Tax Court holds microcaptive insurance company was not a bona fide insurer

Editor: Michael Dell, CPA

In Avrahami, 149 T.C. No. 7 (2017), a case of first impression, the Tax Court held that amounts that the taxpayers’ passthrough business entities paid to a purported insurance company they owned (a captive) were not premiums paid for insurance contracts and were not deductible by the business entities under Sec. 162.

Moreover, the court held that the contracts issued by the captive were not insurance contracts, based in part on its determination that the unrelated offshore company from which the captive accepted pooled terrorism risk was not a bona fide insurance company. Consequently, the court held, the captive was not taxable as an insurance company, and its elections to be taxed as a small (micro) insurance company under Sec. 831(b) and as a domestic corporation under Sec. 953(d) were invalid. The court declined, however, to impose accuracy-related penalties on the Avrahamis, other than with respect to certain unreported distributions made to them by the captive.

Avrahamis’ businesses and captive insurance company

Benyamin and Orna Avrahami owned jewelry stores and other businesses in Arizona, which reported for federal tax purposes as either S corporations or partnerships. In 2006, these entities paid about $150,000 to insure the businesses. In 2007, the Avrahamis’ CPA referred them to a lawyer, Neil Hiller, for estate planning advice. The CPA also suggested that a captive insurance company might be a good fit for the Avrahamis and referred them for this purpose to another lawyer, Celia Clark. Clark had helped draft captive insurance legislation for the Caribbean island nation of St. Kitts and Nevis and had a number of captive insurance clients there, which constituted a large part of her business.

In November 2007, after consulting with Hiller, the Avrahamis signed a retainer agreement with Clark, providing that the Avrahamis would set up a captive insurance company, with Clark and Hiller acting as co-counsel in exchange for a $75,000 fee. To this end, they incorporated Feedback Insurance Co. Ltd. in St. Kitts. Orna Avrahami wholly owned Feedback, and both Avrahamis had signature authority over its bank account. Feedback hired a St. Kitts company to assist with management and compliance with local regulations. In 2008, Feedback made two elections: (1) to be treated as a domestic corporation under Sec. 953(b) for federal tax purposes (an election available only to entities that would be taxed as insurance companies if organized in the United States); and (2) to be taxed as a small insurance company under Sec. 831(b).

Captive insurance payments and reinsurance

The Avrahamis’ businesses began purchasing various types of insurance coverage from Feedback in 2007. Also in 2007, the Avrahamis’ businesses purchased terrorism coverage from an unrelated Nevis corporation, Pan American Reinsurance Co. Ltd. (Pan Am Re) established by Clark to form a pool encompassing risks of multiple clients that could be reinsured by her clients’ captives to provide the captives with risks sourced from unrelated insureds. Feedback entered a quota share reinsurance arrangement with Pan Am Re and accepted a portion of the pooled risk proportionate to the portion of the pool’s risk attributable to the Avrahamis’ entities insured by Pan Am Re. The reinsurance premium paid to Feedback equaled the insurance premiums paid to Pan Am Re by the Avrahamis’ businesses.

The Avrahamis’ businesses continued to pay premiums to Feedback and to Pan Am Re in 2009 and 2010, the years at issue, and during those years Feedback continued to reinsure risk from Pan Am Re for a reinsurance premium equal to the premiums paid by the Avrahamis’ businesses to it. The total cost of insurance deducted by the Avrahamis’ businesses increased from $150,000 in 2006 to $1.1 million in 2009 and $1.3 million in 2010. No claims were filed with Feedback or Pan Am Re by the Avrahamis’ businesses until after the IRS mentioned Feedback’s failure to pay claims in a notice of proposed adjustment sent in 2013.

The court discussed in some detail the nature and terms of the Feedback and Pan Am Re policies and how they differed from any available from unrelated commercial insurers, as well as how the pricing for the policies was determined. The court found that the methods used by the actuary engaged by Clark to price the policies produced unreasonable premiums; among other things, the actuary consistently applied factors designed to produce higher premiums and ignored factors that would reduce premiums. Clark communicated a “target” amount for direct premiums to be paid to Feedback, and the actuary made final adjustments to the proposed premiums to approximate the target. The terrorism insurance and reinsurance premium amounts of $360,000 were chosen to ensure that 30% of Feedback’s total premiums could be attributed to insurance of unrelated risks, in an attempt to satisfy court precedent with respect to the adequate distribution of risk.

Flow of funds back to the Avrahamis

The Avrahamis set up an LLC named Belly Button Center in 2007. Although the Avrahamis’ three adult children owned the LLC, they testified at trial that they were unaware of its existence. Benyamin Avrahami acted as Belly Button’s manager and effected all of its transactions. Belly Button purchased real estate for $1.96 million, using $1.2 million in cash lent by Benyamin Avrahami and issuing a note for the balance to the seller. Belly Button issued an unsecured note to Benyamin Avrahami in exchange for the loan. In 2008, Feedback transferred $830,000 to Belly Button in exchange for a note due in 10 years and accruing compound interest at the rate of 4.3%. The same day, Benyamin Avrahami, acting as the manager of Belly Button, withdrew the funds advanced by Feedback, allegedly to settle the note to the sellers.

