In a widely followed U.S. Tax Court case on micro captives, the U.S. Tax Court, on August 21, 2017, decided in a lengthy decision two companion cases, Avrahami v. Commissioner and Feedback Insurance Company, Ltd., v. Commissioner, 149 T.C. No. 7, which involved various issues surrounding the formation and operation of a captive insurance company in Saint Kitts that made elections under Internal Revenue Code (IRC) sections 953(d) (i.e., to be treated as a domestic insurance company) and 831(b) (i.e., to be taxed as a small insurance company, which, for the years at issue, would not be taxable on underwriting income if premiums in general were less than $1,200,000). The cases involved issues relating to whether the premiums paid by various entities owned by the Avrahamis were deductible under IRC Section 162, whether Feedback should be treated as a bona fide insurance company for federal income tax purposes, the characterization of certain distributions from Feedback to Mrs. Avrahami, and, among other things, the imposition of certain penalties.
The Avrahamis argued (1) that Feedback is a valid insurance company that qualified for, and properly elected to be taxed under, Section 831(b), (2) all of its policies covered insurable risks, (3) premiums were actuarially determined, and (4) the captive distributed risk. However, the Internal Revenue Service (IRS) argued that the intent of the micro captive was to provide tax deductions under Section 831(b) of the Internal Revenue Code and lacked insurance risk, and that risk was not shifted to the captive. The Court’s analysis included:
- Whether there was adequate risk distribution;
- Whether Feedback adhered to various regulatory requirements in its domicile;
- If the policies written could be characterized as bona fide insurance for federal income tax purposes;
- Whether the process utilized by the actuary in determining the pricing of the policies issued by Feedback was proper and adequate;
- The nature, type and structure of the coverages being pooled under the pooling agreement that had been entered into by Feedback, and as such, the efficacy of the pooling agreement;
- A review of claims history and a concern that no claims were made on any of the Feedback policies until the IRS began an audit of the Avrahamis and their various entities’ returns;
- An analysis of Feedback’s accumulated surplus much of which had been transferred back to the Avrahamis, as loans, loan repayments or distributions.
In its ruling, the Tax Court backed the IRS’s decision to deny Benyamin and Orna Avrahami access to the Internal Revenue Code Section 831(b) election for certain financial years, finding that certain amounts paid by Feedback were not insurance premiums for federal income tax purposes. In addition, the Tax Court found that:
- Feedback’s risk exposures fell short of meeting the threshold for insurable risk, according to Judge Holmes. He ruled: “While we recognize that Feedback is a micro captive and must operate on a smaller scale than [other insurance companies the Tax Court has examined], we can’t find that it covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities.” The judge’s holding is novel in light of earlier cases and even IRS guidance, which until now had always focused on the number of related companies that are insured; with this case there appears to be the added need to drill further down and quantify a much larger quantum of ultimate risk exposures.
- The pooling entity was not a bona fide insurance company, and that the captive did not operate like an insurance company because it issued policies with unclear and contradictory terms, had insufficient assets with which to pay claims, charged wholly unreasonable and seemingly indefensible premiums at times 80 times the cost of what the court considered comparable premiums and the circular flow of funds including the loan back of reserves and illiquid investments.
As a result, premiums were not deductible, the insurance company would have been subject to tax on its income and the distributions were characterized as dividends from Feedback taxed as ordinary income and not at the more favorable rate applicable to dividends paid by US corporations to individuals.