Guidance for Small Captives

| 8/31/2017


On Aug. 21, the U.S. Tax Court published its decision in Avrahami v. Commissioner of Internal Revenue, holding that the Avrahamis’ captive arrangement does not constitute insurance for federal income tax purposes because of the arrangement’s poor design and implementation.

Benyamin and Orna Avrahami owned three jewelry stores and three shopping centers in Arizona. In 2007, their CPA indicated that a captive insurance company might be useful to them and referred them to an attorney focused on forming and maintaining insurance companies. The Avrahamis ultimately formed a captive organized under the laws of St. Kitts and wholly owned by Orna Avrahami. The captive, Feedback Insurance Company Ltd., filed an IRC Section 953(d) election to be taxed as a domestic insurance company for federal income tax purposes and to be taxed under IRC Section 831(b) on its net investment income. For the two tax years under audit, 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. In addition, Feedback participated in a risk distribution pool established by the attorney to reinsure terrorism insurance for other small captive insurers.

The Tax Court applied the usual four-part test to determine if the arrangement qualified as insurance for tax purposes: whether the arrangement achieved risk distribution, risk shifting, and insurance risk and whether it met commonly accepted notions of insurance.

Risk Distribution

The Tax Court first considered whether Feedback had achieved risk distribution by insuring three related entities in one year and four in the next year. The Tax Court held that this activity was not sufficient to achieve risk distribution, specifying that the number of entities was not as important as the number of risk exposure units. Next, the court examined whether Feedback insured adequate risk exposures to achieve risk distribution and found that seven types of direct policies covering only three stores, two key employees, 35 nonkey employees, and three commercial real estate properties in the same city were not enough to achieve risk distribution.

In addition, the Tax Court examined the reinsurance arrangement to determine if Feedback achieved risk distribution by reinsuring terrorism risk insurance. Under the risk distribution program, the related entities paid Pan American Reinsurance Company Ltd. a premium for terrorism risk insurance, and Pan American ceded all of the risks to other participating captive insurance companies and then ceded the identical amount of premium back to Feedback to reinsure the other participating entities. In analyzing whether the risk distribution program was valid, the Tax Court rejected the actuary’s pricing methodology holding that the method used did not consider fundamental underwriting practices for the commercial terrorism policy. Additionally, the court found that the policy was structured so that it was improbable that any event would trigger a claim, and, if a claim was filed, it was unlikely that Pan American could pay such a claim as the company had only $75,000 in capital and would need to collect from more than 100 participating entities to pay claims in excess of its capital. In light of these factors, the Tax Court held that Pan American was not a bona fide insurance company and that reinsuring such policies did not result in risk distribution.

Other Considerations

Failure to achieve risk distribution was fatal for Feedback in its quest to be taxed as an insurance company, but the Tax Court also indicated that if it had passed the risk distribution test, it would have failed the alternative test of “whether it looks like insurance in the commonly accepted sense.” The Tax Court indicated that this alternative test involves determining “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.” Because Feedback invested only in illiquid, long-term loans to related parties and cash, failed to obtain regulatory approval for related-party transactions, had no claims prior to its IRS audit, had an ad hoc claims process, unrealistically determined premiums, and immediately distributed funds without prior regulatory approval, the Tax Court held that Feedback was not operated like an insurance company. The court further indicated that, as a result, both the IRC Section 953(d) and IRC Section 831(b) elections were invalid and the premiums paid were not deductible under IRC Section 162 for the Avrahami entities.

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