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Tax Court Rejects Insurance Expense Deductions Relating to Microcaptive Transaction

(Parker Tax Publishing September 2017)

In a case of first impression, the Tax Court held that a couple's businesses could not deduct insurance payments made to a captive insurance company and another company because the companies did not qualify as insurance companies for federal tax purposes. Further, elections made by the captive under Code Sec. 831(b) and Code Sec. 953(d) were invalid and the company is thus treated as a foreign corporation. Avrahami v. Comm'r, 149 T.C. No. 7 (2017)

Background

Benyamin and Orna Avrahami own three shopping centers and three successful jewelry stores. In 2007, the Avrahamis business entities were flourishing and they were in need of some business advice. They turned to Craig McEntee, who had been their trusted CPA for about 25 years. Upon McEntee's recommendation, the Avrahamis retained Neil Hiller for some estate-planning services. McEntee also suggested that a captive insurance company might be a good fit for the Avrahamis and recommended that they consult Celia Clark, a founding partner of Clark & Gentry, PLLC. In 2006, Clark helped draft captive-insurance legislation for the dual-island Caribbean nation of Saint Christopher and Nevis (St. Kitts). Clark had more than 75 captive insurance clients in St. Kitts by 2008. Hiller also discussed the captive insurance idea with the Avrahamis and recommended that they hire Clark. In November 2007, the Avrahamis signed a retainer agreement with Clark in which they agreed that Clark and Hiller would act as co-counsel and provide all legal services relating to the start-up of a captive insurance company in exchange for $75,000. This agreement eventually led to the formation in 2007 of the Avrahamis' captive insurance company - Feedback Insurance company, Ltd. (Feedback).

Mrs. Avrahami was Feedback's sole shareholder as well as its treasurer and bookkeeper, though both Avrahamis had signature authority over Feedback's bank account. Feedback applied for and received authorization from St. Kitts to conduct a small group captive insurance business under the St. Kitts 2006 Captive Insurance Companies Act. In 2008, Feedback made two elections. The first was an election under Code Sec. 953(d) to be treated as a domestic corporation for federal income tax purposes. The second was an election to be taxed as a small insurance company under Code Sec. 831(b).

In 2006, the Avrahamis had spent approximately $150,000 insuring their business entities. In 2009, they paid more than $1.1 million for insurance and, in 2010, that amount increased to more than $1.3 million. The Avrahamis made the overwhelming share of these payments to Feedback. Feedback also entered into a cross insurance program to reinsure terrorism insurance for other small captive insurers through a risk-distribution pool set up by Clark exclusively for clients of her firm. Despite the formation of Feedback, each of the Avrahamis' entities continued to buy insurance from third-party commercial carriers. They made no change to coverage under those policies after contracting for insurance with Feedback.

There were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis' tax returns and tax returns of entities they owned. With money coming in and none going back out to pay claims, Feedback accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which ended up back in the Avrahamis' bank account. Included in Feedback's surplus was $720,000 that the Avrahamis' jewelry stores paid to an off-shore company, Pan American Reinsurance Company (Pan American), which reinsured a portion of its risk with Feedback. The full $720,000 (which equaled 30 percent of target premiums for 2009 and 2010, the rate necessary to ensure risk is being distributed) then came right back to Feedback. Feedback used its surplus to transfer funds to Mrs. Avrahami and an entity named Belly Button Center, LLC (Belly Button). Belly Button owns approximately 27 acres of land in Arizona, which it purchased using $1.2 million in cash borrowed from Mr. Avrahami and a note payable to the sellers. Belly Button was owned equally by the Avrahamis' three children, none of which had any knowledge of the company. Feedback funneled money to Belly Button in exchange for promissory notes payable to Belly Button.

In 2010, Feedback reported two types of assets on its tax return - more than $1.35 million in cash and $2.53 million in mortgage and real estate loans. The $2.53 million comprised an $830,000 secured promissory note from Belly Button with no payments due until February 2018, a $1.5 million unsecured promissory note from Belly Button due in March 2020, and a $200,000 unsecured note from Belly Button - even though the funds went directly to Mrs. Avrahami - due no earlier than December 2012. In 2010, Belly Button transferred $1.5 million from its bank account into the Avrahamis' bank account, claiming this was a repayment of the $1.2 million loan for the Arizona property. However, these amounts were inconsistently reported on the Feedback and Belly Button returns.

For 2009 and 2010, the Avrahami entities collectively took business expense deductions for insurance premiums of $1,090,000 and $1,170,000, respectively. No claims were filed against Feedback under any of its direct policies in either 2009 or 2010. And no events took place triggering a terrorism claim in either year.

Insurance Arrangements and Sec. 953(d) and Sec. 831(b) Elections

The Supreme Court addressed insurance arrangements in Helvering v. Le Gierse, 312 U.S. 531 (1941). In that case, the Supreme Court listed four nonexclusive criteria that must be met for an arrangement to constitute insurance. According to the Court, the arrangement must: (1) involve risk-shifting; (2) involve risk-distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance.

Under Code Sec. 953(d), a foreign corporation that would qualify as an insurance company under subchapter L of the Code if it were a domestic corporation, and that meets certain other requirements, can elect to be treated as a domestic corporation for federal income tax purposes. By making this election, the corporation is not treated as a controlled foreign corporation (CFC) and is not subject to the burdensome requirements that a CFC is subject to, such as filing Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Failure to file Form 5471 can result in hefty penalties as well as an extension of the statute of limitations in which to assess taxes on the taxpayer.

Code Sec. 831(b) allows qualifying non-life insurance companies whose net written premiums do not exceed $2,200,000 ($1,200,000 before January 1, 2017) to elect to be taxed solely on investment income.

