Weathering the Storm: 18 Tips for Assessing Your Client's Section 831(b) Micro-Captive Insurance Planning Following the Avrahami Decision

The Tax Court’s decision in Avrahami v. Commissioner created a storm that is brewing in the I.R.C. Section 831(b) micro-captive insurance industry. Some microcaptives are a safe distance away from the storm’s path. Others are at risk for an indirect hit. Still others are likely facing the very eye of the storm. For a discussion of the Avrahami decision, click here.

The key is preparation, and this requires an objective assessment. We must know where the captive insurance planning sits on the storm’s projected path so we can help our clients make the planning storm-ready. As we begin to look more closely at our clients’ captive insurance planning in light of Avrahami, we should be mindful of the following warning signs:

    1.    Promotional Materials emphasizing the income tax goals of the captive
           insurance arrangement. The IRS will evaluate whether such materials
           emphasize premium deductions as opposed to insurance needs. The
           primary reason to form a captive must always be to manage and/or
           mitigate risk. It is not an income tax, nor transfer tax, strategy, and any
           insurance implemented as such is sure to fail.

    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, 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.

    3.    Reverse engineering the amount of premiums to equal exactly the maximum
           exemption amount to the penny. The IRS believes certain taxpayers are
           exploiting this advantage by signing up for premiums exactly at the $1.2 million
           level (or $2.2 million level starting in 2017).

    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.

    5.    Lack of adequate risk distribution to be considered an insurance company for
           tax purposes. This arises where the captive insures only a single or small
           handful of businesses and simply holds the premium monies in the event of a
           claim.

    6.    Failure to obtain an actuarial study supporting the premiums charged by the
           captive for the insurance. The IRS will examine the underwriting process. While
           not all risk premiums can be actuarially determined, many can and should be.
           Too often the premiums charged are not commensurate with the coverage
           received by the client.

    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.

    8.    Material emphasizing the estate planning benefits of the captive insurance
           structure. For instance, the IRS will scrutinize a captive insurance company
           owned by a family limited partnership or irrevocable trusts that benefits the
           business owners’ family members. The IRS takes the position that I.R.C.
           Sec. 831(b) was not enacted as an estate planning tool, but to assist taxpayer
           who wants to manage risk.

    9.    The existence of guarantees. The IRS believes that guarantees may be an
           indication of inadequate capitalization or a lack of a true shifting of risk.

    10.  Lack of claims history. The IRS believes that no claims may indicate that the
           reinsurance pool is insufficient and risk shifting may not exist.

    11.  Use of reserves to purchase life insurance. The IRS views this as a tax
           avoidance strategy designed to reduce the captive’s income tax on investment
           gains.

    12.  Claims of prior self-insurance. Often times clients claim that they are insuring
           risks with the captive that they could not previously secure insurance and
           therefore self-insured. But clients should be prepared to show inquiries and
           attempts to secure insurance as well as the prior setting-aside of funds by either
           the business or business owner for the purpose of self-funding the perceived
           risk of loss.

    13.  Questionable risk pools. Be wary of pools that have operated for years with little
           or no claims, with little or no support for premiums (or updates for claims
           experience) and which may or may not truly “pool” the risks of the various
           insurance policies that it reinsures. The IRS is on the lookout for linkage,
           whereby the risks of loss under specific policies reissued by the pool are linked
           to certain members of the pool (i.e., the captive related to the business
           purchasing the insurance).

    14.  Feasibility study. Before the decision to form a captive is made, a feasibility
           study should be conducted that looks at all aspects of the captive and validates
           its need, validity, and economic viability. The IRS expects and routinely requests
           a copy of a feasibility study.

    15.  “Unique” policies. While one of the benefits of captive insurance is custom
           tailored policies, the insurance contracts should still bear resemblance to
           traditional policies underwritten by other insurance companies. Often times
           promoters will eliminate common exclusions from the policy in an effort to
           increase the premium. These exclusions can often mean the difference between
           insurable risk and non-insurable risk.

    16.  “Soft” insurance contracts. Be on the lookout for promoters that tout the
           “enhanced” advantages of captive insurance where there are no claims. If a
            client incurs an insured loss, it should always file a claim.

    17.  Inadequate capital. Captives are often created offshore because of less-
           restrictive conditions to form and operate a captive and less government
           oversight compared to the US. This is true regarding the amount of capital
           reserves. Keep in mind, however, that simply satisfying local law does not
           necessarily establish that the captive was “adequately capitalized” for purposes
           of testing for “insurance” for federal tax purposes.

    18.  Highly questionable risks. Insurance coverages should not be selected (or even
           recommended) by the promoter or its affiliates. Any decision on the business
           risks to insure must be made independently by the business. Too
           often insurance coverage is recommended that will help the client
           generate a targeted premium amount and thus targeted deduction.

The existence of one or more of these red flags does not automatically invalidate the Section 831(b) captive insurance planning, but such warning signs should be observed and heeded. The time is now to identify lines of potential IRS attack and to mitigate, as much as possible, litigation risks while taking corrective action to fortify potential IRS defenses.

If you have any questions about ways to assess, and perhaps bolster, your client’s Section 831(b) captive insurance planning, please do not hesitate to contact me at (214) 749-2464 or adaddino@meadowscollier.com.