August 23, 2017
By Emily L. Foster
Published in TaxNotes
Although the Tax Court’s long-awaited Avrahami decision provided a detailed analysis shedding some light on what might constitute insurance for a microcaptive arrangement, it didn’t provide clear guidance on resolving long-standing issues, according to some practitioners.
IRS officials and practitioners “were hoping for a bright line or at least a brighter line,” John H. Dies of Alliantgroup LP said, adding that the IRS has been holding decisions on some captive cases in anticipation of further guidance. But the Avrahami case does not provide the necessary level of guidance, he said.
In Avrahami v. Comm’r, 149 T.C. No. 7 (2017), Judge Mark V. Holmes decided the reportedly first microcaptive insurance case and determined that the arrangements were not insurance and that the company’s section 831(b) election was invalid.
Under section 831(b), captive insurers that qualify as small insurance companies can elect to exclude some of the annual net premiums from income so that the captive pays tax only on its investment income. Effective in 2017, the limitation on premiums received for section 831(b) treatment increased from $1.2 million to $2.2 million.
In abusive microcaptive structures, promoters, accountants, or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance. Whether an arrangement or a product constitutes insurance for federal tax purposes has been an issue that the IRS has grappled with for many years.
In Avrahami, the court followed a traditional path for the definition of insurance by looking at case law factors and addressed two of the four factors: risk distribution and insurance in the common sense of the term, Steven T. Miller, also of Alliantgroup, said. He emphasized that it was unfortunate that the court opted not to address risk-shifting and insurable risks, which would have provided more guidance, adding that those issues “will have to wait until another day.” But because the court’s analysis was “incredibly factually based,” it’s unclear how this decision will apply in other cases.
Microcaptive cases “are going to be determined on their facts and circumstances,” Charles J. Lavelle of Bingham Greenebaum Doll LLP said, adding that the IRS selected a case to litigate that “had some facts that the court found to be woefully insufficient.” But there are better
fact situations for microcaptive insurance arrangements “that don’t have some of the failings that the court found in Avrahami,” and presumably the courts would look at those more favorably, he said. As the courts continue to draw the line between a valid and invalid insurance arrangement, the question is where the taxpayer’s facts fall along the spectrum, Lavelle said.
Sheryl Flum of KPMG LLP said that IRS officials felt that the Avrahamis’ situation “would be a strong case to test their theory that some of these section 831(b) microcaptives are in fact tax avoidance vehicles, and they got a good decision.” This case provides more ammunition for the IRS in its efforts to pursue promoters involved in abusive microcaptive insurance transactions. But Flum emphasized that “it’s quite possible for a microcaptive to be a legitimate insurance vehicle” — it just needs to ensure for risk distribution, for example, that it has a sufficient number of risk units and valid insurance pooling arrangements.
“Because of the number of taxpayer unfavorable factors in the case, the holding was not surprising,” Saren Goldner of Eversheds Sutherland LLP said, adding that the case seems to encourage taxpayers that have elected section 831(b) treatment and have similar unfavorable facts to settle and possibly avoid penalties.
The Avrahamis’ Arrangements
Benyamin and Orna Avrahami owned three jewelry stores and several commercial real estate companies in Arizona, for which they established Feedback Insurance Company Ltd. as a captive insurance company in 2007, wholly owned by Mrs. Avrahami and incorporated in St. Kitts. Feedback filed an election under section 953 to be treated as a domestic corporation for federal tax purposes and an election under 831(b) to be taxed as a small insurance company. In 2009 and 2010 — the years at issue — Feedback insured the Avrahami entities for risk of administrative actions, business risk indemnity, competition and reputational damage, employee infidelity, litigation expenses, loss of key employees (the Avrahamis), and tax indemnity. During that time period, the Avrahamis’ entities maintained their commercial insurance coverage.
The captive insurance company also reinsured terrorism policies through Pan American Reinsurance Co. Ltd.
