In Avrahami v. Commissioner, 149 T.C. No. 7, the Tax Court has held, in a case of first impression, that amounts that taxpayers' pass-through business entities paid to a purported insurance company owned by them (a "captive") were not premiums paid for insurance contracts and were not deductible by the business entities under Section 162. Moreover, because the contracts issued by the captive were not insurance contracts (a holding based in part on the Court's determination that the unrelated offshore company from which the captive accepted pooled terrorism risk was not a bona fide insurance company), the captive is not taxed as an insurance company. As a result, its elections under Section 831(b) to be taxed as a small (micro) insurance company and under Section 953(d) to be taxed as a domestic corporation are 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.

Facts

Avrahamis' businesses and captive insurance company

Mr. and Mrs. Avrahami own jewelry stores and other businesses in Arizona, which report for federal tax purposes as either S corporations or partnerships. In 2006, they paid about $150,000 to insure these businesses. In 2007, the Avrahamis' CPA referred them to a lawyer, Mr. 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, Ms. 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 fee of $75,000. To this end, they incorporated their captive insurance company (Feedback) in St. Kitts. Mrs. Avrahami wholly owned Feedback, and both Mrs. and Mr. Avrahami 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 Section 953(b) for federal tax purposes (an election only available to entities that would be taxed as insurance companies if organized in the US) and (2) to be taxed as a small insurance company under Section 831(b).¹

Captive insurance payments and reinsurance

The Avrahamis' businesses began purchasing various types of insurance coverage from Feedback in 2007. In addition, in 2007, the Avrahamis' businesses purchased terrorism coverage from an unrelated Nevis corporation (Pan Am Re) established by Clark to form a pool comprised of risks belonging to 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 Avrahami entities insured by Pan Am Re. The reinsurance premium paid to Feedback equaled the insurance premiums paid to Pan Am Re by the Avrahami businesses.

The Avrahami businesses continued to pay premiums to Feedback and to Pan Am Re in 2009 and 2010, the years at issue in the current case, and during those years Feedback continued to reinsure risk from Pan Am Re for a reinsurance premium equal to the premiums paid by the Avrahami businesses to it. The total cost of insurance deducted by the Avrahami 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 Avrahami businesses until after the Internal Revenue Service (IRS) mentioned Feedback's failure to pay claims in a notice of proposed adjustment sent in 2013.

The Court discussed in some detail (and often critically) the nature and terms of the Feedback and Pan Am Re policies and how they differed from those, if any, available from unrelated commercial insurers and the manner in which the pricing for the policies was determined. The Court found that the methods used by the actuary engaged by Clark to price 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 Avrahamis

The Avrahamis set up a partnership named Belly Button in 2007 owned by the Avrahamis' three adult children, who testified at trial that they were unaware of the partnership's existence. Mr. Avrahami acted as Belly Button's manager and effected all of Belly Button's transactions. Belly Button purchased real estate for $1.96 million, using $1.2 million in cash lent by Mr. Avrahami and issuing a note for the balance to the seller. Belly Button issued an unsecured note to Mr. 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, Mr. 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, Mr. and Mrs. Avrahami 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 Mrs. Avrahami's account; the transfer was documented by Mr. Avrahami 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 Section 953(d) and 831(b). In accordance with the Section 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 Mrs. Avrahami was not included in taxable income.

The IRS sent Feedback a notice of deficiency, challenging Feedback's status as an insurance company, its elections under Sections 831(b) and 953(d), and its exclusion of the amounts paid it by the Avrahami businesses from taxable income. 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 the $200,000 transfer 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 begins with a summary of the history and operation of Section 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 is the first such Section 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: (a) Feedback issued seven different types of policies covering a variety of risks to four Avrahami businesses; and (b) 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: (a) 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 (b) 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 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.² The Court emphasized that risk distribution does not just depend 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 pieces of property located 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 noted that that the Court has previously found adequate risk distribution when 30% of the captive's premium revenue was from unrelated parties. The Court considered this to be too narrow an interpretation of its precedent and a proper interpretation would require Pan Am Re first to be a bone 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, relying on 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 that Pan Am Re 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 Section 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: (a) distribute risk; and (b) 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 pass-through entities, and Feedback could not make the elections under Sections 831(b) and 953(d).³

