October 13, 2017
By Eric Kroh
Law 360

As the Internal Revenue Service continues to scrutinize the tax treatment of small captive insurance companies, tax practitioners are looking to a trio of cases before the U.S. Tax Court to discern where the lines will be drawn between legitimate insurers and shams.

The cases — one that has already been decided and two in which decisions are pending — are the court’s first to make it to trial over the intersection of captive insurance companies and Section 831(b) of the tax code, under which companies can elect to be treated as small insurance companies subject to tax on investment income but exempt from tax on premiums received.

In its August opinion in Avrahami v. Commissioner, the Tax Court provided some guidance on how it will decide which captive firms are true insurance companies that merit the small insurer tax exemption, but left tax attorneys and their clients in the dark regarding some important questions.

Practitioners hope the upcoming opinions in the two remaining cases can shed further light on those issues, but they also acknowledge that the decisions are unlikely to fill in all the details.

“I’m willing to bet that after these three cases are out that I will have a little more information, but not enough information to tell my clients that they’re clearly in the black,” Steven T. Miller, national director of tax at Alliantgroup LP, said.

The IRS said last year that it was cracking down on so-called microcaptive insurance structures in which a taxpayer avoids taxes by setting up a directly or indirectly owned company and deducting payments made to that company as insurance premiums, while the company excludes the premiums from its taxable income by electing to be taxed only on its investment income under Section 831(b). Microcaptive insurance companies have also made the IRS list of “dirty dozen” tax scams the last three years in a row.

The Tax Court, however, did not have a chance to provide its take on the arrangements until Avrahami.

The case concerns Benyamin and Orna Avrahami, an Arizona couple who owned three jewelry stores in the Phoenix area and several commercial real estate businesses. In 2009 and 2010, the years examined by the IRS, the Avrahamis claimed some $1.54 million in deductions for premiums they and their businesses paid to Feedback Insurance Co. Ltd., a captive insurer they had set up in the dual-island Caribbean nation of Saint Christopher and Nevis known as St. Kitts, according to the Tax Court opinion. The Avrahamis also deducted some $720,000 in premiums for terrorism insurance paid to Pan American Reinsurance Co. Ltd., also in St. Kitts.

Feedback was organized with the advice of Celia Clark, a New York attorney who specializes in captive insurance companies and helped write captive insurance legislation for St. Kitts. Orna Avrahami was the sole owner of Feedback. Pan American, meanwhile, had four shareholders, two of whom were Clark’s children. One of the other shareholders was the wife of the owner of Heritor Management Ltd., which helped run Feedback, according to the opinion.

The Avrahamis and their companies purchased insurance policies from Feedback to cover losses related to business risk, the loss of key employees, litigation expenses, tax indemnity and other occurrences. Premiums for the policies were calculated by actuary Allen Rosenbach, who told the court he developed his pricing models on the basis of public filings by large commercial insurance companies and his own experience.

Feedback also participated in a risk distribution program through Pan American in which a handful of small insurance companies spread their risk among one another by buying and reinsuring terrorism insurance. For example, in 2009, Pan American paid Feedback $360,000 to assume a small share of its terrorism risk, the same amount that the Avrahamis had paid Pan American for the terrorism insurance policy, the opinion said.

Feedback did not pay any insurance claims in 2009 and 2010 and built up a large surplus of funds, according to the Tax Court opinion. In 2010, Feedback transferred some $1.5 million to Belly Button Center LLC, a partnership owned by the Avrahamis’ three children, reporting it as a mortgage and real estate loan. Two days later, the same amount was transferred from Belly Button to the Avrahamis’ personal account, according to the opinion.

The IRS audited the Avrahamis’ 2009 and 2010 tax returns and determined that Feedback and Pan American did not provide legitimate insurance. The agency disallowed the deductions the Avrahamis claimed for premiums paid to the companies, said the $1.5 million transfer from Feedback to Belly Button and an additional $200,000 transfer from Feedback to Orna Avrahami should be characterized as income and determined the couple owed $1.37 million in additional taxes for the two years. The IRS also assessed penalties of nearly $275,000. The Avrahamis appealed.

Tax Court Judge Mark V. Holmes, who is overseeing the case, agreed with the IRS that Feedback and Pan American did not provide legitimate insurance and that the premium deductions should be disallowed. In his opinion, he provided some guidance on how the court would look at microcaptive insurance companies according to criteria recognized under U.S. Supreme Court precedent as determining whether an arrangement qualifies as insurance. In 1941’s Helvering v. Le Gierse, the high court said insurance must involve risk shifting, risk distribution and insurance risk and meet commonly accepted notions of insurance.

Judge Holmes said Feedback had not achieved sufficient risk distribution by insuring the Avrahamis’ entities. Feedback’s policies covered only three of the companies in 2009 and four in 2010. The policies covered three jewelry stores, two key employees, 35 total employees and three commercial real estate properties in the Phoenix area, he said.

The number of insured entities in the Avrahami case fell far short of those in cases that have previously passed muster with the court, Judge Holmes said. In 2015’s R.V.I. Guaranty Co. Ltd. v. Commissioner, for example, the court found there was adequate risk distribution when an insurance company covered 714 unrelated parties, he said.