The Avrahamis deducted a little over $1 million in insurance expenses for each year in question for premiums paid to Feedback, compared to around $150,000 in 2006 before establishing its captive. No claims were filed by the Avrahami entities against Feedback in either 2009 or 2010, and no events triggered a claim under the terrorism reinsurance policy. Thus, Feedback had a surplus during the years at issue and transferred funds to Mrs. Avrahami and to an entity owned by the Avrahamis’ children called Belly Button Center LLC. Feedback reported the transfer to Belly Button as “mortgage and real estate loans” on its tax return, and Mr. Avrahami executed a promissory note payable to Feedback. The following day, the Avrahamis transferred the funds into their personal account.
The IRS issued a notice of deficiency to Feedback, questioning its validity as an insurance company and finding that amounts reported as premiums were income. The IRS also determined deficiencies and penalties against the couple.
Holmes noted that because neither the code nor regulations define insurance, the courts have turned to case law and have applied a four-prong test arising from Helvering v. Le Gierse, 312 U.S. 531 (1941) for captive insurance companies. For an arrangement to be considered insurance for federal tax purposes, it must involve risk-shifting, risk distribution, and insurance risk, and meet common accepted notions of insurance. Holmes pointed to several cases to illustrate the facts and circumstances for which the courts have deemed some arrangements as insurance for federal tax purposes (Rent-A-Center, Inc. v. Comm’r, 142 T.C. 1 (2014); R.V.I. Guaranty Co. v. Comm’r, 145 T.C. 209, (2015); Harper Group, 96 T.C. 45 (1991); Americo & Subs. V. Comm’r, 96 T.C. 18 (1991); aff’d. 979 F.2d 162 (9th Cir. 1992); and Securitas Holdings, Inc. v. Comm’r, T.C. Memo. (2014-225).
The court first determined that Feedback did not achieve sufficient risk distribution through its affiliated entities or through the Pan American terrorism reinsurance program. The question concerning the affiliated entities was whether Feedback pooled a large enough collection of unrelated risks with the seven different types of direct policies to the Avrahamis’ entities. While expert witnesses for the two sides debated whether 12 or 35 would provide a sufficiently large pool, the case involved situations with three or four entities. The court, however, emphasized that “it isn’t just the number of brother-sister entities that one should look at in deciding whether an arrangement is distributing risk. It’s even more important to figure out the number of independent risk exposures.” But the court found that Feedback lacked a sufficient number of risk exposures to achieve risk distribution merely though its affiliated entities.
The court then addressed the Avrahamis’ argument that Feedback distributed risk by participating in the Pan American program and reinsuring over 100 geographically diverse third parties. But the court said that in the cases the plaintiff cited to support that its captive insured a sufficient number of unrelated parties, the court also found that the polices issued covered insurable risks, successfully shifted the risk to the captive, and satisfied all the commonly accepted notions of insurance. The court continued that it must therefore decide if Pan American was a bona fide insurance company based on several established factors. Holmes said, “We won’t condemn Pan American solely for its atypical fee structure, but that structure came combined with excessive premiums, an ultralow probability of a claim ever being paid, and payments of a circular nature.” The question is whether “such an entity [is] engaged in insurance or is it just part of a tax-reduction scheme papered to look like an entity engaged in insurance? The answer is that more likely than not, Pan American is not a bona fide insurance company.”
Although “the absence of risk distribution by itself is enough to sink Feedback,” Holmes said that courts may assess whether the assessment “looks like insurance in the commonly accepted sense . . . . [as] an alternative ground.” But based on six different factors, the court found that Feedback was not selling insurance in the commonly accepted sense. “Although Feedback was organized and regulated as an insurance company, paid the claims filed against it, and met the minimal capitalization requirements of St. Kitts, these insurance-like traits cannot overcome its other failings. It was not operated like an insurance company, it issued policies with unclear and contradictory terms, and it charged wholly unreasonable premiums,” the court wrote.
The Tax Court concluded that because Feedback wasn’t an insurance company under two of the tests, it didn’t need to determine whether its transactions involved insurance risk or risk shifting. The court held that the insurance premiums paid to Feedback weren’t deductible as business expenses, and Feedback’s elections under sections 953 and 831(b) were invalid.
The court held that a $200,000 transfer Feedback made to Mrs. Avrahami was a dividend, taxable as ordinary income, and that $1.2 million of a $1.5 million transfer from Belly Button to Feedback was a nontaxable loan repayment with the $300,000 difference being interest to the Avrahamis and a taxable distribution to Mrs. Avrahami.
