August 23, 2017
By Allyson Versprille
Taxpayers should expect the IRS to take an even harder stance on “micro-captive” insurance arrangements after a recent U.S. Tax Court decision in the agency’s favor, practitioners told Bloomberg BNA.
The Internal Revenue Service will likely feel emboldened after the Aug. 21 decision, said John Dies, managing director of tax controversy at Alliantgroup LP. In the decision, the court ruled that taxpayers—Benyamin and Orna Avrahami—who set up a micro-captive arrangement to protect their three jewelry stores from terrorist attacks can’t claim deductions for amounts paid to their captive insurance company ( Avrahami v. Commissioner, 149 T.C. No. 7, T.C., No. 17594-13, 8/21/17).
“I actually see this case as making it harder to resolve the mass number of captive cases that are out there being examined,” Dies said. “If anything, it’s likely to entrench the positions of both parties even more.”
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. Dies said he expects the IRS to continue to seek penalties against other captives under audit as a result of this ruling or at least try to use the decision as a leveraging tool to force taxpayers to back away from these transactions, he said.
In Avrahami, the Tax Court invalidated the micro-captive’s tax code Section 831(b) and 953(d) elections to be treated as a small insurance company and domestic corporation. Section 831(b) allows insurers with $2.2 million or less in premium income to be taxed only on their investment income.
The decision is the latest development in the IRS’s efforts to crack down on what it perceives as abuses under Section 831(b). Last November, the agency issued Notice 2016-66, which identified certain captive insurance arrangements that qualify under Section 831(b), and any similar structures, as “transactions of interest.” Section 831(b) captives have also been on the agency’s “Dirty Dozen” list of tax scams for the past several years, and are one of the first 13 issues being targeted by the IRS Large Business and International Division’s new tax compliance campaigns.
Numbers Affected
“With respect to the captive insurance industry at large, I don’t think that there would be a significant impact on legitimate, well-designed, properly capitalized, and established captive insurance companies,” said Matthew J. Mueller, of counsel at Wiand Guerra King PA and a former prosecutor with the Justice Department’s Tax Division.
Mueller said he doesn’t anticipate a “sea change” from this ruling but that more aggressive uses of captive insurance companies—especially those that make the Section 831(b) election—will continue to be frowned upon by the government.
Captive insurance companies are often formed to insure the risk of an operating business, which may be a corporate parent, as well as subsidiaries of a corporate parent. One of the main benefits is that a captive can insure risks that otherwise can’t be insured because it would be too expensive or coverage isn’t available in the commercial marketplace. The industry covers both large captives that insure the risks of giant corporations and smaller captives that fall into the Section 831(b) space.
David Provost, deputy commissioner of the Captive Insurance Division in Vermont’s Department of Financial Regulation, said the decision won’t have a significant impact on his state—the leading captive insurance domicile in the U.S.—because only about 5 percent of Vermont’s captives make the Section 831(b) election.
However, he worried about how this decision might tarnish the industry as a whole. The ruling will give people the impression that captives are “tax manipulation tools instead of insurance companies and that’s what we’ve been trying to avoid for years,” he said.
Risk Pool Concerns
Jay Adkisson, a founding partner of Riser Adkisson LLP who practices in the captive insurance area, said the case is likely to cause a lot of micro-captives—as many as 1,000—problems. But in terms of premium dollars and reserves, “this decision is only going to affect a very small slice” of the total industry, he said.
“We have to keep in mind that the captive industry is huge,” Adkisson said, noting that it won’t impact large corporate captives at all. The captives that have to be most concerned are those that take the Section 831(b) election and participate in risk pools, he said.
In the 105-page opinion, the Tax Court said the risk pool that the Avrahamis’ micro-captive—Feedback Insurance Co. Ltd.—used to distribute risk was not a bona fide insurance company.
In 2009 and 2010, Feedback started participating in a risk distribution program through Pan American Reinsurance Co. Ltd. The court found that Pan American wasn’t a bona fide insurance company, citing its “excessive premiums, an ultralow probability of a claim ever being paid, and payments of a circular nature.”
Some Penalties, Not Others
The Tax Court imposed penalties on the Avrahamis on amounts related to distributions from Feedback Insurance Co. Ltd.—their offshore captive insurance company—that the taxpayers classified as loans but that the IRS reclassified as dividends or interest.
The court, however, didn’t impose penalties on the taxpayers for improperly deducted captive insurance premiums that were paid to Feedback. The court found that the Avrahamis acted reasonably and in good faith when they relied on the professional advice of their attorney Neil Hiller, who is based in Phoenix and practices in estate planning, employee benefits, and tax.
When discussing whether the Avrahamis acted in good faith, the court noted that there is a lack of prior case law that deals with the issues the Avrahamis were facing. “There is no clear authority to guide taxpayer,” the opinion said.
Miller said he hopes the opinion prompts the IRS to move quickly to issue guidance on micro-captives, which the industry has been requesting for several years.
Two Out of Four
David J. Slenn, chair of the American Bar Association’s Captive Insurance Committee, said the Tax Court’s decision is beneficial to the captive industry because it provides both current captive insurance owners and taxpayers that are considering using captives with some direction on how to structure their arrangements.
But there are issues that practitioners are still waiting for guidance on.
For an arrangement to be “insurance” for federal tax purposes, there are four factors that need to be considered: risk shifting, risk distribution, insurance risk, and whether it meets commonly accepted notions of insurance.
The Avrahami decision only explores risk distribution and the commonly accepted notions of insurance, Slenn and Miller said.
The other two “areas remain very much wide open,” Miller said. However, there are several other Section 831(b) cases in the pipeline, includingJames L. Wilson & Vivien Wilson, et al., v. Commissioner , where these topics might be addressed, he said.
“We’ll have to see what happens with those cases,” Miller said.
Steven T. Miller served as former IRS Acting Commissioner in 2012, but prior to that he served for several years as the Deputy Commissioner for Services and Enforcement, leading all IRS enforcement and service activity. Steven also served as the Commissioner of the Large and Mid-Size Business Division, overseeing IRS audits of large taxpayers and the IRS programs relating to offshore tax compliance and international tax law enforcement. As the Commissioner of the Tax Exempt and Government Entities Division, he supervised the IRS oversight of governments, tax exempt entities and retirement programs.
In a career devoted to government service, Steven has spent the last 25 years with the IRS, serving the agency in a number of diverse and increasingly important roles.
John Dies is Managing Director of Tax Controversy at alliantgroup. As an experienced trial attorney and former
partner in a litigation firm, he has represented hundreds of clients and tried cases to verdict throughout the United States. John
specializes in rehabilitating audits where a taxpayer requires assistance after the IRS or other taxing authority announces its intent to issue a total disallowance or other negative result.
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