Judge Holmes added, however, that the court should not just look at the number of entities covered to determine when a captive insurance arrangement is adequately distributing risk but also at what he called the number of independent risk exposures. In 2014’s Rent-A-Center Inc. v. Commissioner, the court found there was a sufficient number of statistically independent risks when a captive insurer covered 14,000 employees, 7,100 vehicles, and 2,600 stores in 50 states, he said.

Nicole M. Bodoh of Primmer Piper Eggleston & Cramer PC said tax practitioners had relied on IRS guidance provided in Revenue Ruling 2002-90, in which the agency said amounts paid to a captive insurer that covered 12 entities could be deducted as insurance premiums. After Avrahami, however, it’s clear that simply meeting that test is not enough for the court, she said.

Even though Feedback fell short of the 12-entity line, Judge Holmes seemed to be saying that even if it hadn’t, it would not have achieved sufficient risk distribution because it didn’t insure a sufficient number of risk exposures, Bodoh said.

“You can’t just look at the safe harbor, the 12 subsidiaries rule of 2002-90,” she said. “You have to look at whether there are a sufficient number of exposure units as well that are being insured.”

The court is “going to be looking at captives in general on a case-by-case basis,” Bodoh said. “Safe harbors that practitioners and captives have relied upon in the past are not really safe harbors anymore.”

Judge Holmes said the absence of adequate risk distribution was enough to disqualify the Avrahamis’ insurance premium deductions, but he also examined whether Feedback and Pan American met commonly accepted notions of insurance.

The court looked askance at the fact that Feedback did not pay out any claims until after the IRS started auditing the Avrahamis’ returns. It also took issue with the way that Rosenbach calculated Feedback’s and Pan American’s premiums, finding that he likely priced the plans so that total premiums would come as close as possible to the $1.2 million statutory limit for qualification as a small insurance company under Section 831(b).

“Despite the attempts of Feedback to make its transactions look like traditional insurance and take advantage of the apparent loophole at the intersection of Section 831 and captive insurance case law, the premiums paid to Feedback and deducted by the Avrahami entities are not ‘insurance’ for federal tax purposes,” Judge Holmes said.

Pan American, meanwhile, appeared to be a conduit for a circular flow of funds, and it’s unlikely that an unrelated party would have agreed to pay Pan American’s exorbitant premiums for terrorism insurance, Judge Holmes said, finding the company was likely not a bona fide insurance company.

Judge Holmes also decided that $1.2 million of the $1.5 million payment from Belly Button to the Avrahamis was a genuine loan repayment that should not be included in their taxable income and trimmed their penalties, finding they had relied in good faith on the advice of attorney Neil Hiller. The Avrahamis could not reasonably rely on Clark, however, because she was a promoter of the microcaptive transaction, he said.

Jennifer E. Benda, a partner with Fox Rothschild LLP, said that even though the Tax Court in Avrahami addressed only two of the four criteria laid out by the Supreme Court in Le Gierse, it was clear that the court would look for captive insurance companies that take advantage of the tax benefits afforded by Section 831(b) to meet all four.

“You have to check all of those boxes, and if the court doesn’t check one of those boxes, they can focus on that box in order to reach their conclusion,” Benda said.

The Avrahamis have asked the Tax Court to reconsider its opinion. In the meantime, tax practitioners and their clients will be looking for further guidance from the court on microcaptive insurance companies in the two other cases that have already gone to trial, Caylor Land & Development Inc. v. Commissioner and Wilson v. Commissioner. Both cases are on Judge Holmes’ docket. He has ordered the parties in Caylor to submit additional briefs in response to his opinion in Avrahami and has asked for a joint status report from the parties in Wilson, which means decisions in the cases are unlikely to come until next year.

Miller at Alliantgroup said the upcoming opinions would likely shed more light on microcaptive insurance arrangements but still leave key questions unanswered. Caylor involves a captive insurance company that insured 12 entities that did not participate in a risk distribution pool, as in Avrahami, he said. The case could provide an opportunity for a clear ruling from the court on the 12-entity threshold of Revenue Ruling 2002-90, he said.

“We may learn something interesting there in terms of how the court feels about pure captives and the number of affiliates and the number of risks” that are acceptable, Miller said.

Wilson, on the other hand, involves an arrangement similar to that in Avrahami, so that case may not yield much useful information, he said.

In the end, the IRS may need to weigh in on microcaptive insurance companies to fill in the blanks, Miller said.

“It’s going to be a little difficult until the service comes out with real guidance to allow my clients to have a sense that they’re operating in a matter the agency is comfortable with,” he said.


Steven T. Miller served as former IRS Acting Commissioner in 2012, but prior to that he served for several years as the Deputy Commissioner for Services and Enforcement, leading all IRS enforcement and service activity. Steven also served as the Commissioner of the Large and Mid-Size Business Division, overseeing IRS audits of large taxpayers and the IRS programs relating to offshore tax compliance and international tax law enforcement. As the Commissioner of the Tax Exempt and Government Entities Division, he supervised the IRS oversight of governments, tax exempt entities and retirement programs.

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