On 21 August, the U.S. Tax Court issued its long-awaited decision on the 831(b) Captive Insurance Case: Avrahami v Commissioner.
In Avrahami v. Commissioner, 149 TC No. 7 (Aug. 21, 2017), the Tax Court disallowed Benyamin and Orna Avrahami's insurance premium deductions for amounts paid to a purported captive insurance company (captive). The Phoenix-based businessman and his wife owned a jewelry business and some real estate holding companies. The IRS found that the entity they claimed was their captive insurance company did not meet the stated requirements and was not an insurance company for 831(b) purposes. The Tax Court also held the couple liable for taxes on unreported interest and dividends and for some accuracy-related penalties.
A Summary of the Case
Avrahami's case contains extremely egregious facts surrounding the taxpayer's captive arrangement for his jewelry store business in Arizona. The captive in question used a pooling arrangement (pool) whereby only one type of insurance (terrorism policies) was in the pool. The court ruled that the pool did not meet proper risk distribution. Further damaging facts in the case include these:
- The pool never paid claims until it had been audited.
- The captive and the pool loaned back most of the funds to the taxpayer for other, unrelated real estate investments.
- The insurance premiums were unreasonable and unsubstantiated.
- The entire arrangement lacked documentation and the actuary (who analyzed the statistics of the arrangement to calculate insurance risks and potential premiums) could not substantiate why his premium amount was so coincidentally close to the (then) statutory premium limit of $1.2 million.
The Court's Decision
The court's decision is based on this taxpayer’s specific scenario, yet it is significant because it give the IRS continued precedence to challenge 831(b) arrangements.
Captive Insurance Considerations
This case does not address other captive issues currently under debate, but rather it focuses only on risk distribution in an insurance pool structure. However, it is critical that our clients and colleagues using small captive insurance companies that participate in pooling arrangements have discussions with their captive managers in order to review what steps to take to mitigate the potential effects of this case on their own companies and interests.
Having consulted a captive insurance manager who uses a pooling arrangement, it is important to note that the results of the Avrahami case should cause taxpayers to clearly review these facts when evaluating their own pooling arrangements:
- Pools should contain many different policies representing many different risks. Avrahami contained only terrorism insurance in its pools.
- Pools should contain many different entities from different geographic locations and lines of business. Avrahami’s did not.
- Policies should be well documented with actuarial evidence to support them. Avrahami had very sloppy policies and poor actuarial support.
- There should be no "target premiums," in which a premium is strategically planned in order to achieve statutory limits. This, coupled with poor actuarial support, caused all the premiums in the Avrahami case to be disallowed.
- Pools should have sufficient assets to pay claims and correspondingly, must actually pay those claims. Being in a pool actually causes higher captive costs for the insured; however, the cost of paying claims and sharing risk in the pool are strong support for insurance operations. The pool in the Avrahami case did not pay claims until the IRS audit and it offered no assets to pay claims because the money was lent back to the taxpayers in circular loans for personal investments.
- Using contract pools, where all the other participating captives reinsure the pool, is another strong fact for risk distribution. This method has been upheld in previous case law and private letter rulings. These were not the facts in the Avrahami case.
If you have questions about captive insurance companies or how the Avrahami case could impact your company, please feel free to contact Nick Demetrios at email@example.com or call 330-758-8613.