831(b) blues: the Avrahami aftermath
In a long-anticipated ruling, the US Tax Court has ruled in favour of the Internal Revenue Service (IRS) in the case of Benyamin Avrahami & Orna Avrahami, et al. v Commissioner of Internal Revenue, the first micro captive case to be decided.
The 105-page opinion issued on August 21 concluded that arrangements made by Benyamin and Orna Avrahami through their captive insurance company, Feedback Insurance Company, were not insurance for federal tax purposes.
There have been concerns within the industry that cases such as this could paint a negative picture of using the Internal Revenue Code 831(b) election for small insurance companies, also known as 831(b)s or ‘microcaptives’.
While 831(b) captives have existed since 1986, they have come under increased scrutiny from the IRS after being labelled as a 'transaction of interest' in Notice 2016-66 in November 2016.
One of the advantages of an 831(b) captive is that earnings from premiums are not subject to federal income taxes, and only interest income is taxed. The maximum annual premium was $1.2 million, but this increased to $2.2 million on January 1, 2017.
However, the IRS argues such mechanisms could be abused, where 831(b) captives could be used as wealth transfer vehicles.
In the last few years, the IRS has audited more of these captive structures in the belief that small businesses are using them to insure against improbable risks that they never pay claims on, and the premiums then return to the business owners with little or no tax.
In light of Avrahami v Commissioner, industry experts have said what they think went wrong with this particular captive structure, and have highlighted the need to seek proper guidance on how to manage this structure for any existing or prospective owners who want to do it the right way.
Dan Towle, president of the domicile-neutral Captive Insurance Companies Association, commented: “CICA has provided considerable guidance when it comes to the formation and operation of small captive insurance companies. Our ‘Captive Best Practices Guidelines,’ our white paper, ‘Do them right or don’t do them at all,’ and our ‘Information Statement Regarding Micro-Captives’ have been very clear about the proper utilisation of small captives.”
“It will take some time to fully understand the impact this will have on our industry and is something CICA and its Board of Directors will be watching closely.”
What went wrong?
Judge Mark Holmes, in the opinion issued on Avrahami v Commissioner, held that certain amounts paid by the Avrahamis' captive Feedback were not insurance premiums for federal income tax purposes and were therefore not deductible under the Internal Revenue Code section 162.
Benyamin and Orna Avrahami own three shopping centres and three jewelry stores in Arizona. In 2006 they spent around $150,000 insuring them against the possibility of a chemical or biological terrorist attack, and in 2009 the bill grew to more than $1.1 million. In 2010 it reached $1.3 million.
The Avrahamis were paying an overwhelming share of these bills to Feedback, wholly-owned by Orna Avrahami, Holmes noted. However, no claims were made on any of the Feedback policies until the IRS began an audit of the Avrahamis' and their various entities' returns.
Feedback had accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which ended up back in the Avrahamis' bank account. Feedback's surplus also included $720,000 that the Avrahamis' jewelry stores sent down to a Caribbean company for terrorism cover.
"The full $720,000 then flew right back to Feedback after – the Avrahamis argue – it distributed enough risk for the whole plan to constitute insurance as that term is commonly understood," said Holmes.
David Kirkup, CFO and COO of Captive Alternatives, commented: “As anticipated by us, the judge went to lengths to target bad activities and explain why they failed the tests of a true Insurance structure. Thus the Avrahami structure was not deemed to be real insurance and the original tax deduction was denied.”
Kirkup suggested the major issues were poorly drafted and incoherent policy formers, very weak actuarial support for pricing, and targeting $1.2m in premium – rather than looking at the actual risk.
He continued: “The insurance company - a back end pool - was deemed to have $308m in theoretical limits and zero funds to pay claims because all premiums were returned to captive in six months. Terrorism risk was bloated and the only coverage in the third party pool. The pool was also compared adversely to a real fronting company.
Andrew Barile, CEO of Andrew Barile Consulting, believes the captive in question had specifically been designed as a wealth transfer concept rather than setting up an insurance company.
"Captives can explore reinsuring other microcaptives to create real risk distribution," Barile said. "Pools of captives have existed for years. When I was working for American Re I reinsured General Re who reinsured a pool of captives started by Fred Reiss. Captive owners need to get a better understanding of the risks they are insuring and the feasibility study needs more detail especially in how claims are to be handled or adjusted."
While this ruling could have a negative impact on the opinion of microcaptives, various industry executives suggest it provides more guidance to captive owners, and that the industry remains committed to the promotion of captives as a legitimate risk management tool and not something set up solely for tax purposes.
JLTIM’s consulting practice leader and executive vice president Anne Marie Towle believes that 831(b)s are still an attractive option for smaller companies looking to retain their own risk, as long as they are set up the “right way”, with all the right parameters and appropriate tests.
“This ruling finally provides additional clarity for captives organised under Section 831(b),” she says. “As captive insurance professionals, we always seek this added measure of clarity. This ruling provides clear guidance, as the court ruled that Feedback had a poor fact pattern.”
She highlighted that that microcaptive owners who operate their captives for legitimate risk-transfer and follow the best practices – including those managed by JLTIM – are not impacted by this ruling.
“As an industry best practice, we don’t recommend that our clients utilise third-party risk pools to qualify as an insurance company for tax purposes. If any captive owner has concerns, we will be happy to answer their questions,” she continued.
Kirkup also believes this ruling will give guidance, validate the smaller captives and will hopefully allow the risk management industry to focus on growth and bring professional risk management to SMEs.
“For us, it's a validation that each step along the way a captive reinsurance company should comply with the spirit and letter of the safe harbour rules,” says Kirkup. “Paying attention to coverages, forms, underwriting, actuarial rating, fronting, risk reserve funds, claims management, conservative surplus management, and stringent lending rules are all key to creating a thriving and resilient risk management solution.”
The Self-Insurance Institute of America (SIIA) states the ruling is consistent with SIIA's long-term message: strengthening the enterprise risk captive industry through the promotion, education and advocacy of appropriate captive compliance, management, and oversight practices.
However, the ruling does not address a number of issues faced by the industry, SIIA claims.
SIIA said in a statement: "In an effort to gain clarity on one such issue, SIIA’s amicus brief with the court in Avrahami was intended to illustrate how a properly run enterprise risk captive can mitigate catastrophic risk of loss for small to mid-size businesses via general risk pooling arrangements, an issue not ultimately addressed with any detail in the decision. Rather, the court’s decision focused on the specifics of a pooling arrangement with attributes that are not representative of SIIA membership, nor current captive best practices."
The group had recently made comments to the IRS, where it was argued that the much of the data being requested as part of Notice 2016-66 was already being collected by the IRS and it was premature as the court may focus on other items. It highlighted many details requested by Notice 2016-66 were not material to the court's decision and are already being collected through tax return documents.