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A U.S. Tax Court judge handed a victory to the Internal Revenue Service on Monday in a closely watched case involving an 831(b) captive insurer.
The ruling by Judge Mark V. Holmes was fact-specific, and a tax consulting firm says it’s unclear how it will affect microcaptives going forward.
In Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue, the IRS alleged that the 831(b) for a jewelry business in Phoenix that ostensibly covered insurance risks charged unrealistic premiums and did not meet risk distribution requirements for captives.
Captives electing Section 831(b) of the Internal Revenue Code are taxed only on their investment income, not their underwriting income. The limit of premiums for the structures was raised this year to $2.2 million from $1.2 million a year.
The 831(b) captives are often used by small and midsize firms that are too small to establish conventional captives, but many observers say they have also been used by wealthy individuals and others to avoid tax.
In the Avrahami case, Benyamin and Orna Avrahami set up an 831(b) captive in St. Kitts called Feedback Insurance Co. Ltd. in 2007 to cover their three jewelry stores and three shopping centers. In 2006, they spent a little more than $150,000 insuring the stores, but the insurance premium paid was more than $1.1 million by 2009 and more than $1.3 million in 2010, with the vast majority of the premium being paid to Feedback, which was wholly owned by Ms. Avrahami, according to the ruling.
“With money flooding in and none going back out to pay claims, Feedback 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 — as loans and loan repayments, say the Avrahamis; as distributions, says the Commissioner,” the ruling states.
Included in Feedback’s surplus was $720,000 related to terrorism coverage, which the captive covered through a reinsurance pooling agreement with other captives.
“The Avrahami entities collectively deducted — as business expenses — insurance premiums of $1,090,000 for 2009 and $1,170,000 for 2010. No claims were filed against Feedback under any of its direct policies in either 2009 or 2010,” and no terrorism events occurred to trigger the terrorism coverage, the ruling states.
Some of the surplus in Feedback was used to fund a real estate purchase in Arizona. The company formed to conduct the deal, Belly Button Center L.L.C., was nominally owned by the Avrahamis’ three children, but the children testified that they had no knowledge of the company.
“Insurance regulators often raise their bureaucratic eyebrows at related-party dealings like this. But Feedback did not seek approval from its Kittian regulators for any of these transfers,” the ruling says.
In 2013, the IRS questioned whether Feedback was a valid insurance company and “determined that ‘the amounts characterized as insurance premiums’ were income to Feedback,” the ruling states.
In the ruling, Judge Holmes found: “Although Feedback was organized and regulated as an insurance company, paid the claims filed against it, and met the minimal capitalization requirements of St. Kitts, these insurance-like traits cannot overcome its other failings. It was not operated like an insurance company, it issued policies with unclear and contradictory terms, and it charged wholly unreasonable premiums.”
In a statement commenting on the decision, tax consultancy Alliantgroup L.P. said the decision is fact-specific and likely to be appealed.
“While we now know that the Tax Court has a very unfavorable view of certain facts, the Avrahami decision is seemingly isolated to those unfavorable facts. We do however think that based on the facts the court focused on, it will be vital for all captives to undergo a thorough review of their program, and to implement immediate changes,” the statement said.
A coalition of state captive insurance and trade associations has asked the U.S. Treasury Department and the IRS to provide much-needed guidance on the structure and operation of enterprise risk captives — also known as microcaptives — ahead of an impending deadline for certain tax law changes to take effect.