Hard-hitting Avrahami ruling by US tax court, but captive was ‘destined to fail’

The recent ruling of the US Tax Court in the Avrahami case, involving a US 831(b) captive, is unlikely to have much effect on the wider captive sector as there were very specific circumstances, though clearly it does not help when the industry is working so hard to challenge the perception of captives as tax avoiding vehicles.

The case was not concerned with traditional captives, but specifically concerned microcaptives or 831(b) captives, used by SMEs in the US, and the subject of considerable scrutiny by the US Internal Revenue Service (IRS) because of their use as illegal tax shelters. In this case, in the words of the court, the captive was “not operated like an insurance company, it issued policies with unclear and contradictory terms, and it charged wholly unreasonable premiums”.

The case involved the IRS’s decision that the captive, Feedback Insurance Company, was not a valid insurance company and that payments to the company were not insurance premiums. The IRS determined that the captive’s “elections under I.R.C. section 831(b) to be treated as a small insurance company and under I.R.C. section 953(d) to be taxed as a domestic corporation were invalid, as the amounts paid did not qualify as insurance premiums for federal income tax purposes”.

The court agreed and ruled that the amounts paid to the captive were not insurance premiums for federal income tax purposes and are not deductible under I.R.C. section 162. The court noted that the Avrahamis owned three shopping centres and three thriving jewellery stores. In 2006, they spent a little more than $150,000 insuring them. In 2009, this insurance bill soared to more than $1.1m and to more than $1.3m in 2010.

The Avrahamis were paying the overwhelming share of these big bills to a new insurance company called Feedback Insurance Company, established in St. Kitts in 2007 and wholly owned by Mrs Avrahami. Yet there were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis and their various entities’ returns. According to the court, “with money flooding in and none going back out to pay claims, Feedback accumulated a surplus of more than $3.8m by the end of 2010, $1.7m of which ended up back in the Avrahamis’ bank account”. The Avrahamis said this represented loans and loan repayments, but the IRS said this represented distributions.

The court was unequivocal in its decision, stating: “We find that the premiums were utterly unreasonable.” On the issue of claims, the court said Feedback did pay its claims, but these claims were only filed against Feedback once the Avrahamis knew the IRS was looking at the transactions. In total, six claims were made, of which five were paid and one was still pending at the time of trial. “Does this add up to ‘insurance in the commonly accepted sense’? We find that the answer is ‘no’,” said the court.

“Although Feedback was organised and regulated as an insurance company, paid the claims filed against it, and met the minimal capitalisation 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 found.

‘Not a bona fide insurer’
The wider captive sector in general has condemned the case as a poor example of captive utilisation and management, but is also concerned at the potential to taint all captives as tax avoidance vehicles, and the fact that it emboldens the IRS in its challenging of captive insurance arrangements.

Commenting on the case, Capstone Group, an independent risk management, employee benefits and insurance brokerage firm, said: “While there are captives formed by unsophisticated managers that have some issues, this case is unusual in that the structure failed in almost every possible area. The Avrahamis and their advisers got almost everything wrong.”

David Osbourn, director of Northeast & Mid-Atlantic operations for Capstone, said: “I’ve met with ‘captive managers’ who have limited insurance knowledge and no legal or tax expertise. They were run by administrative types whose planning is destined to fail. Hiring a captive manager that lacks the professional insurance, tax, and legal experience is the equivalent of hiring an ‘accounting firm’ with no CPAs on staff.”

Logan Gremillion, a senior tax attorney with The Feldman Law Firm, said: “A captive insurance company is, before all else, an insurance company. It is, or rather, should be a regulated financial institution. When a company ceases to be operated as an insurance company, it will not withstand challenge. As a complex risk management vehicle, care should be taken at all phases of planning and implementation to ensure that the captive is formed and operated in a manner that is consistent with laws, regulations, and industry best practices.

“In Avrahami, the IRS found the low-hanging fruit that embodies its concern with captives being used for tax-motivated planning rather than as a legitimate risk management tool.”

According to Capstone’s Lance McNeel: “We’ve seen one-man, captive insurance shops purport to be captive managers, while disclaiming in their contracts all legal, tax and insurance responsibilities. As demonstrated by Avrahami, captives that are poorly designed and halfheartedly managed are destined to fail. A captive insurer is a risk-bearing entity and must be designed and operated as such. In Avrahami, it was not difficult for the IRS to recognise that no matter how you dress it up, the captive was not a bona fide insurer.”

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