The Captive Insurance Company risk mitigation strategy often provides tax breaks, but in recent months, it has come under scrutiny. As a result, many tax advisors question the appeal and value of the strategy, with an immediate veto at the suggestion.
However, a recent Tax Court ruling, the first captive insurance case tried in U.S. Tax Court, helped shed some light on the issues of concern and provided a virtual roadmap of procedures to identify and follow for a secure and legal position.
The small captive insurance sector has come under fire in the past year. At odds are the Treasury Department, the IRS, the Senate Committee on Finance, the Joint Committee on Taxation and so-called promoters.
At issue is the use of IRC 831(b), also known as the Tax Shelter Captive. The government has expressed concerns about the increase in the number of tax shelter captives.
The captive is a small insurance company that has made an election under Code Section 831(b), which allows an insurance company owned by the insured to avoid taxes on its annual premium income up to $2.2 million.
In the abused arrangements, businesses are using captive structures that appear on the surface to have a real insurance purpose. But when examined, the risk is not sufficiently existent. The main business receives a tax deduction for insurance premiums paid to its sister insurance company, and the insurance company uses the election to shield the premiums from taxable income.
What has been discovered in many of the cases examined is the insurance is just a sham to hide the real intent of generating a large deduction while providing a tax-free wealth transfer passing premiums to future generations.
In fact, under Notice 2016-66, the IRS identified micro captives as transactions of interest in late 2016.
In a recent Tax Court decision, the Internal Revenue Service prevailed against a business and its owners who attempted to deduct insurance premiums through their jewelry store business.
In Avrahami vs. Commissioner, the Court ruled against the taxpayers who owned three shopping centers and three jewelry stores in the Phoenix area. In this case, the businesses were insured by the Avrahamis’ offshore captive insurance company, Feedback Insurance Company, Ltd., domiciled in St. Kitts.
Looking for a way to reduce their tax liability, the Avrahamis asked their CPA for advice, who recommended an estate planner. The estate planner worked with a New York attorney who advised the family on the strategy.
The Tax Court found that the attorney sent the actuary a “target premium”, which the actuary used to back into the premium amounts. (This is a red flag when looking at the arm’s length rules)
An important issue in the case was whether the company was entitled to deduct the insurance premiums under IRS 162. These rules require a true insurance company to provide for distribution of risk and shifting of risk. In the Avrahamis' case, the insurance company participated in terrorism risk. The company participated in a risk pool with a company owned in part by the New York attorney’s children.
The IRS also questioned the premium amounts. In previous years, the Avrahamis had purchased similar insurance through a commercial insurance company at a rate of approximately $1,500 per year. However, after the taxpayer established their own insurance company to provide the coverage, the premiums jumped to $360,000!
Ultimately the Tax Court disallowed the Avrahamis’ deduction of premiums, but the Court did not find that the captive was a sham or that the taxpayers were negligent in deducting the premiums at issue in the case.
However, the Court’s decision is beneficial for the industry to provide direction on how to structure their arrangements. In addition, the Court ruling provided a virtual roadmap to creating a valid captive insurance company.
As the Court noted in its decision, the facts and circumstances test on whether the transactions were insurance for federal income tax purposes looked at the following:
- Does the arrangement involve risk shifting?
- Does the arrangement involve risk distribution?
- Does the arrangement involve insurance risk?
- Does the arrangement meet the commonly accepted notions of insurance?
The Tax Court agreed with the IRS that the insurance company in question did not distribute risk because they only insured three or four other related entities, far fewer than were insured in other cases.
The Tax Court also sided with the IRS, which established that the insurance company in question only had a maximum of four policyholders. Therefore, the insurance company failed to adequately distribute risk.
In addressing the third question, the Court also found that there was a circular flow of funds, a factor that shows a business is not a true insurance company. In fact, the outside reinsurance company owned by the attorney advising the taxpayers paid the same amount in premiums for reinsurance as the captive paid for its own coverage.
Finally, the premiums paid for terrorism insurance was unreasonable. In fact, the rate 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.
“The facts and circumstances that led the Court to its decision were very specific to the Avrahamis’ situation,” said Steven Miller, a former acting IRS commissioner who now works at Alliantgroup representing captives in agency audits.
“As a result, taxpayers will argue that their facts are different, and the IRS will say it doesn’t matter because the transaction is similar enough,” he said.
Is the future of captive insurance strategies doomed? Only if you follow a similar pattern as the Avrahamis’.
Establish your captive insurance company as a real insurance company, one with shifting and distribution of risk, reasonable premiums, and behavior consistent with commercial insurance companies.
According to the Tax Court in this case, there is a clear plan to follow.
About Dominique Molina
Dominique Molina is co-founder and President of the American Institute of Certified Tax Coaches.