In 2010, Feedback transferred an additional $1.5 million to Belly Button in exchange for an unsecured note due in 10 years and accruing simple interest at the annual rate of 4%. Two days later, the Avrahamis transferred the $1.5 million from Belly Button’s account into their personal bank account. Later the same year, an additional $200,000 was transferred from Feedback directly to Orna Avrahami’s account; Benyamin Avrahami documented the transfer as a real estate loan to Belly Button. These transfers from Feedback meant that, by the end of 2010, more than 65% of its total assets consisted of long-term, illiquid, and partially unsecured loans to related parties (approval for which had not been sought or obtained from the Nevis regulator as required). Perhaps due to its expected illiquidity, Feedback’s policies permitted it in certain circumstances to pay claims by issuing notes to claimants.

Tax returns and audit

Feedback timely filed its 2009 and 2010 tax returns, indicating on the returns its elections under Secs. 953(d) and 831(b). In accordance with the Sec. 831(b) election, Feedback paid income tax only on its investment income, not the premiums it received. The Avrahamis also filed timely returns, and their taxable income reflected the effect of the deductions by their businesses of the premiums paid to Feedback and to Pan Am Re; the $200,000 paid to Orna Avrahami was not included in taxable income.

The IRS sent Feedback a notice of deficiency, challenging its status as an insurance company, its elections under Secs. 831(b) and 953(d), and its exclusion from taxable income of the amounts paid it by the Avrahamis’ businesses. The IRS also issued a notice of deficiency to the Avrahamis, adjusting their taxable income by eliminating the deductions claimed by their businesses for the premiums paid to Feedback and Pan Am Re and by characterizing the $1.5 million and $200,000 transfers from Feedback that ended up with the Avrahamis as ordinary income to them. The IRS also asserted understatement and accuracy-related penalties against the Avrahamis.

Opinion

The Tax Court’s opinion first summarized the history and operation of Sec. 831(b) and the case law applicable to captive insurance arrangements. Regarding the intersection of these two areas of tax law, the court noted that the IRS has been applying increased scrutiny to microcaptive insurance companies like the one established by the Avrahamis and that the IRS had added such transactions to its “dirty dozen” list of tax scams in 2015 and declared them a “transaction of interest” in 2016 in Notice 2016-66. The court added, however, that this was the first such Sec. 831(b) case to make it to trial.

In its discussion of captive insurance case law, the Tax Court broke no new ground. It noted that, to be considered insurance, the arrangement must (1) involve risk shifting; (2) involve risk distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance. The taxpayers argued that risk distribution was achieved because (1) Feedback issued seven types of policies covering a variety of risks to four Avrahami businesses; and (2) Feedback derived approximately 30% of its premium revenue from third-party risk.

In response, the Tax Court acknowledged that in previous decisions, it had held that the captive distributed risk when it (1) insured only its sister entities, but only after finding that the captive was formed for legitimate business reasons and was insuring a sufficient amount of statistically unrelated risk; and (2) derived as little as 30% of its premiums from risks originating with unrelated insureds, but only after determining the captive conducted a bona fide insurance business, charged arm’s-length premiums, and was financially capable of satisfying claims.

The court noted that the government’s expert testified that a captive insurer must insure a minimum of 35 sibling entities to get risk distribution, while the Avrahamis’ expert testified that having 12 entities was adequate. Because Feedback insured only three or four entities, it failed to adequately distribute risk under either expert’s proposed standard, thus allowing the court to conclude that it did not need to resolve the question of how many insured entities is sufficient.

The court emphasized that risk distribution does not depend just on the number of entities insured; it is “even more important to figure out the number of independent risk exposures.” The court noted that the Avrahamis’ policies covered three stores and about 35 employees — whereas cases in which the court has found adequate risk distribution have involved coverage for thousands of employees or properties in numerous jurisdictions.

The Avrahamis argued that Feedback distributed risk by participating in the Pan Am Re pooling program, thereby reinsuring third-party risk, which accounted for 30% of Feedback’s annual premiums. The Avrahamis claimed the Tax Court had previously in Harper Group, 96 T.C. 45 (1991), established a rule that adequate risk distribution existed when at least 29% of the captive’s premium revenue was from unrelated parties. The court found this to be too narrow an interpretation of its decisions in Harper Group and similar cases, and a proper interpretation would require Pan Am Re first to be a bona fide insurance company before it could transfer third-party risk to Feedback.

The court concluded that Pan Am Re was not a bona fide insurance company for various reasons, including the circular flow of funds, the unreasonable premiums, and the lack of arm’s-length contracts. Because Pan Am Re was not a bona fide insurance company, the court held, it did not transfer insurance risk to Feedback, and Feedback therefore lacked risk distribution.