Holmes declined to impose accuracy-related penalties on underpayments stemming from the disallowed deductions, noting that the issue regarding the deductibility of the insurance premiums was one of first impression and that the Avrahamis relied on professional advice. However, the court held that penalties apply to underpayments resulting from their unreported interest and distributions.
Takeaways and Questions
Practitioners have thought that the courts should consider risk distribution considering the number of inherent risk exposures, according to Tom Cyr of KPMG. Holmes’s references to Rent-A-Center, R.V.I, and Securitas “go a long way to making those cases more important,” Flum said, adding that she’s not sure that Avrahami would be cited to the level of those cases because of the fact-specific nature of the opinion. But Holmes’s affirmative stance on the units of risk — inherent risk exposures — is good information for practitioners trying to apply the common law in determining sufficient risk distribution.
Goldner noted the court’s focus on the pricing of premiums in the Pan American reinsurance arrangement and said there’s a “clear message [that] in the 831(b) context that premiums need to be set reasonably, not just at the maximum allowed under the statute.” Holmes went to great lengths to illustrate that the premiums were targeted to be close to the $1.2 million limit in effect at the time, Cyr said, adding that the reinsurance companies should understand that they need to ensure their pricing is documented and that the premiums are appropriately set.
Dies said he would expect the IRS to pull some pages from the court’s playbook concerning premium pricing and employ those at the exam level and delve deeper into, for example, how pricing was determined, the level of actuarial support for adjustments relative to the commercial market, and validity of other comparison points actuaries may use.
Holmes provided at a granular level how some of the tests should be applied, such as the different factors to consider in determining whether the arrangements satisfy the common notions of insurance test, which should help clarify for taxpayers what’s important to the courts, Lavelle said.
Lavelle pointed out that the court said it didn’t need to address the IRS’s other arguments that the premium amounts deducted should be disallowed under the judicial doctrines of economic substance, substance over form, or step transaction. The question is whether the IRS in its audit program will analyze each captive situation strictly against the four tests or continue to press the lack of economic substance, Lavelle said.
Miller said that he believes the IRS “will remain undeterred by the court” in its application of economic substance, substance over form, and step transaction principles, and continue to impose 40 percent penalties at the exam level.
Holmes’s surprise ruling not to impose penalties concerning the deduction of the insurance premiums — in part because of the lack of guidance — “was at least a quiet call to the Service to provide that guidance,” Dies said. The court’s ruling suggests that if the IRS wants to hold taxpayers accountable, it is going to need more precision concerning current expectations, he said.
The Campaign Connection
The IRS has emphasized its intent to curtail the abusive arrangements by identifying microcaptive insurance transactions on its annual “Dirty Dozen” list of tax scams since 2015 and announcing in January that those transactions, which were identified as transactions of interest in Notice 2016-66, 2016-47 IRB 745, would be a focus of one of the Large Business and International Division’s initial campaigns.
“Regardless of current resource constraints, this case illustrates that the IRS — along with Chief Counsel — has both the talent and the determination to vigorously pursue resolution of issues identified in the new campaign strategy of tax enforcement,” Susan E. Seabrook of Eversheds Sutherland said. For the microcaptive insurance campaign, the Avrahami decision may prove an effective tool for resolving many of the section 831(b) microcaptive cases in the pipeline, she said. “One of the court’s most important factual findings — that is, that Pan American was not a ‘bona fide’ insurance company — is also relevant to the resolution of challenges brought by other taxpayers whose microcaptive structures incorporated transactions with Pan American.”
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.
In a career devoted to government service, Steven has spent the last 25 years with the IRS, serving the agency in a number of diverse and increasingly important roles.
John Dies is Managing Director of Tax Controversy at alliantgroup. As an experienced trial attorney and former
partner in a litigation firm, he has represented hundreds of clients and tried cases to verdict throughout the United States. John
specializes in rehabilitating audits where a taxpayer requires assistance after the IRS or other taxing authority announces its intent to issue a total disallowance or other negative result.
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