The IRS has recently indicated a level of “unhappiness” with the concept of a microcaptive insurance company, adding them to the agency’s “dirty dozen” tax scams list in 2015 and declaring them a transaction of interest in Notice 2016-66. In the case of Avrahami, et al v. Commissioner, 149 TC No. 17 we have the first time the Tax Court scrutinized this particular structure.

Captive insurance companies have been recognized as legitimate insurance arrangements by the courts in several cases (see Rent-A-Center, Inc. v. Commissioner, 142 TC 1 and AMERCO & Subs. v. Commissioner, 96 TC 18) so long as certain criteria are met that distinguish the arrangement as insurance rather than merely establishing a “set aside” of funds for potential liabilities. These cases have generally involved large entities with the resulting captive being itself a relatively large organization.

Small insurance companies, other than life insurance companies, are subject to special tax rules that provide them what can be a significant tax advantage if they are eligible to be taxed under IRC §831(b). Generally, if an insurance company has gross receipts below a set level it is totally exempt from tax, while if it has premiums higher than that level but less than a second cap the insurer can elect to pay no tax on the premiums it receives, but rather only pay on its investment income. For the years involved in the Avrahami case that second limit was $1.2 million.

The concept of “microcaptive insurance company” attempts to combine these two concepts. As the Tax Court explains:

Combining these two concepts — captive insurance companies and the section 831(b) tax advantages for small insurance companies — yields the “microcaptive”. In theory, a microcaptive could be run in the manner of the captives in Rent-A-Center or Harper Group, albeit on a much smaller scale. But it might also be run so that related parties pay the captive deductible insurance premiums of just under $1.2 million a year. In turn the captive might pay out few if any claims, might make a section 831(b) election so it pays tax only on its investment income, and might quickly build up a large surplus. Then, if the captive were to be licensed and regulated in a jurisdiction with extremely low reserve requirements and loose rules on related-party transactions, it might lend its surplus back to its affiliates. This might generate nearly $1.2 million in tax deductions while arguably only moving money from one pocket to another. Or perhaps the captive could be owned by a Roth IRA, which might mean it could make large dividend payments to its stockholder, creating a form of deductible, yet tax-free, retirement savings. Or perhaps the captive could be owned by its business owner’s children or an irrevocable family trust, which might enable the avoidance of future gift and estate taxes.

In this case the taxpayers owned three jewelry stores and several shopping centers. The taxpayers’ long time CPA recommend that they consult with a local estate planning attorney and, as well, consider a captive insurance company. The CPA recommended they consult with an attorney in New York who specialized in captive insurance companies. The taxpayers discussed this option with the estate planning attorney who agreed with both the concept of considering a captive insurance company and retaining the New York attorney to give advice in setting up such a program.

Eventually the taxpayers set up a captive insurance company (Feedback Insurance Company, Ltd.) that was incorporated in St. Kitts. The corporation elected to be treated as a domestic corporation for U.S. tax purposes under IRC §953(d) and to be taxed as a small insurance company under IRC §831(b).

For the years in question the jewelry stores and shopping centers paid Feedback premiums for various insurance policies on business income, employee fidelity, litigation expense, loss of key employee, tax indemnity, administrative actions, and business risk indemnity. As well, the jewelry stores bought terrorism-risk insurance from a Caribbean company. Feedback entered into a reinsurance arrangement with this entity (Pan American) regarding the terrorism insurance.

The Avrahami’s operating entities continued to purchase insurance from traditional commercial carriers during the years in question, with payments to those parties being far less than what was paid to Feedback. The result was that the total insurance premiums paid by the operating entities soared during the years in question.

As well, Feedback invested most of its assets in what it labeled as mortgages that were long term obligations issued to a partnership controlled by the Avrahamis, though technically owned by their children. The ownership was technical because the children admitted they weren’t aware they owned the partnership interests.