IRS Stepping Up Audits Relating to Microcaptive Insurance Companies

In 2015, in IR-2015-19, the IRS began warning taxpayers about engaging in microcaptive transactions. It characterizes such transactions as transactions of interest under Code Sec. 6011, Code Sec. 6111, and Code Sec. 6112. In Notice 2016-66, the IRS identified the type of transactions it would consider microcaptive transactions and warned persons involved in such transactions that certain responsibilities and penalties may arise from participating in such transactions.

Microcaptive transactions involve a captive insurance company (i.e., a captive), a related insured business, and another insurance company that is generally unrelated to the insured business but related to the promoter of the captive transactions. The captive excludes the premium income from its taxable income by electing under Code Sec. 831(b) to be taxed only on its investment income. The captive uses that premium income for purposes other than administering and paying claims under the insurance contract, generally benefitting the insured or a party related to the insured. For instance, the captive may use premium income to provide a loan to the insured.

As a result of this increased scrutiny of microcaptives by the IRS, the Avrahamis weren't alone in having returns audited because of their interactions with a related microcaptive insurance company. However, the Avrahamis' returns were the first Code Sec. 831(b) case to make it to trial.

IRS and Taxpayers' Positions

The IRS argued that the amounts paid to Feedback and Pan American were not deductible business expenses because the arrangements lacked all four criteria necessary to be considered insurance for federal tax purposes. According to the IRS, (1) several of Feedback's policies included uninsurable risks; (2) Feedback failed to distribute risk because it had an insufficient pool of insureds; (3) no risk was shifted because neither Feedback nor Pan American was financially capable of meeting its obligations; and (4) the arrangements did not embody common notions of insurance because Feedback and Pan American did not operate like insurance companies and their premiums were not determined at arm's length. According to the IRS, the funds transferred out of Feedback that eventually ended up in the Avrahamis' bank account - whether directly or indirectly via Belly Button - constituted ordinary income to them.

The Avrahamis and Feedback, on the other hand, argued that (1) Feedback was a valid insurance company that qualified and properly elected to be taxed under Code Sec. 831(b); (2) all the policies covered insurable risks; (3) all premiums were actuarially determined; and (4) Feedback distributed risk by ensuring at least 30 percent of its premium income came from unrelated parties participating in the Pan American program. As a result, they maintained that the insurance-expense deductions claimed by the various Avrahami entities were proper and all the distributions to Belly Button were valid, documented loans. However, they conceded that the $200,000 distributed directly to Mrs. Avrahami should have been reported and taxed - at qualified dividend rates, they argued - and would have been but for an error by their CPA. The Avrahamis also argued that Feedback distributed risk by participating in the Pan American program and reinsuring third-party risk.

Tax Court's Decision

The Tax Court held that the elections made by Feedback were not valid and the amounts paid to Feedback and Pan American did not constitute insurance premiums for federal income tax purposes and thus were not deductible under Code Sec. 162. The court also concluded that the $200,000 transferred directly from Feedback to Mrs. Avrahami was an ordinary dividend taxed at ordinary income tax rates; however, amounts transferred indirectly from Feedback to the Avrahamis through Belly Button was not taxable to the extent it represented a loan repayment. Any excess over this amount was either taxable interest or ordinary dividends. Finally, because this was the first case to ever address microcaptives and the interplay among Code Sec. 162, Code Sec. 831(b), and Code Sec. 953(d), the court held that the Avrahamis were not liable for the accuracy-related penalties under Code Sec. 6662(a) except in relation to the amounts determined to be ordinary dividends or taxable interest.

In concluding that Feedback did not qualify as an insurance company, the court said Feedback's operations left much to be desired. While noting that Feedback met the minimum capitalization requirements of St. Kitts and that case law implied that this meant it was adequately capitalized, the court also noted that Feedback dealt with claims on an ad hoc basis and invested only in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them. Additionally, the court observed, the Avrahami entities made no claims whatsoever against Feedback from its inception in 2007 until March 2013 - two months after the IRS began its audits. And even the claims Feedback did receive it dealt with in questionable ways, the court noted. The policies required that Feedback be notified within 30 days of the loss; however, most of the claims were approved despite being filed after 30 days.

Further, the court said, Feedback also made investment choices only an unthinking insurance company would make. By the end of 2010, more than 65 percent of Feedback's assets were tied up in long-term, illiquid, and partially unsecured loans to related parties. And, despite Kittian regulations requiring advance approval for any loan to a parent or affiliated person, such loans weren't disclosed until September 2014. If something catastrophic happened to Belly Button, its ability to repay the loans would be impaired, the court noted, and make Feedback's ability to pay on any claims doubtful. Even if Feedback was organized and regulated as an insurance company, the Tax Court found that it was not operated like one.

In determining whether Pan American was a bona fide insurance company, the court said it wouldn't condemn the entity solely for the atypical fee structure it had; however, the court noted such fee structure came combined with excessive premiums, an ultralow probability of a claim ever being paid, and payments of a circular nature. The court had to make a finding of fact as to whether Pan American was an entity engaged in insurance or was just part of a tax-reduction scheme papered to look like an entity engaged in insurance and concluded that, more likely than not, Pan American was not a bona fide insurance company. According to the court, even though Pan American was regulated under the laws of the Island of Nevis and met that loosely regulated regime's low capitalization requirements, that was not enough. The court concluded that the policies Pan American was issuing were not insurance, which in turn meant Feedback's reinsurance of those same policies did not distribute risk. Therefore, neither through its affiliated entities nor through Pan American did Feedback accomplish sufficient risk distribution for its arrangements to be considered insurance for federal income tax purposes.

For a discussion of insurance expense deductions and captive and microcaptive insurance arrangements, see Parker Tax ¶92,730.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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