As an alternative ground for sustaining the disallowance of the insurance premiums and the Sec. 831(b) election, the court further concluded that Feedback failed to meet the criterion of offering insurance in the commonly accepted sense. In this respect, the court noted that Feedback did not receive or pay claims (until after it was aware the IRS was examining it); it paid submitted claims that arguably were not valid; it invested primarily in illiquid loans to related parties and did not seek regulatory approval before transferring funds to these related parties; it charged unreasonable premiums; and it could issue notes to pay claims.

The court did not address the other two criteria required for insurance (i.e., risk shifting and insurance risk), because it had already determined that Feedback did not issue insurance contracts and was not taxable as an insurance company because it failed to (1) distribute risk and (2) sell insurance in the commonly accepted sense. Each failure provided independent grounds to disqualify the transactions with Feedback as insurance for federal tax purposes.

As a result of its determination that Pan Am Re was not a bona fide insurer, that the contracts issued by Feedback did not constitute insurance, and that Feedback was not taxable as an insurance company, the court held that the Avrahami entities could not deduct the premiums paid to Feedback and to Pan Am Re, resulting in increases in the Avrahamis’ taxable income through their ownership interests in these passthrough entities, and that Feedback could not make the elections under Secs. 831(b) and 953(d).

The Avrahamis acknowledged that they should have reported the $200,000 as taxable income and only argued that it should be taxed at the preferential rates afforded to “qualified dividend income.” Having held that Feedback’s election under Sec. 953(d) was invalid, the Tax Court further concluded that the $200,000 dividend from the company was taxable at ordinary income rates because Feedback was not a domestic corporation or a qualified foreign corporation and thus the dividend was not a qualified dividend. The court found that the $1.2 million loan from Benyamin Avrahami to Belly Button was bona fide, as was, generally, the subsequent $1.5 million loan from Feedback to Belly Button. Although $1.2 million of the amount transferred from Belly Button to Benyamin Avrahami was repayment of the loan, the court concluded that the Avrahamis should have treated the $300,000 in additional funds transferred to them partly as taxable interest and partly as taxable distributions.

Penalties

Regarding the IRS’s assertion of penalties, the court found that the Avrahamis’ underpayments were “substantial” under Sec. 6662(a). The court considered, however, whether the Avrahamis acted with reasonable cause and in good faith. In this respect, the court stated that the Avrahamis could not have relied on Clark, who the court concluded was a “promoter” of the disputed transaction, reasonably and in good faith.

The testimony of other long-serving advisers allowed the court to conclude that the Avrahamis reasonably relied on the lawyer Hiller’s professional advice with respect to the deductibility of the premiums paid to Feedback. Moreover, given the lack of existing law (as this is a case of first impression), the court was willing to conclude that the Avrahamis relied on that advice in good faith. Nonetheless, the court determined that accuracy-related penalties did apply solely to the $200,000 distribution to Orna Avrahami from Feedback and the excess $300,000 loan repayment.

Implications

In general, this case provides additional support for the argument that the existence of risk distribution may be found by considering the number of statistically independent risk exposures, which does not depend on the number of entities insured. This is the fourth case to make that point, and the IRS refrained from appealing previous losses in that area. The question of when the IRS will make Rev. Rul. 2005-40 (which focuses on the number of entities) obsolete remains unanswered.

The court dismissed the notion that transactions that merely provide significant amounts of third-party premiums to a captive automatically create risk distribution. As noted, providing risk distribution to a captive through a reinsurance pooling arrangement must involve the participation of a fronting company that is a bona fide insurer accepting insurance risk from third parties and actually transferring some of that third-party insurance risk to the captive. This did not happen inAvrahami.

In this case, the court made it clear that, for a captive, especially a microcaptive, to be respected as an insurance company, it is absolutely critical that its functions be consistent with commercial practice, that premiums be fairly priced, that the insureds and the insurer deal with each other at arm’s length, that claims be timely filed and properly reviewed and approved, and that regulatory requirements be observed.

The Avrahamis escaped the bulk of the Sec. 6662 substantial-understatement penalties asserted by the IRS because the court found they placed “good faith” reliance on Hiller’s advice. As the court noted, the IRS designated the microcaptive transactions described in Notice 2016-66 as reportable transactions of interest. As such, in the future the IRS may seek to assert a Sec. 6662A reportable transaction understatement penalty on what it perceives to be abusive microcaptive arrangements. Taxpayers will not be able to claim good-faith reliance on disqualified tax advisers to avoid Sec. 6662A penalties. For individuals, a disqualified tax adviser includes any adviser who was paid a fee of $10,000 or more and participated in the organization, management, promotion, or sale of the microcaptive transaction.

Taxpayers that own a captive or insure with an affiliated insurance company that has elected to be taxed under Sec. 831(b) should review the operations of the captive and their transactions with it to ascertain the differences from and similarities to this case. The findings of the Tax Court regarding the operation of, and transactions with, the captive that persuaded it to hold in favor of the IRS apply not only in the microcaptive context but could present a problem even when using a captive that has not made an election under Sec. 831(b). Taxpayers whose arrangements present facts similar to this should consider consulting an adviser.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.