Jonathan W. Benowitz, CPA
Loyola University Chicago School of Law, JD 2019
Captive insurance companies, insurance companies owned by persons related to the insureds, have long served as an important risk management tool for businesses as varied as Sears and The New York Times. In recent years, there has been an explosion of “micro-captive” insurance companies, companies with premiums that do not exceed $1.2 million in a year. Until 2017, $1.2 million was the allowable maximum amount of premiums for an insurance company to elect favorable tax treatment under I.R.C. § 831(b), allowing the small insurance company to be taxed only on its investment income. The IRS believes that these “831(b)” micro-captives are often used as tax-shelters rather than for legitimate business purposes.
Micro-captive insurance singled out on IRS “Dirty Dozen” list
The IRS has singled out micro-captives on their “Dirty Dozen” List of Tax Scams for the last three years). Recently, the IRS received a major victory in its initiative against micro-captive tax shelters in Avrahami v. Commissioner, 149 T.C. No. 7 (Aug. 21, 2017).
In a captive insurance arrangement, the owners of the business establish an insurance company, often offshore or in a state with relatively lax regulatory oversight of captives. The insurance company insures or reinsures some or all of the risks of the business and its affiliates. If the captive also covers risks of unrelated persons or companies, those risks may be from other entities represented by the person who promoted the captive insurance arrangement. The business (or its owners if the business is a flow-through entity like an S Corporation or LLC) will claim a tax deduction for the premiums paid to the captive.
The Supreme Court established that for an arrangement to be treated as insurance, it must involve an insurable risk, risk shifting, and risk distribution, and also meet commonly accepted notions of insurance. Helvering v. LeGierse, 312 U.S. 531, 539 (1941). Besides failing to distribute risk, the tax-shelter in Avrahami failed to even look like or behave like insurance, so the court focused on this characteristic to uphold the IRS’s decision to disallow the Taxpayer’s deduction for the premiums paid to their micro-captive.
The Avrahami case
The Avrahamis, who owned several jewelry stores and shopping malls in metro Phoenix, Arizona, hired Celia Clark, a New York attorney, to create and maintain their own micro-captive, Feedback Insurance Company, Ltd., located in St. Kitts (a small Caribbean island). Clark referred them to an actuary to calculate the insurance premiums payable to Feedback, guided by a “target premium” of $840,000. The actuary then determined what insurance risks and premiums were required to meet that target. The court’s language suggests that this was a backwards way of coming up with insurance and premiums, and questioned the “arms-length” nature of the premiums.
It seems transparently obvious that similarly situated arms-length parties would never pay the sort of premiums the Avrahamis paid their own captive insurance company, especially considering that they never had any claims for the risks covered by their extravagant self-insurance. Meanwhile, the Avrahamis continued their insurance coverage with third-party commercial insurers for normal business risks at about $150,000 in premiums, the same as coverage and premiums as before they set up their micro-captive.
In an attempt to meet the risk distribution requirement, this captive also participated in a reinsurance arrangement with Pan American Reinsurance Company, Ltd., also created in St. Kitts by Ms. Clark for her client’s micro-captives. The court noted as significant that the $360,000 of premiums paid by an Avrahami-owned entity to Pan American ended up being paid back to Feedback (with interest), and no claims were ever filed against the Pan American terrorism risk insurance pool. The $360,000 of funds received by Feedback, along with the $840,000 of premiums paid directly to Feedback by the Avrahami businesses ended back in an Avrahami family owned partnership.
The court asked if these facts added up to insurance in the commonly accepted sense of the term, and answered its own question with a resounding “no.” The arrangement suggested that the Avrahamis were interested in taking very large tax deductions, but had little interest regarding the details of the insurance for which they spent $1.2 million in premiums in 2010.
The Implications of Avrahami
The Avrahami ruling may be a harsh wake-up call to micro-captives, many of which are structured like feedback and use promoter-created risk pools like Pan American to distribute risk. Although the language of the ruling focuses on the failure of the micro-captive to meet the standard of “insurance in the commonly accepted sense,” there is an even more fundamental rule of tax compliance that this resembles: the IRS may treat business transactions based on their economic and business substance and not their legal form (I.R.C. § 7701(o); Gregory v. Helvering, 293 U.S. 482 (1935)). As a result of this conclusion, the IRS may allocate and adjust income, deductions, credits, and allowances between related parties to clearly reflect income, based on an “arm’s length” standard (see I.R.C. § 482). It is a stark reminder for captive insurance companies and more broadly, any related-party business, that that the IRS can look to the underlying purpose of an attempt structure a business and transaction, and that transactions not performed at “arms-length” are inherently suspect.