Avrahami v. Commissioner

On August 21, 2017, the fourth  U.S. Tax Court captive insurance case to make it to trial in recent years [but, notably, the first section 831(b) case], the U.S. Tax Court (presided by Judge Mark Holmes) held for the Internal Revenue Service (IRS), by ruling that a micro-captive’s elections under section 831(b) to be treated as a small insurance company, and section 953(d) to be taxed as a domestic corporation were invalid, as the arrangement did not constitute a bona-fide insurance arrangement.

Background

The petitioners in Avrahami v. Commissioner, 149 T.C. No. 7 (Benyamin and Orna Avrahami), owned three shopping centers and three jewelry stores, as part of a closely held retail enterprise in Arizona. In 2007, the Avrahamis formed a captive insurance company, Feedback Insurance Company, Ltd. (Feedback), to insure certain identified risks of their business ventures, including business income, employee fidelity, litigation expense, loss of key employee, and tax indemnity coverages. From Feedback’s inception in 2007 to the end of 2010, Feedback had received premiums totaling almost $3.9 million but had paid no claims. In addition to the coverages provided to the Avrahamis, in 2009 and 2010, Feedback started participating in a risk-distribution pool through Pan American Reinsurance Company, Ltd. to reinsure terrorism insurance for other small captive insurers.

The IRS Challenge to Feedback’s Status as Insurance Company

The IRS took the position that Feedback was not providing insurance, thereby the premiums paid to the captive insurance company would not be deductible as “ordinary and necessary business expenses.” The Commissioner argued that several of Feedback’s policies included uninsurable risks, and there was not adequate risk distribution due to an insufficient pool of insureds.

The Commissioner also held that risk shifting was not present, as neither Feedback nor Pan American was financially capable of meeting its obligations. Furthermore, the Commissioner put forth that the arrangements did not embody common notions of insurance, as Feedback and Pan American did not operate like insurance companies and their premiums were not determined at arm’s length.

What does the Avrahami Opinion Mean for your Ryan-managed captive insurance company and the 831(b) industry, in general?

The negative facts relied upon by the Court are specific to the Avrahami case and are not precedential to other arrangements on a prima facie basis. That said, the opinion does serve as an important reminder for Ryan’s professional captive managers, our clients, and our clients’ trusted advisors to revisit the structures of our currently managed 831(b)-elected captive insurance facilities, to compare our approach and captive management protocols against the findings and the ultimate holding of the court case.

Criteria of a Well-Structured Captive Insurance Arrangement, as Compared to Avrahami

The pivotal elements of the Tax Court’s recent ruling in Avrahami represent long-standing “indicators” of properly structured captive insurance arrangements (or in their absence, indicia of poorly structured captive insurance arrangements) for many years in the captive insurance industry. To meet the applicable definitions of a bona-fide insurance arrangement, it is important that the captive insurance company maintain the following elements at all times:

• Risk Shifting
• Risk Distribution
• Insurance Risk
• Meets Commonly Accepted Notions of Insurance

How did the Avrahami approach fail these standards, according to the U.S. Tax Court?

The Avrahami decision provides general guidance for the captive insurance industry but primarily in the areas of “risk distribution” and “the commonly accepted notions of insurance.” In other words, the presence of risk shifting and insurance risk elements were not opined upon, per se, by Judge Holmes.

Risk Distribution

According to the IRS, the “risk sharing” arrangements present in the Avrahami case were designed for no reason other than “to meet the risk distribution requirements of insurance for federal income tax purposes.” Under the arrangement developed by the attorney who structured the arrangement (Celia Clark), the captives first issued direct policies to the captives’ related insureds, and they did not share that risk with any other captive. Under a “cross-insurance” program, Clarks’ clients would then swap insurance premiums with each other’s captive insurance companies and operating businesses.

As an example presented in court documents:

Client A would have its business pay client B’s captive in exchange for client B’s business paying client A’s captive. As a result of the swap, each of Clark’s clients could have their businesses pay $1.2 million in premiums and claim associated insurance deductions while each of their captives would receive a $1.2 million in premiums to be excluded under section 831(b), with $360,000 or 30% derived from Clark’s other clients’ unrelated businesses.

At the heart of the cross-insurance program was a terrorism policy to provide coverage in excess of the insured’s Terrorism Risk Insurance Act (TRIA) backed commercial policies.

In 2009, Clark set up a revised reinsurance arrangement for all of her clients through Pan-American, another St. Kitts entity. However, according to court documents, this arrangement was designed  

…purportedly to generate more fees for herself and to create the appearance of risk distribution. Under the arrangement, the client’s captives would enter into a quota-share reinsurance agreement obligating the captive insurance company to assume a percentage of the risk from the policies that Pan-American issued to all operating businesses participating in the arrangement. Each client’s participation was at $360,000, calculated as 30% of their target premiums for each year ($1.2 million).

