Authored by Carrie Small
In the first section 831(b) case to make it to trial, the U.S. Tax Court backed the Internal Revenue Service (IRS) by holding that a micro-captive’s elections under section 831(b) to be treated as a small insurance company and section 953(d) to be taxed as a domestic corporation were invalid. The Court also ruled that amounts paid to the captive insurance company did not qualify as insurance premiums for federal income tax purposes and therefore were not deductible under section 162.
The Court held that the micro-captive and risk-pooling arrangement did not meet the definition of insurance and thereby could not be respected as such.
The petitioners in Avrahami v. Commissioner, 149 T.C. No. 7, Benyamin and Orna Avrahami, owned three shopping centers and three jewelry stores. In 2007, they formed a captive insurance company, Feedback Insurance Company, Ltd. (Feedback), to insure certain risks of their business ventures, including business income, employee fidelity, litigation expense, loss of key employee and tax indemnity coverages. Despite the formation of the captive insurance company, each of the entities owned by the Avrahamis continued to buy insurance from third-party commercial carriers and made no change to the coverage under those policies even after purchasing additional insurance from Feedback. In addition to the coverages provided to the Avrahamis, in 2009 and 2010, Feedback started participating in a risk-distribution pool through Pan American Reinsurance Company, Ltd. to reinsure terrorism insurance for other small captive insurers.
In 2007, prior to the formation of Feedback, approximately $150,000 was spent insuring the businesses. In 2009 and 2010, the insurance premiums increased to approximately $1.1 million and $1.3 million, respectively. From Feedback’s inception in 2007 to the end of 2010, Feedback had received premiums totaling almost $3.9 million, but had paid no claims.
The IRS took the position that Feedback was not providing insurance, thereby the premiums paid to the captive insurance company would not be deductible as ordinary and necessary business expenses. The Commissioner argued that several of the micro-captive’s policies included uninsurable risks, and there was not adequate risk distribution due to an insufficient pool of insureds. The Commissioner also held that risk was not shifted as neither Feedback nor Pan American was financially capable of meeting its obligations. Lastly, the arrangements did not embody common notions of insurance because Feedback and Pan American did not operate like insurance companies and their premiums were not determined at arm’s length.
Judge Mark Holmes confirmed that amounts paid to Feedback and Pan American are not deductible under section 162 and Feedback’s section 831(b) and section 953(d) elections are invalid for 2009 and 2010.
What does this mean for your captive?
While the negative facts highlighted by the Court are specific to this case in and of itself, it still serves as an important reminder for taxpayers to revisit the structures of their micro-captives. The IRS has applied increased scrutiny to micro-captives in recent years, most recently listing them as a transaction of interest in 2016. The concern is that micro-captives are being formed to create a deduction for the related-party owner for the insurance premiums paid, while the micro-captive only pays tax on its investment income under section 831(b). The micro-captive then builds up a surplus from the annual premium income while paying few, if any, claims.
Criteria and factors to revisit
In light of the Tax Court’s ruling, taxpayers should revisit micro-captive arrangements to ensure the criteria to meet the definition of an insurance company are met, meaning the arrangement:
- Involves risk shifting
- Involves risk distribution
- Involves insurance risk
- Meets commonly accepted notions of insurance
Other factors to consider include:
- Is the company organized, operated and regulated as an insurance company?
- Is the insurer adequately capitalized?
- Are policies valid and binding?
- Are premiums reasonable and the result of an arm’s-length transaction?
- Are claims paid?
The micro-captive should operate as a separate risk-bearing enterprise and function no differently than a third-party insurer.
Specific areas to be aware of
The Court also noted that the taxpayer went to great lengths to target the collective premiums to be near the $1.2 million limit for micro-captive insurance companies. Taxpayers should expect the IRS to utilize specific concerns addressed by the Court in reviewing premiums in this case when reviewing other captive arrangements. These concerns include the determination of pricing, the presence of actuarial support that represents the current market and the validity of actuarial assumptions used as compared to those used by other actuaries.
Also, taxpayers involved in a risk-pooling arrangement should ensure the fronting company has a valid business purpose, operates as an insurance company and is not formed merely as a mechanism to meet risk-distribution requirements.
We recommend organizations contact their tax and captive advisor to review their specific situation for potential issues. For more information on this ruling and its implications for your situation, contact Baker Tilly’s specialized in-house captive and actuarial team.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.