The IRS argued that this was all a scheme to generate tax deductions for payments that weren’t really insurance and to create a tax advantaged structure. The taxpayers argued that, in fact, what they had was simply a captive insurance company that was much the same as that in Rent-A-Center and, as was true in those cases involving larger captive insurers, they should be able to claim deductions for the insurance premiums in their operating entities.

The Tax Court noted that was the first case where the combination of the captive insurance arrangement and the small insurer special tax provisions of §831(b) had come before the court.

Fundamentally the case boils down to a simple question—did Feedback really issue insurance policies to the related entities. If that answer is yes, then Feedback would be a small insurance company eligible for the treatment under §831(b) (if it so elected) and the premium payments would represent an ordinary and necessary expense for the operating entities. If not, then the payments would not represent ordinary and necessary business expenses to the operating entities, but rather indirect distributions to the owners via payments to another controlled entity.

As the Court noted, the question of whether the transactions were insurance for federal tax purposes was a “facts and circumstances” test that looked at the following

Does the arrangement involve risk shifting?
Does the arrangement involve risk distribution?
Does the arrangement involve insurance risk? And
Does the arrangement meet the commonly accepted notions of insurance?

The Tax Court summarized the taxpayer’s arguments that the arrangements constituted insurance as follows:

The Avrahamis and Feedback claim their arrangement distributed risk in two independently sufficient ways. First, they rely on Securitas and the Sixth Circuit’s opinion in Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989), aff’g in part, rev’g in part 88 T.C. 197 (1987), to argue that Feedback created a sufficient pool of risks merely by issuing seven types of direct policies — each covering a variety of risks — to the Avrahami entities. Second, they argue that Feedback adequately distributed risk through the Pan American program by reinsuring over 100 geographically diverse third parties. They read Harper Group to establish a rule that risk is distributed whenever premiums from unrelated insureds constitute more than 29% of a captive’s premiums and point out that Feedback received over 33% of its premiums in 2009 and almost 31% of its premiums in 2010 from Pan American participants.

The IRS objects to both justifications. First, the IRS notes that Feedback only insured three or four related entities, far fewer than were insured in the cases the taxpayers cited and far too small to benefit from the law of large numbers to amount to a true distribution of risk. Second, the IRS also claims that the reliance on Harper is misplaced by focusing only on the amount of premiums from unrelated insured, rather at the number of unrelated insured (which was over 7,500 in Harper) and that, in any event, the Pan American program doesn’t distribute risk because it did not cover relatively small, independent risks.

The Tax Court quickly dismissed the taxpayer’s first justification—that the transactions represented insurance merely based on the numbers and types of policies issued to the related entities. The Court noted that even the taxpayer’s own expert indicated that there must be at least 12 affiliated policyholders that pool their risk in a captive arrangement and at least seven policyholders in an association captive arrangement. As Feedback only had a maximum of four policyholders in the years in question, it failed to adequately distribute risk.

The Court also noted that even if there had been enough entities, that still would not be enough to show an adequate distribution of risk. The Court stated “[i]t’s even more important to figure out the number of independent risk exposures.” The Court continues:

For example, in R.V.I. we found risk distribution not just because an insurance company insured 714 different unrelated parties, but also because it issued 951 policies covering more than 750,000 vehicles, 2,000 real estate properties, and 1.3 million equipment assets in 7 different geographic regions. R.V.I., 145 T.C. at 228-29. And in Rent-A-Center we found “a sufficient number of statistically independent risks” when the captive provided workers’ compensation, automobile, and general liability policies that covered more than 14,000 employees, 7,100 vehicles, and 2,600 stores in all 50 states. 142 T.C. at 24. We also held that risk distribution was achieved when a captive provided worker’s compensation coverage for more than 300,000 employees, automobile coverage for more than 2,250 vehicles, and other coverages for more than 25 separate entities. See Securitas, at *26. Even in Humana, 881 F.2d at 257, where the Sixth Circuit held that risk distribution could occur when a captive “insures several separate corporations within an affiliated group”, the captive insured more than 20 corporations operating more than 60 hospitals with more than 8,500 beds. See Humana Inc. v. Commissioner, 88 T.C. 197, 199-202 (1987).