The Court further observed:

The amount of Terrorism insurance you bought depended on how much outside risk you needed to achieve 30% of total premium as unrelated.

The Court held that Pan-American functioned “like” a pooling arrangement but was ultimately rejected by the Court for circular cash flow, excessive premiums, and questionable ability to collect on its retrocession. 

Not Insurance in its Commonly Accepted Sense

In its brief, the IRS has asserted that the Feedback and Pan-American arrangements are not insurance in the commonly accepted sense. Some of the relevant points made in this regard are as follows:

The Avrahamis learned about captive insurance through their CPA, not an insurance broker. Premiums were not actuarially determined, but rather suggested by Hiller (the estate planner) who in correspondence said that 20% of the premiums should come from American Findings and the remaining 80% from real estate operations, and by Clark who allegedly communicated to the actuary what the premiums should be.

Feedback did not prepare financial statements or hold meetings of its board of directors. Feedback allegedly did not have any employees or contract with experienced insurance professionals to conduct insurance functions such as underwriting, setting of premiums and preserves, investment management, and claims administration.

In fact, it was Clark who took on the role of a quasi-management company by drafting the policies and generating invoices, though she did not perform any underwriting services for Feedback, manage investments or set reserves. Feedback paid claimed losses without establishing the validity of those claims. Feedback and Pan-American were not regulated by St. Kitts and did not follow regulations.

The policy language issued by Feedback was also challenged by the Service:

The policies were confusing and sloppily drafted, combining features of both an occurrence and claims made-policy.

The IRS also pointed out that the policies under the Pan-America arrangement were not arms’ length because of the “safeguards” put in place to ensure that no insurer would be required to pay a claim in the event of a loss:

In the event of a loss, if an insured wished to repair damage at a cost in excess of the deductible amount, the written consent of the insurer was required. Because the policies had no deductible, the insured would have to seek written consent of the insurer for all repairs.

And further:

Another safeguard put in place was that losses occurring in cities with populations over 1.5 million were excluded under the policy.

Although the term “city” was not defined in the policy, according to the IRS, nearly half of the insureds were based in locations that could only be construed as “cities” by any definition—Los Angeles, New York, Houston, Cleveland, Miami, Phoenix, and Las Vegas, to name a few.

These ambiguities, the IRS contended, “acted as safeguards to protect the insurers (Clark’s clients) from any one of her other clients submitting claims that an insurer did not want to pay.” The Court agreed with these points, leading to its opinion on the matter that the arrangement was not “insurance,” in its commonly accepted sense.

The Ryan Difference; Key Distinctions from the Avrahami Fact Pattern and Important 831(b) Considerations Relevant to the Overall Holding

1. The IRS will evaluate whether the overall 831(b) program emphasizes premium deductions as opposed to insurance needs.

It is not the existence of a tax benefit that controls but the lack of a business benefit. Nevertheless, the emphasis should be on insurance needs. Ryan’s Captive Insurance division approaches every captive insurance case with a thorough examination of the risk management needs of the prospect. If there is not a bona-fide, justifiable insurance need, the process does not move forward.

2. The realistic probability of coverage applying to the business. If the likelihood of the insurable event happening is low, the IRS believes the cost of coverage should likewise be low.

To illustrate (using a very timely example), there would be little need for hurricane coverage in a land-locked area or earthquake coverage where there is no fault line within hundreds of miles. The probability of loss should be reflected in the level of premium.

This element is analyzed in every case at Ryan. The idea of “ethereal” or “incredulous” risk coverages, unrelated to the client’s enterprise risk management program, is a very risky proposition, and any business owner considering a captive insurance arrangement would be well-advised to steer clear of any captive manager glossing over the risk analysis or blurring the lines of independence by relying on an in-house actuarial analysis. As reinforced by the Avrahami ruling, there should not be substantive “obstacles” to the proper administration of claims of economic loss.

3. Reverse engineering the amount of premiums to equal exactly the $2.2 million exemption amount to the penny. The IRS believes certain taxpayers are exploiting this advantage by signing up for premiums exactly at the $2.2 million level.

There is no prohibition to limiting coverage to an amount that qualifies for a statutory benefit. An example that many business owners can relate to is an employer limiting employee life insurance to the amount that is not taxable to the employee (for instance). That is not an abuse per se.

The 831(b) election is made by the taxpayer on an affirmative basis and disclosed on every 1120-PC tax return. In other words, a $2.2 million dollar premium level does not “tip off” the tax authorities that the Congressionally authorized tax provision of 831(b) is being invoked—they would already know that by the affirmative election itself.

An enterprise risk analysis indicating sufficient exposures to justify a $2.2 million level of premium does not have any particular bearing on the overall determination of whether or not a legitimate insurance structure has been introduced to capture such premium payments and assume the associated risk exposures. This concept remains a constant, regardless of premium level.

