By: Matthew S. Sutphen
In recent years, the Internal Revenue Service (the “IRS”) has increased its audits of micro-captive insurance companies in the belief that small businesses are using them to insure against improbable risks on which they never pay claims, and which the premiums return to the business owners or heirs with little to no tax. In fact, micro-captive insurance is one of the IRS Large Business and International Division’s 13 tax compliance campaigns, which officially rolled out in January.
The recent case, Avrahami v. Commissioner, 149 T.C. No. 7 (Aug. 15, 2017), embodies these concerns. This case involved husband and wife taxpayers (the “Taxpayers”) owning several shopping centers and jewelry stores, which were insured by an offshore captive insurance company, called Feedback Insurance Company, Ltd. (the “Micro-Captive”), domiciled in St. Kitts. The Micro-Captive also entered into a cross-insurance program to reinsure terrorism insurance for other small captive insurers through a risk-distribution pool of the insurer Pan America (the “Pan America Cross-Insurance Program”), which is also domiciled in St. Kitts and was created by the attorney who established micro-captives for the Taxpayers and other clients. Although the Taxpayers formed the Micro-Captive, they continued to buy insurance for their businesses from third-party commercial carriers and made no changes in coverage. Also, each year, the attorney involved gave the actuary “target premiums” for the Micro-Captive.
NOTE, while this case contains some excesses, the basics of the IRS challenge can apply to other arrangements which are not as aggressive as terrorism insurance if the insurance fails to constitute insurance as defined by the tax court in the Avrahami case. If you have a micro-captive insurance company, you should review its operations in light of the Avrahami case to make certain (i) that the micro-captive is providing risk distribution through its insurance products, (ii) that the micro-captive is acting like an insurance company through its operation, and (iii) that the insurance arrangement looks like insurance in the commonly accepted sense.
IRS Argument
The IRS challenged the deductions for the premiums paid to the Micro-Captive and Pan America, asserting that what it sold was not insurance, so the premiums were not deductible as ordinary and necessary business expenses.
More specifically, the IRS claimed (i) that several of the Micro-Captive’s policies included uninsurable risks; (ii) that the Micro-Captive failed to distribute risk because it had an insufficient pool of insureds; (iii) that risk was not shifted because neither the Micro-Captive nor Pan America was financially capable of meeting its obligations; (iv) that the arrangements did not embody common notions of insurance; and (v) the premiums were not determined at arm’s length.
Tax Court Decision
The case ultimately turned on whether the transactions at issue involved “insurance” for federal tax purposes. For there to be “insurance,” the arrangement must involve risk shifting, risk distribution, and insurance risk, as well as meeting the commonly accepted notions of insurance. Although the Court could have decided this case based on just its determination that the Micro-Captive failed to distribute adequate risk, it went on to invalidate the Micro-Captive by finding that it did not act like an insurance company.
a. Risk Distribution
For there to be bona fide “insurance,” the arrangement must meet the risk-distribution requirement, which occurs when the insurer pools a large enough collection of unrelated risks. In making this determination, consideration must be given to the number of entities involved in the arrangement, as well as to the number of independent risk exposures. As such, having either too few entities involved in the arrangement or too few independent risk exposures can be fatal for achieving adequate risk distribution.
Turning to the Avrahami case, the IRS argued that the Micro-Captive directly insured only three and four related entities for the tax years at issue, which were too few compared to the number of related-entities required by caselaw. The IRS also argued that the percentage of premiums that came from third parties and the total number of unrelated insureds were equally important for risk distribution purposes. As such, the IRS argued that the Taxpayers over relied upon and misread caselaw by focusing solely on the percentage of premiums that came from third parties.
The Court found that there was no true risk distribution in this case. The Micro-Captive only had three and four entities in the risk pool for the tax years at issue, which under caselaw, IRS rulings, and even the Taxpayers’ own expert witness, were too few to adequately distribute risk. Moreover, the court found that the Micro-Captive’s risk exposures were relatively small in number and, therefore, were insufficient – e.g., five policies issued to one of the affiliated entities covered three retail stores, two key employees, and around 35 employees. Whereas in Rent-A-Center v. Commissioner, 142 TC 1 (2014), although few entities were involved, the captive provided workers’ compensation, automobile, and general liability policies covering more than 14,000 employees, 7,100 vehicles, and 2,600 stores. As such, the Court held that the arrangement failed to adequately distribute risk because there were too few entities involved in the risk pool and there were not enough independent risk exposures.
The Court also analyzed whether the Micro-Captive’s participation in the Pan America Cross-Insurance Program adequately distributed risk to survive scrutiny. The Court, ultimately, concluded that Pan America was not a bona fide insurance company. As such, the policies it was issuing were not insurance, which meant that the Micro-Captive’s “reinsurance” of those same policies did not distribute risk. The Court made its determination based on its findings that the overall effect of the arrangement was a circular flow of funds; that Pan American charged “grossly excessive” premiums (e.g., it charged a premium of $360,000 for insurance that the taxpayers bought for another business at $1,600 from a commercial carrier); that when looking at the overall terms of the coverage, no reasonable business would have bought it; the probability of a claim being actually triggered was extremely low; and it was questionable whether a qualifying loss would have been paid.
b. Insurance in the Commonly Accepted Sense
As an alternative approach to examining whether an arrangement is bona fide “insurance,” a court can consider whether the insurance arrangement looks like “insurance in the commonly accepted sense.” In making this determination, the court will consider several factors, e.g., whether the company acted like an insurance company; whether the company was adequately capitalized; whether the premiums were reasonable and the result of an arm’s-length transaction; whether the policies were valid and binding; and whether claims were paid. To determine whether a micro-captive is acting like an insurance company, the following are some key factors: (i) whether the micro-captive set premiums based on actual risk factors and not on a set target; and (ii) whether the micro-captive made investment choices that are typical of insurance companies, e.g., making liquid investments and not illiquid ones like loaning back the money to a shareholder.
In Avrahami, the IRS argued that the Micro-Captive was organized solely for tax purposes, did not operate as an insurance company, lacked arm’s-length premium determinations, failed to get timely approval for transfers to related parties in violation of St. Kitt regulations, did not satisfy Arizona insurance regulations, and issued policies with contradictory provisions.
The Court, again siding with the IRS, concluded that, in addition to the absence of risk distribution, the insurance arrangement through the Micro-Captive did not constitute insurance in the “commonly accepted sense.” The Court stated, “[a]lthough [the Micro-Captive] 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 did not address the IRS’s Arizona insurance argument because whether or not the IRS was correct would not change the outcome of the case.)
The Court found that the actuary/underwriter’s calculations of the premiums were difficult to understand and over-adjusted the price by overstating particular factors that were inapplicable. In fact, it appeared that the Micro-Captive’s premiums were cooked up by the actuary/underwriter to reach the “target premiums” that were provided by the attorney as previously mentioned. Although the Court stated that the Micro-Captive paid claims filed against it, the Court also noted that it dealt with those claims “on an ad hoc basis” and that no claims were even filed until after the IRS began its audit. The Micro-Captive also made investment decisions that “only an unthinking insurance company would make.” More specifically, it invested only in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them.
In conclusion, the Avrahami case demonstrates the level of scrutiny that the IRS is giving to micro-captive arrangements and indicates what the Tax Court will look for when analyzing the validity of such arrangements.
This article was written by Matthew S. Sutphen. For questions regarding this, or other tax related issues, please contact a member of Jackson Kelly’s Tax Practice Group.