to deduct the premiums (even though the Court found they should not have done so), and acted in good faith in doing so. Taxpayers had consulted an estate planning lawyer who was competent to evaluate the arrangement and knew all the facts and thus the Taxpayers acted in good faith in relying upon the lawyer. Even though the lawyer received part of the start-up fee, he was not a promoter, because he had a prior relationship with the Taxpayers, billed the rest of his work on an hourly basis and did not give unsolicited advice. The Court was sympathetic to the Taxpayers’ position, because it was the first time that the Court had addressed a case involving microcaptives and the interplay of Code sections 162 (premium deduction), 831(b) and 953(d) (election to treat a foreign insurer as domestic corporation).
In the end, the Court found that the arrangement was not insurance for Federal income purposes because it neither possessed “risk distribution” nor was it insurance in its commonly accepted sense. Because it had found the arrangement not to be insurance, the Court did not opine on the other two tests for insurance (risk shifting and insurance risk), nor did it address the Government’s other arguments under the economic substance, substance-over-form, and step-transaction doctrines.
If a taxpayer continues to be involved in an insurance company electing section 831(b) it should ensure that it is entering into transactions for acceptable non-tax business reasons, to shift and distribute insurance risks in an arrangement that is insurance in its commonly accepted sense. Premiums should be reasonable, claims should be filed, investments should be appropriate, policies should be proper, arrangements involving third-party risks should be valid, the captive should be operated as an insurance company, capital should be adequate, etc. – and the taxpayer must be able to prove the existence of these facts to the satisfaction of the IRS or the Courts.
A version of this article first appeared in Captive Review online on August 24, 2017 and in print on August 28, 2017.