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Editorial: Tax ruling should rouse captives


If you own a captive insurer and have a spare couple of hours, you might want to read the U.S. Tax Court ruling in the Avrahami case. Not that the 105-page decision will, as you might imagine, be a cure for insomnia; rather, it should serve as a wake-up call to captive owners who don’t have a disciplined approach to captive management.

The long-awaited ruling, which came down late last month, focuses on microcaptives that elect to be taxed under Section 831(b) of the Internal Revenue Code and are taxed only on their investment income, not their underwriting income.

In the Avrahami case, owners of a family business in Phoenix set up an 831(b) captive in St. Kitts and ran it for several years before it caught the eye of the IRS. According to the court ruling, the premiums the owners paid for insurance more than quadrupled after they set up the captive; the captive made some large loans to the Avrahamis, including one for a real estate deal made in their children’s names; and the captive only started paying claims after the IRS audit began.

831(b) captives have come under a lot of suspicion over the past several years as their numbers have exploded. While the structures are useful ways for smaller companies to enter the captive arena, some observers, including the IRS, suggest they are frequently used as estate-planning devices rather than as alternative risk transfer vehicles.

It would be easy to write off the Avrahami ruling as a case that affects only small-time enterprises, but that would be a mistake.

The IRS has for decades battled with captive owners in the courts. Sometimes the IRS has won, and sometimes the captive owners have won, but any case where a captive, regardless of size, is ruled to have been a tax shelter rather than an insurance company must go down in the loss column for owners.

Looking through the ruling, there are many examples given by the judge — who is due to rule in other significant captive cases — that illustrate his thinking on captive issues, and there are key lessons for captive owners.

No. 1 is don’t charge excessive premiums. The numbers in the Avrahami case may look egregiously out of line, but owners of larger captives that are used to covering high-severity losses should make sure they can justify the premiums they charge. No. 2 is pay claims. Again, captives structured to cover low-frequency risks may have to consider this issue. And No. 3 is be careful with loan-backs. Captive owners have become increasingly creative with the way they structure loans to parent companies, but that creativity should be kept in check.

One ruling on microcaptives should not unduly disturb owners with well-designed alternative transfer vehicles, but they should still sit up and take notice rather than hit the snooze button on captive compliance.


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