The Court found that Feedback’s situation was comparable to these situations, noting:

We find that Feedback’s risk exposures fall short of these situations. It issued seven types of direct policies — five to American Findings and two each to Chandler One, O&E, and White Knight. American Findings’ policies covered 3 jewelry stores, 2 key employees, and around 35 employees. The remaining policies covered three commercial real estate properties, all in metropolitan Phoenix. While we recognize that Feedback is a microcaptive and must operate on a smaller scale than the insurance companies in R.V.I. or Rent-A-Center, we can’t find that it covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities.

This left the taxpayers relying upon their use of Pan American’s reinsurance program to reinsure third party risk. The taxpayers emphasized that in prior cases the Court had looked at the percentage of premiums received from unrelated insured—in this case over 30% of the premiums received by Feedback came from participating in Pan American’s reinsurance program.

But the Court noted that this is reading the case law too narrowly—that percentage only matters if Pan American was a bona fide insurance company. If Pan American is not a bona fide insurance company then the payments would not serve create the issuance of insurance by Feedback for unrelated parties.

The Court found several issues with Pan American’s operations. First, the Court that there was a circular flow of funds, a factor that indicates an entity is not a true insurance company. As the Court described the arrangement:

Recall that Pan American was structured in such a way that a small business would pay Pan American a premium for coverage up to a certain limit. Then Pan American would turn around and reinsure all the risk it had assumed, making sure that the captive related to the small business received reinsurance premiums equal to those paid by that small business. Under the 2009 program, for example, American Findings paid Pan American $360,000 for up to $5,525,000 in terrorism coverage and Pan American paid Feedback $360,000 for reinsuring 1.797% of Pan American’s total losses. The same was true under the 2010 program — American Findings paid Pan American $360,000 for up to $5,125,000 in terrorism coverage and Pan American paid Feedback $360,000 for reinsuring 1.56% of Pan American’s total losses. While not quite a complete loop, this arrangement looks suspiciously like a circular flow of funds. The end result of two years in the Pan American program was the transfer of $720,000 from an entity owned 100% by the Avrahamis to one owned 100% by Mrs. Avrahami.

The Court also found the premiums paid for the terrorism insurance was unreasonable, being well above the amounts charged for any commercially available policy on the market. While agreeing that the policy issued by Pan American covered additional items normally excluded in commercially available coverage, it also had an odd exclusion (no coverage for events occurring in cities of more than 1.5 million individuals) and the right pay in a promissory note payable over three years rather than immediately. Ultimately the Court found no reasonable explanation for a rate that was 80 times more than the rate under a commercial policy held by one of the entities.

The Court also found that if a claim had been triggered under a policy, it was unlikely to have been paid. Pan American retained almost no funds with which to pay claims in the event that one of the captives that it paid for reinsurance refused to pay—as the Court noted “an event that would be more probable if, like Mr. Avrahami, other captives owners would ‘freak out’ if they lost money in the Pan American program.” Thus, this doesn’t appear to be a program that a party looking for actual insurance against these risks would be willing to participate in due to uncertainty regarding the ability to have a claim paid.

Finally, the Court did not find that Pan American qualified as a “fronting company” agreeing with the IRS view that this wasn’t operated as a fronting company would be, looking much more like a mechanism to allow the various captives to claim to meet risk distribution requirements. While fronting companies don’t take on insurance risk, they do take on significant credit risk that one of the companies won’t pay. But Pan American received very little in terms of fees for taking on that substantial risk.