The Avrahamis acknowledged that the $200,000 should have been reported as taxable income and were only arguing that it should be taxed at the preferential rates afforded to "qualified dividend income." Because the Court held Feedback's election under Section 953(d) was invalid, it further concluded that the $200,000 was taxable at ordinary income rates. The Court was persuaded that the $1.2 million loan from Mr. 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 Mr. Avrahami was repayment of the loan, the Court concluded that the $300,000 in additional funds transferred to the Avrahamis should be treated partly as taxable interest and partly as taxable distributions.

Penalties

Regarding the IRS's assertion of penalties, the Court acknowledged that the Avrahamis' underpayments were "substantial" under Section 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 reasonably and in good faith have relied on Clark, who the Court concluded was a "promotor" of the disputed transaction. The testimony of other long-serving advisors allowed the Court to conclude that the Avrahamis reasonably relied on professional advice of Mr. Hiller with respect of the deductibility of the premiums paid to Feedback. Moreover, given that 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 Mrs. 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 Revenue Ruling 2005-40 (which focuses on the number of entities) obsolete remains unanswered. The Court dismissed the concept that transactions that merely provide significant amounts of third-party premiums to a captive automatically create risk distribution. As we have 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 in Avrahami.

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 the functions of the insurance company 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 Section 6662 substantial understatement penalties asserted by the IRS because the Court found they placed "good faith" reliance on Mr. Hiller's advice. As the Court noted, the microcaptive transactions described in Notice 2016-66 were designated as reportable "transactions of interest." As such, the IRS may, in the future, seek to assert a Section 6662A reportable transaction understatement penalty on what it perceives to be abusive microcaptive arrangements.⁴ Taxpayers will not be able to assert good faith reliance on "disqualified advisors" to avoid Section 6662A penalties. For individuals, a "disqualified advisor" includes any advisor that was paid of 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 Section 831(b) should review the operations of the captive and their transactions with it to ascertain the differences and similarities to this case. The findings of the Tax Court regarding the operation of and transactions with the captive that persuaded the Court to hold for 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 Section 831(b). Taxpayers whose arrangements present facts similar to this should consider consulting with EY or its advisor.

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ENDNOTES

¹ During the years in issue, an insurance company could elect to be taxed only on its investment income if its net written premiums (or, if greater, its direct written premiums) for the tax year did not exceed $1.2 million.

²It is interesting that the Tax Court apparently was not bothered by the fact that the Avrahami noninsurance business entities were each formed as pass-through entities for federal tax purposes because, when doing a count of insured entities, the Court treated each of them as one insured. Compare this to the IRS position in Revenue Ruling 2005-40, 2005-2 CB 4, in which it ignored the separate existence under state law of single member limited liability companies each conducting separate business operations because, as single-owner LLCs (and without an election to be taxed as associations), the limited liability companies are disregarded entities for federal tax purposes. Although the IRS has not issued any revenue rulings involving captives that insure S corporations or partnerships, it has issued a private letter ruling, PLR 200816029, in which it ruled that only the general partner of an entity organized as a limited partnership should be counted as an insured (and not the partnership itself) because only the general partner is exposed to maximum exposure to loss. These rulings have led some practitioners to believe that the IRS would not treat an S corporation or a partnership as an insured but instead would look through such entities to their owners.

³ The parties had stipulated that the premiums paid to Feedback are not US-source fixed or determinable, annual or periodical income under Section 881 or income that is effectively connected with a US trade or business under Section 882, thus preventing Feedback from being subject to tax under those two sections.

⁴ The Section 6662A penalty is 20% of the amount of understatement. This understatement is calculated by multiplying the amount of increase in taxable income due to the proper tax treatment of an item times the highest rate of tax.