The Tax Court has delivered its long-awaited decision in Avrahami v. Commissioner, which represents the first court decision – ever – addressing an IRS challenge to a microcaptive insurance arrangement. Not only did the Tax Court hand the IRS a critical first win in disavowing the tax benefits of the planning, the Tax Court also handed the IRS something far more valuable: a potentially unlimited statute of limitations with which to attack microcaptives. The verdict: score one for Uncle Sam. A copy of the decision is linked here.
Although the facts presented in the 105-page opinion are detailed, in a nutshell the case involves a series of businesses owned by Mr. Avrahami, his wife, and/or their children that purchased property and casualty insurance from an insurance company owned by Mrs. Avrahami (the “Microcaptive”). The Microcaptive participated in a reinsurance program designed to achieve risk distribution, which is a requirement to establish “insurance” for tax purposes. The Avrahami businesses deducted the insurance premiums paid to the Microcaptive, and the Microcaptive excluded its earned premiums from income pursuant to its election under IRC section 831(b) to be treated as a small insurance company. The IRS challenged the planning from all sides, including the deductibility of the insurance premiums paid by the businesses, the Microcaptive’s IRC section 953(d)/831(b) elections, and the excludability of premiums earned by the Microcaptive. The IRS also proposed accuracy-related penalties. In the end, the Tax Court disallowed all of the claimed tax benefits from the planning, but refused to impose penalties (at least as it related to the insurance). Relevant findings of the Tax Court include:
- The Tax Court held that the reinsurance pool was not a bonafide insurance company, and therefore the Microcaptive failed to distribute its insured risks. The Court found that the reinsurance pool charged “excessive premiums”, had an “ultralow probability” of a claim ever being paid, and had cash inflows and outflows of a “circular” nature.
- Although the lack of risk distribution was sufficient to disavow the tax benefits, the Tax Court also held that the arrangement did not meet the requirement of being insurance “in the commonly accepted sense.” The Tax Court criticized the Microcaptive’s ad hoc claims processing, its lack of liquid investments, and the complete absence of claims history prior to the IRS initiation of a tax audit. The Tax Court succinctly held, “Even if [the Microcaptive] was organized and regulated as an insurance company, we find it was not operated like one.”
- The Tax Court further held that the premiums charged for the direct insurance and reinsurance were “utterly unreasonable.” While the starting point for the premiums was actuarially based, the Tax Court found that the numerous adjustments to the initially-calculated premium were aimed at “justifying total premiums as close to $1.2 million – the target – without ever going over.”
- Based on these holdings, the Tax Court concluded that the Microcaptive’s policies were not contracts for insurance, and therefore the Microcaptive’s IRC section 831(b) election was invalid.
- The Tax Court further invalidated the Microcaptive’s election under IRC section 953(d) to be treated as a U.S. corporation for tax purposes (which enabled the Microcaptive to make the section 831(b) election). As a result, the Tax Court concluded that the Microcaptive, organized under the laws of St. Kitt, was a controlled foreign corporation.
While there are many important aspects to the Avrahami decision, perhaps the most far-reaching is the Tax Court’s decision to invalidate the IRC section 953(d) election, rendering the Microcaptive a controlled foreign corporation for federal income tax purposes. The tax consequences flowing from an invalid election are significant, including (i) potential penalties for not filing Form 5471 returns with the IRS reporting the existence of a foreign insurance company (due to the invalid election), and (ii) a potentially unlimited statute of limitations based on the failure to file the Form 5471 under IRC section 6501(c)(8). The IRS revealed these potential legal attacks following the invalidation of a section 953(d) election in a 2014 Chief Counsel memorandum, linked here.
Avrahami is only the first battle in the IRS’ war against microcaptives. The IRS will undoubtedly feel vindicated, and emboldened, by this first victory, many more battles will be fought, with the IRS facing greater challenges with facts distinguishable from those presented in Avrahami. What is certain is that the future is decidedly uncertain. It is therefore critical in these uncertain times for tax practitioners to visit with their clients that have IRC section 831(b) captives insurance arrangements to evaluate the merits of the planning, analyze the potential risks of litigation, and explore ways to fortify potential defenses.
If you have any questions about the Avrahami decision or microcaptive insurance, please do not hesitate to contact me at (214) 749-2464 or email me at firstname.lastname@example.org.