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Tax ruling provides insights on captive structures


A long-awaited U.S. Tax Court ruling on 831(b) captives, which was a victory for the Internal Revenue Service, should not have a direct effect on larger, well-managed captives, but the ruling provides insights into the judge’s reasoning that other captive owners should review, a tax lawyer said.

Given the facts at issue in the case, which many captive experts have acknowledged in the past did not reflect well on the captive involved, it’s not surprising that the judge ruled against the captive’s owners, but the ruling does not provide any new analysis of how captives should be characterized for tax purposes, others say.

In the Aug. 21 ruling in Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue, U.S. Tax Court Judge Mark V. Holmes in Washington ruled that a microcaptive that elected to be taxed under Section 831(b) of the U.S. tax code was not operated like an insurance company and charged inflated premiums, among other things.

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.

The captive made significant loans to entities controlled by the Avrahamis and only began paying claims after and IRS audit began, 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.

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.”

The ruling is the first significant tax ruling on 831(b)s and has been closely watched. In addition, Judge Holmes is due to rule on another important 831(b) case, Caylor Land & Development, Inc. v. Commissioner of Internal Revenue.

The Avrahami ruling should not have a direct effect on larger captives, but it does provide some insights that captive owners should review, said Charles J. Lavelle, senior partner at Bingham Greenebaum Doll L.L.P. in Louisville, Kentucky.

“The IRS will review this and any subsequent decisions and determine their application to larger captives, for instance, there were large loans to affiliates and that may have application to larger captives,” he said.

In addition, the judge appeared to be concerned about the frequency of claims payments and the size of premiums, Mr. Lavelle said. This would be a concern for some captives that are formed to cover low frequency/high severity risks, he said.

“Those companies should have rigorous justifications for their premiums and low loss ratios,” Mr. Lavelle said.

The Avrahami ruling was critical of many aspects of the operations of the microcaptive involved, but it did not provide any new analysis on insurance characterization of captives for federal tax purposes, according to a statement by tax lawyers Saren Goldner and Bruce Wright, who are partners at Eversheds Sutherland (U.S.) L.L.P. in New York.

“Given the facts of the case the outcome was expected; the court had issues with the coverages provided by the microcaptive, the pricing of the coverages as well as the methodology for determining pricing, the coverages being pooled and, therefore, the substantive effect of the pooling arrangement, and ultimately the lack of risk distribution,” the statement said.

The ruling should not affect legitimate captives, said Anne Marie Towle, consulting practice leader and executive vice president of JLT Insurance Management USA, a unit of Jardine Lloyd Thompson Group P.L.C.

The court ruled that Feedback did not meet the risk distribution, risk shifting and “common notion of insurance” requirements typical of an insurance company, she said in a statement.

“Microcaptive owners who operate their captives for legitimate risk-transfer and follow best practices … are not impacted by this ruling,” Ms. Towle said.