Microcaptive premium deductions disallowed

The Tax Court disallowed deductions for premiums paid to a microcaptive insurance company because the arrangement did not constitute insurance under federal income tax law. This was a case of first impression—the Tax Court could find no other cases involving microcaptives and Secs. 162, 831(b), and 953(d)—and it may have broad-reaching implications for captive insurance arrangements.

Facts: Benyamin and Orna Avrahami owned a number of partnerships and S corporations. In 2007, the Avrahamis formed a captive insurance company, Feedback, with Orna Avrahami as the sole shareholder. Feedback elected to be taxed as a small insurance company under Sec. 831(b). The Avrahamis set target prices for the policies issued by Feedback to the Avrahamis’ entities and retained an actuary to price the policies according to the targets.

In 2009 and 2010, the years at issue in this case, the Avrahamis’ entities paid insurance premiums to Feedback of $730,000 and $810,000, respectively. American Findings, one of the Avrahamis’ entities, also purchased terrorism-risk insurance from Pan American, which was then reinsured through other companies, including Feedback. Pan American was a third-party company designed to help captive insurance companies distribute risk. It operated by issuing policies to entities insured by a captive company and then reinsuring the policies through the captive companies, paying each captive company an annual reinsurance premium equal to the premium paid to Pan American by the captive company’s insured entity. For example, in 2009 and 2010, American Findings paid Pan American insurance premiums of $360,000 per year, and Pan American in turn paid a reinsurance premium to Feedback of $360,000 per year.

In all, for 2009 and 2010, the Avrahamis’ entities combined deducted $2.26 million in insurance premiums paid to Feedback and Pan American. The entities also continued to maintain the same third-party commercial insurance coverage that they had purchased prior to the formation of Feedback, at a cost of less than $90,000 per year.

No claims were filed with or paid by Feedback from its inception in 2007 until 2013. Because of the Sec. 831(b) election, Feedback also paid no income tax on its premium income. Feedback quickly accumulated funds, a large portion of which it transferred directly or indirectly to the Avrahamis in 2010.

The IRS disallowed the insurance expense deductions and recharacterized transfers from Feedback, determining deficiencies in the Avrahamis’ individual income tax returns of approximately $1.37 million for 2009 and 2010, plus nearly $275,000 in penalties.

Issue: The primary issue before the Tax Court was whether the arrangement between the Avrahamis’ entities and Feedback and Pan American constituted insurance for federal income tax purposes and the premiums paid to the companies were deductible insurance premiums.

Insurance premiums are deductible under Sec. 162(a) as ordinary and necessary business expenses, but amounts set aside as a loss reserve or self-insurance are not deductible. In addition, under Sec. 831(b), insurance companies with net written premiums of $2.2 million or less ($1.2 million or less in the years at issue) that meet certain requirements are taxed only on their investment income.

Pure captive insurance companies are companies that insure only risks of related-party companies. As such, the line between insurance and self-insurance is not always clear with captives. Microcaptives are captives that qualify as small insurance companies under Sec. 831(b). Microcaptives have been subject to increased scrutiny in recent years because of the opportunity for abuse. Entities can pay deductible insurance premiums to a related-party microcaptive. The microcaptive is not taxed on the premium income under Sec. 831(b), and then the microcaptive can, for example, loan the money back to the insured, generating deductible business expenses by moving money from one related company to another and back. The IRS declared microcaptive insurance transactions a “transaction of interest” in 2016 (Notice 2016-66).

Under the Supreme Court’s definition of insurance in Helvering v. Le Gierse, 312 U.S. 531 (1941), to be considered insurance, an arrangement must involve risk shifting, risk distribution, and insurable risk, and it must meet commonly accepted notions of insurance. The IRS argued that the arrangement did not meet these requirements because neither Feedback nor Pan American maintained sufficient reserves to meet its obligations, leaving the risk with the insured; Feedback had an insufficient pool of insureds to adequately distribute risk; the policies included uninsurable risks; and Feedback and Pan American did not operate as insurance companies and did not determine the premiums on their policies at arm’s length. Thus, the IRS argued, the arrangement did not constitute insurance, and premiums paid by the Avrahamis’ entities were not deductible.

The Avrahamis and Feedback argued that Feedback was a valid insurance company that met all requirements of Sec. 831(b), that its policies covered insurable risks, that it distributed risk by ensuring that at least 30% of its premium income came from unrelated parties, and that it charged premiums that were actuarially determined.

Holding: The Tax Court held that the amounts paid to Feedback and Pan American were not insurance premiums for federal tax purposes because the arrangements between the Avrahamis’ entities and Feedback and Pan American were not insurance. Therefore, it denied the Avrahamis the deductions for the insurance premiums that were passed through to them from their various business entities.

The Tax Court first found that Feedback was not selling insurance because it did not sufficiently distribute risk and was not selling insurance in the commonly accepted sense. Feedback issued only seven types of direct policies to four related entities, and the policies covered a small number of employees and locations. The court found that because of the small number of risks covered by the Feedback policies, it did not cover enough risk exposures to achieve risk distribution.

The Avrahamis also claimed that Feedback distributed risk by reinsuring risk through the Pan American program. However, the court found that Feedback did not distribute risk through Pan American because Pan American itself was not a bona fide insurance company. The court found it was not a bona fide insurance company because of its atypical fee structure (it did not take a percentage of premiums as a ceding fee), the excessive premiums it charged, an ultralow probability of ever paying a claim, and the circular nature of the payments between the company and the Avrahamis.

In addition, the Tax Court alternatively found that the Feedback arrangement was not insurance because it did not meet commonly accepted notions of insurance; that is, it did not look like insurance. While Feedback was organized as an insurance company under the laws of the Caribbean island nation of Saint Christopher and Nevis (St. Kitts) and met St. Kitts’s minimum capitalization requirements, Feedback did not operate as an insurance company. It invested only in illiquid loans to related parties, tying up its assets and compromising its ability to pay claims. Further, Feedback had no claims for over five years, and then had them only after the IRS began its audits. When Feedback did receive claims, they were handled on an ad hoc basis, with late-filed claims and claims without sufficient evidence as to the cause for which they were paid. Further, despite being priced by an actuary, the premiums charged by Feedback were “utterly unreasonable” and not the result of arm’s-length transactions, the court said, especially in light of the fact that the entities maintained other comprehensive commercial coverage for less than $90,000 per year and the actuary was unable to clearly explain the methodology used to price the policies.

Because Feedback was not involved in issuing insurance, the Tax Court held, it was not eligible to be taxed as a small insurance company under Sec. 831(b) and was not a foreign insurance corporation that could elect to be treated as a domestic corporation.

The court did not sustain penalties relating to the nondeductiblity of premiums, finding the Avrahamis reasonably relied in good faith on their adviser’s professional advice, but upheld them with respect to certain recharacterized purported loan repayments from Feedback.

• Avrahami, 149 T.C. No. 7 (2017)

—By Elizabeth Lyon, J.D., LL.M., an assistant professor of accountancy at California State University, Sacramento.