Tax Court Ruling Could Affect Financial Services Companies’ Captive Arrangements

By William F. Buechler, J.D., CPA, and Lynn M. McGuire, CPA
| 12/1/2017
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support-img-lp-fs-18900-190b Many financial services companies use, or are considering using, a captive insurance company to protect against the unfunded risks inherent in their business.

The arrangement often is a legitimate and beneficial way to manage risk, but it also increasingly draws the scrutiny of the Internal Revenue Service (IRS). A recent ruling by the U.S. Tax Court in the case Avrahami v. Commissioner1 provides valuable guidance about how financial services companies should proceed to boost the odds of passing IRS muster.

The Growing Popularity – and Scrutiny – of Captive Insurance

The recent Equifax data breach scandal illustrates well how some of the most significant risks facing banks and other organizations today are beyond the scope of traditional commercial insurance. For financial services companies, cyberrisks, employment practices liability, and reputational damage frequently are uninsurable and unreserved for on their books. Even if a bank can find third-party coverage, it is likely to come with sticker shock. A financial services company often could be better off forming a captive insurance company.

As more organizations have gone the captive insurance route, the practice predictably has attracted the attention of the IRS. In fact, certain captive insurance company structures have been included as an abusive tax shelter on the agency's annual list of “Dirty Dozen” tax scams for three years running. More notably, IRS Notice 2016-66 identified certain captive insurance structures as a “transaction of interest” that requires taxpayer disclosure.

The good news is that the court made clear in Avrahami that it is quite possible to structure a legitimate small captive arrangement. The arrangement at issue there, though, was an almost textbook example of how not to go about it.

The Captive Insurance Arrangement

The Avrahamis owned three jewelry stores and three shopping centers in Arizona. On the advice of their CPA, they retained an attorney whose practice focused on forming and maintaining insurance companies. The Avrahamis eventually formed – under the laws of St. Kitts – a captive, which was wholly owned by the wife.

The captive, known as Feedback Insurance Company, Ltd. (“Feedback”), elected to be taxed as a domestic insurance company for federal income tax purposes and to be taxed under Internal Revenue Code Section 831(b) on its net investment income. Feedback sold property and casualty insurance policies to three entities in 2009 and four entities in 2010, all of which were owned by the Avrahamis. The captive also participated in a risk distribution pool established by the attorney to provide terrorism insurance for companies and then reinsure such risk to related small captive insurers. The other risks insured by Feedback were not pooled.

The Four-Part Test

Generally, a captive insurance arrangement must satisfy a four-part test. The test requires that the arrangement must do all of the following:

  1. Involve risk shifting to the captive insurer
  2. Involve risk distribution among policyholders
  3. Involve insurance risk
  4. Meet "commonly accepted" notions of insurance

The arrangement in the Avrahami case failed on at least two fronts.

The Tax Court began its analysis by examining the risk distribution factor. It explained that risk distribution occurs when the insurer pools a large enough collection of unrelated risks.

The court stressed that, when it comes to risk distribution, the number of risk exposures is more important than the number of entities, but it implied that a certain number of entities was still required to achieve risk distribution. In this case, though, the court found an insufficient number of risk exposures to achieve risk distribution merely through the Avrahamis' affiliated entities.

And, while Feedback also participated in a risk pool through a third-party terrorism reinsurance program, the court held that the program did not qualify as a bona fide insurance company. Among other reasons, it found the premium rates were “grossly excessive” and the company was “thinly capitalized.” In addition, the Tax Court held that if a risk pool is used to achieve risk distribution, the risks shared must be plausible risks, but every insured in the risk pool received terrorism coverage – regardless of whether terrorism was an actual risk for each company. Because it was not an insurance company and the risks were not plausible, its policies were not insurance, so Feedback’s reinsurance of the policies did not distribute risk.

The Tax Court next turned its attention to commonly accepted notions of insurance. When assessing whether a captive arrangement looks like insurance in the commonly accepted sense, the court will consider numerous factors, including whether the company was organized, operated, and regulated as an insurance company; whether the insurer was adequately capitalized; whether the policies were valid and binding; whether the premiums were reasonable and the result of an arm’s length transaction; and whether claims were paid. The Tax Court also has looked at whether the policies covered typical insurance risks and whether a legitimate, nontax business reason for acquiring insurance from the captive existed.

The court found that Feedback was organized and regulated as an insurance company, paid the few claims filed against it, and met the minimal capitalization requirements of St. Kitts. However, the court concluded that these “insurance-like traits” could not overcome the fact that it was not operated like an insurance company because it had related-party loans, had illiquid investments, and had issued policies with unclear and contradictory terms for unreasonably high premiums.

Because Feedback failed to distribute risk and did not operate as an insurance company in the commonly accepted sense, the court did not bother determining whether its transactions involved insurance risk or risk shifting.

Lessons Learned

The Avrahami case illustrates some of the missteps captive arrangements must avoid to withstand scrutiny, including:

  • Loans to parent companies or other related parties
  • Illiquid investments not typical to insurance companies
  • Excessive premiums not supported actuarially
  • Poorly written policies
  • Untimely issued policies
  • Untimely payment of premiums
  • Failing to file all claims covered under captive policies, and not paying such claims after determining that they are valid

In addition, the decision provides some guidance to banks about how they can satisfy the risk distribution requirements. It reiterated that a captive can distribute risk by insuring only its “brother-sister businesses” and that it is the number of independent risk exposures that is most critical. Thus, a financial holding company that is a C corporation might achieve sufficient risk distribution by forming a captive subsidiary and insuring all of its branches in a valid risk pool.

Proceed With Caution

Although the Tax Court rejected the Avrahamis’ captive insurance arrangement, it also repeatedly cited previous cases where it found properly structured arrangements that satisfied the four-part test. Financial services companies have a number of business reasons to consider establishing a captive insurance company, and the recent Tax Court decision provides a road map for avoiding some potential pitfalls with such structures.

In This Issue

1 149 T.C. No. 7 (2017).

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