While the lack of risk distribution by itself dooms the structure, the Court also found many problems with viewing the policies issued by Feedback as insurance in the commonly accepted sense. The Court notes first that Feedback wasn’t operated like an insurance company, dealing with claims on an “ad hoc” basis. No claims were submitted at all until the exam was underway and then the claims were dealt with in a way not like how insurance claims are normally handled. Feedback approved claims even though they were submitted well after the 30-day period called for in the policies and did not demand basic evidence to support claims.

It made investments that, in the words of the Court, “only an unthinking insurance company would make.” Most of its assets were tied up in unsecured promissory notes with no payments due until years in the future—long term, illiquid loans made to related parties. The company also did not inform the regulators on St. Kitts of these related party loans until after the exam was underway.

The Court found some of the policies were “less than a model of clarity.” The Court notes:

The Avrahamis assert that all the policies issued by Feedback were claims-made policies, yet the policies say otherwise. For example, Chandler One’s 2009 Administrative Action policy states that Feedback “agrees to pay to the Insured any legal expense incurred by the insured during the Policy Period, arising from or relating to the defense of any Insured Event as defined hereunder, which Insured Event is instituted against the Insured during the Policy Period.” The policy then defines “Policy Period” as “[e]vents occurring and reported from and after 12:01 a.m. December 15, 2009 and prior to 12:01 a.m. December 15, 2010.” By its plain terms the policy limits coverage to legal expenses incurred and reported between December 2009 and December 2010, terms indicative of both a claims-made policy — the claim must be reported during the policy period — and of an occurrence policy — the claim must occur during the policy period.

The premiums paid were also found unreasonable by the Court. The taxpayers had a “target premium” that would get them to just under the $1.2 million level that allowed them to be a micro-captive. While an outside expert was hired to provide justification for the premiums set, the Court found that the expert’s work was not acceptable. The Court concluded:

We find from all this that Rosenbach’s calculations aimed not at actuarially sound decision-making but at justifying total premiums as close as possible to $1.2 million — the target — without going over. To do so he would add in a proration factor or drop the policy limits until he reached his goal.

Ultimately, the Court denied the deductions for insurance paid by the various operating entities, all of which flowed through to the Avrahami’s returns.

The taxpayers did escape penalties on the disallowed insurance premiums based on reasonable reliance on one of the three professionals involved. The Court noted that the CPA had testified that he had only “provided bookkeeping services and signed the tax returns.” Thus, the taxpayers, not having received advice from him on this topic, could not look for relief by point at his work.

Similarly, the New York attorney served as the promoter of the program. Taxpayers cannot rely on the promoter of a program to give them reasonable cause if the tax advantages do not pan out. As the Court noted:

She structured the captive-insurance-company transaction, drafted the purported insurance policies, and designed and set up the failed risk-distribution programs, which she sold to more than 100 of her clients. She also profited a great deal from the transaction, receiving a portion of both an initial $75,000 engagement fee and the annual flat fees. The Avrahamis could not reasonably rely on her.

But the estate planning attorney who assisted with the program was another matter. While he received some compensation from starting up the entity and participated in that function, that involvement was relatively limited. Rather he

…did not provide advice on the capitalization of Feedback; had no involvement in selecting an actuary to determine premiums and underwrite the polices; and played no role — not even as a reviewer — in the formation or documentation of the transactions with Pan American. He also had a prior relationship with the Avrahamis, did not give unsolicited advice, and — aside from the start-up fee — billed the Avrahamis on an hourly basis. These are all signs that a tax adviser is not a promoter, see Countryside Ltd. P’ship v. Commissioner, 132 T.C. 347, 352-53 (2009), and we find that he was not a promoter.

This attorney also testified that he had advised the taxpayers on how captives worked, the structure of Feedback, and what types of investments the captive could make. The taxpayer also credibly testified that they moved forward with this transaction because this attorney “gave his blessing” to the arrangement.

Given this was a case of first impression and the taxpayers sought out and relied upon the advice of counsel they had a working relationship with, there was no penalty imposed on them for this understatement.