In August 2017, the U.S. Tax Court ruled in favor of the Internal Revenue Service (IRS) in a case involving a microcaptive insurance company, Avrahami v. Commissioner, 149 T.C. No. 7 (2017), providing clear direction to the IRS to pursue additional cases.
Microcaptive Insurance Company Tax Breaks Not Deductible
The Avrahamis, who owned several Arizona jewelry stores and shopping centers, set up a captive 
insurance company, with the guidance of their certified public accountant (CPA), an estate planning attorney and an attorney specializing in captive insurance. The company, Feedback, was incorporated in St. Kitts and and was treated as a small insurance company under IRS section 831(b). The Avrahamis also paid Pan America Reinsurance Company for terrorism risk insurance. The Avrahamis deducted the premiums paid and received a tax break by insuring itself for millions of dollars. The Tax Court ruled that payments made to the microcaptive insurance company were not for insurance and could not be deductible as insurance premium payments.
IRS Audit Disallowed Captive Insurance Premiums
In 2009 and 2010, the Avrahamis paid Feedback and Pan America a total of $2.2 million in insurance premiums. An IRS audit disallowed the insurance premiums paid to Feedback and Pan America. The Tax Court agreed. It found that Feedback did not meet the essential insurance characteristic of distributing risk and that Pan America was not a bona fide insurance company.
Tax Court Provides Guidance on Defining “Insurance” in Avrahams
The term “insurance” is not defined in the Federal Tax Code or Regulations so courts have primarily relied on four criteria to determine if an arrangement constitutes “insurance”:
- Risk shifting
- Risk distribution
- Insurance risk
- Meeting commonly accepted notions of insurance
In the Avrahams case, the Tax Court based its findings on risk distribution and commonly accepted notions of insurance. Summarizing the Courts findings, it ruled that:
- The number of insureds (3 companies in 2009 and 4 in 2010, issuing 7 direct policies that covered 3 jewelry stores, 3 commercial real estate companies, 2 key employees, and 35 other employees) did not sufficiently satisfy the concept of risk distribution.
- The “pooling arrangements” did not satisfy risk distribution because of the circular flow of funds (Pan American distributed virtually all of the premiums back to its policyholders).
- Premiums paid to Pan American were considered to be “grossly excessive”.
- Feedback was not operating as an insurance company because it had paid no claims until the IRS began its audit, it invested in highly illiquid investments (loans to the related parties), it’s policies were unclear and contradictory, and it charged unreasonable premiums.
Federal Tax Questions Still Remain for Captive Insurance Companies
While the Avrahams case provides some additional guidance on captive insurance, it only addresses two of the commonly used criteria to determine if an arrangement constitutes “insurance”. Another pending captive insurance tax case, James L. Wilson & Vivien Wilson, et al., v. Commissioner, may address the other two issues and provide additional guidance for both taxpayers and the IRS.
Investigating Captive Insurance Tax Shelters Remain High on the IRS’s Priority List
Captive insurance tax shelters have been on the IRS’s “Dirty Dozen” list for the past several years and are on the IRS Large Business and International Division’s list of new tax compliance campaigns. With this victory, the IRS now has clear direction to pursue even more cases.
If your business is involved in a captive insurance company or considering a captive arrangement, McMahon & Associates can help you assess your captive insurance company to ensure that it is compliant with IRS regulations. If you should receive an audit notice from the IRS, we can help you navigate the examination process and appeals proceedings.