4. An impermissible circular flow of funds where the premium monies, either through loans or distributions, ultimately end up in the hands of the business or a closely related party. The IRS has a history of suspicion over the “circular flow” of funds.

There may be issues with loan backs. However, in the Avrahami decision, the related party loans present in the fact pattern were actually AFFIRMED by the Court as bona-fide loans, exhibiting all expected obligor/obligee contractual factors, and not “veiled dividends,” as the service advanced in its arguments.

The key to insurance is whether the risks are real and priced at fair market value. Suspicion is not a basis for proposing an adjustment.

Ryan’s Captive Insurance division consults directly with any and all clients considering loan activity within their captive arrangement, and as a general adherence to best practices in our industry, would only consider loan activity from accumulated prior year earnings, versus current year premiums.

5. Lack of adequate risk distribution to be considered an insurance company for tax purposes. 

This arises where the captive insures only the single business and simply holds the premium monies in the event of a claim. The IRS is very focused on a perceived lack of risk distribution and risk shifting in certain captive arrangements, as evidenced by its approach to this issue in the Avrahami case.

A captive must be structured so that there is risk shifting and risk distribution. The rules establishing this basic principle have been well established in IRS safe harbor for over a decade. It is important to note that the standards apply to commercial, as well as captive, insurance arrangements. Ryan’s Captive Insurance division maintains strict adherence to the published safe harbors relating to this issue.

6. Failure to obtain an actuarial study supporting the premiums charged by the captive for the insurance.

The IRS will examine the underwriting process. The fair market value of premium is a key factor for deductible insurance. As stated previously, this element is best accomplished by an independent actuarial consulting firm, with specific experience in property and casualty actuarial science.

Ryan’s Captive Insurance division has utilized independent, licensed actuarial consulting firms since its inception. We have also engaged a secondary actuarial firm to provide a “peer review” of the underlying actuarial approach and associated rating methodology, first in 2013, and again in 2016, prior to the issuance of the Avrahami decision. We will continue to engage “best practice peer reviews” on an ongoing basis.

7. Lack of an analysis of the cost and availability of commercial insurance in the non-captive market.

The IRS believes that insurance rates far in excess of commercially available rates defy common sense. Captive premiums should never exceed commercial available rates for the same coverage. It is rare that our clients replace existing commercial coverages. The actuarial consultants focus their attention on those risks that are specifically excluded from commercial policy packet of coverages, or not included, due to lack of commercial coverage availability.

8. The existence of guarantees. 

The IRS believes that guarantees may be an indication of inadequate capitalization. Guarantees create a rebuttable presumption that the captive is undercapitalized and lacks the capacity to assume risk.

Ryan’s Captive Insurance division requires adequate capital based on industry standard premium to surplus ratio, thus eliminating the reason for any guarantee.

9. Lack of claims history. The IRS believes that no claims may indicate that the insurance pool is insufficient, and risk shifting may not exist. The frequency of claims should reflect the frequency of loss events. Thus, real but remote risk cannot be expected to have frequent claims.

Unlike some captive insurance managers who “require” annual claims to be filed by every client to “keep up appearances,” Ryan’s Captive Insurance division allows the actuarial law of large numbers to present themselves in our expanding captive insurance client base. There have been claims to the Ryan risk pool (Commonwealth Risk Transfer), and we suspect there will be more in the future. This demonstrates the essence of the true insurance arrangement present in all of our captive insurance cases.

Summary

The Avrahami case serves as a timely reminder that business owners currently participating in 831(b) Captive Insurance arrangements (or those considering the implementation of such an arrangement) should familiarize themselves with the above list of considerations, which has been recycled in various trade publications, newsletters, and other media properties for years. However, the iterative circulation of these “red flags,” as well as the recent holding in Avrahami should not be interpreted to unilaterally invalidate an otherwise well-structured and well-managed 831(b) captive arrangement. Also, the Avrahami opinion should not indicate that anything has changed with respect to the favorable 831(b) legislation (as of January 1, 2017) or the IRS’s long-standing safe harbor promulgations regarding the rules of proper captive insurance administration. In a facts-and-circumstance approach to a captive insurance audit, it is expected that the IRS may rely on the above-referenced considerations as indicia that the captive arrangement may warrant a closer look, in order to determine if the captive lacks an element of safe harbor protection (risk shifting, risk distribution, traditional notions of an insurance arrangement, etc.).

As a captive insurance owner, it is important to be aware not only of what the IRS is looking for in a “bona fide” captive insurance arrangement but also “why and how” the Ryan Captive Insurance division continues to operate according to safe harbor standards and industry best practices.

If you have any questions regarding the above (or any other elements of proper captive insurance administration), please contact Ken Kotch or a member of the Ryan Captive Insurance division directly.