22 August 2017Accounting & tax analysis

831(b)s take a blow as US Tax Court favours IRS in Avrahami case

In a decision that may place 831(b) captive insurance companies - or microcaptives - under further scrutiny, the US Tax Court has ruled in favour of the IRS in the case of Avrahami v Commissioner.

On August 21, Judge Mark Holmes held that certain amounts paid by the Avrahamis' captive Feedback were not insurance premiums for federal income tax purposes and are 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.

In spite of this, 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 Avrahmis' jewelry stores sent down to a Carribean 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.

With the release of Notice 2016-66, the IRS had labelled 831(b)s as 'transactions of interest'.

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.