Navigating the Avrahami Maze to a Successful Captive©

Navigating the Avrahami Maze to a Successful Captive©
By Michael E. Lloyd, Esq.

August, 25, 2017

 

On August 21, 2017, the United States Tax Court filed their opinion in the case Avrahami v. Commissioner of Revenue.[1]  Although the Taxpayer lost on most of the important issues of this case, much can be learned from untangling the Tax Court’s first opinion on Section 831(b) micro-captives and their risk pools.  This article is intended as a guide for Captive owners and their Advisors in considering how these views relate to their own captive insurance companies.[2]

Summary of Holdings.  The amounts paid by the Avrahami businesses to the captive were not insurance premiums for federal income tax purposes and thus were not deductible under Code Section 162.[3]  In addition, one of the Avrahami transactions with the Captive was treated as a  distribution such that the Avrahamis were taxed as receiving ordinary dividends (thus double taxation).  The captive’s elections under Sections 831(b) and 953(d) were invalid[4].  For the most part, accuracy related penalties did not apply as the Avrahamis relied upon the advice of an independent tax professional.

Important Facts – Formation and Operation.  This case is clearly not a condemnation of Section 831(b) micro-captives.  It is instead a clear message that this particular captive transaction was not compliant.  The following are the most important facts of the case.

  • In 2006, the Avrahami businesses (the “Insureds”)[5] spent a little more than $150,000 in business insurance.
  • In 2007, the Avrahamis were advised to consider a captive insurance company by their long time CPA.
  • They engaged a tax and estate planning attorney who advised them on working with a captive manager in the creation of a captive insurance company that they named Feedback Insurance Company, Ltd. (the “Captive”).
  • Each year, the Actuary was told the Insured’s “target premium” for their direct policies.
  • In years 2009 and 2010, after the creation of the Captive the Avrahami businesses spent more than $1,100,000 in business insurance with most of it going to the Captive.
  • Despite the formation of the Captive, the Insureds continued to buy insurance from third-party commercial carriers with no change in coverage or costs.
  • For all years 2007 – 2013, the Insureds paid premiums to the Captive but did not have any claims.
  • Beginning in 2010, the captive began loaning money indirectly to the Avrahamis.

The Determination of Premiums – The Importance of the Actuary.  This case demonstrates that the Actuary/Underwriter are the most important players in any captive transaction.  In this case, the Court found the Actuary’s work to be lacking and his testimony of questionable reliance.  The Court described the role of the Actuary/Underwriter as follows:

“[T]he actuaries define the rating scheme and the underwriters make * * * the individual selections and adjustments for the given risks.  An actuary typically starts with published rates and large datasets for particular risks and makes adjustments for policy limits, estimates of the frequency and severity of loss, deductibles, the claims history of a particular customer, and perhaps a dozen or so other factors that can be combined into equations that he uses to set a premium for a particular policy. Actuaries are also supposed to ensure their work is appropriate for its intended use, consider whether their work includes large enough risk classes ‘to allow credible statistical inferences regarding expected  outcomes,’ and check the reasonableness of their results. See Actuarial Standard of Practice No. 12: Risk Classification (for All Practice Areas), sec. 3.3 (Actuarial Standards Bd. 2005). No one thinks this process lacks all subjectivity, but the work of an actuary must be reproducible and  explainable to other actuaries.[6] (emphasis added).

 Risk Distribution – the Pan American Risk Pool.  One of the hallmarks of insurance is the distribution of risk among a sufficient pool of insureds.  In this case, “risk distribution” was addressed through participation in a terrorism insurance pool whereby the Insureds purchased  terrorism insurance from the Pan American Risk Pool and Pan American paid roughly the same amount to the Captive for accepting to insure a relative share of the terrorism risk from other captives in the pool.

 The Court’s Perspective.  The Tax Court’s initial perspective was that –

“These cases turn on whether the transactions at issue involved ‘insurance’ for federal tax purposes. Precedent tells us to answer this question by  considering all the facts and circumstances and deciding whether the arrangement involves risk shifting, risk distribution, and insurance risk, and meets commonly accepted notions of insurance.”[7]

 The Court bypassed the risk-shifting factor, and instead focused on risk-distribution.

The Court’s View of Risk Distribution.  Risk distribution is one of the common characteristics of insurance and occurs when the insurer pools a large enough collection of unrelated risks.  The idea is based on the law of large numbers – a statistical concept that theorizes that the average of a large number of independent losses will be close to the expected loss.[8]

The Court considered whether the Insureds meet the Risk Distribution requirements on the basis of the policies issued amount the six different Insureds under a brother/sister analysis.  The Court made clear first that more important than the number of insured companies, is the number of independent risk exposures.  In this case, however, there were not sufficient numbers of either insureds or risk exposures to constitute risk distribution among the affiliated Insureds.

Then, the Court considered whether the Pan American Risk Pool was sufficient to meet the risk distribution requirement.  Instead of considering whether the risk from Pan American was sufficient risk distribution, the Court considered instead whether Pan American was a “bona fide insurance company.”  The Court identified a number of factors as important,[9] but appeared to only focus on three of them.

Circular Funds.  In this case, Pan American provided terrorism insurance for the business insureds and then ceded an amount of risk and paid premiums to the insured’s captive of nearly the same amount.  For example, one of the Insured’s paid Pan American $360,000 for terrorism insurance for 2009, and then Pan American paid a reinsurance premium to the Captive in the amount of $360,000 to accept a percentage of the terrorism insurance risk.  The Court held that “while not a complete loop, this arrangement looks suspiciously like a circular flow of funds.  The end result of two years in the Pan American program was the transafer of $720,000 from an entity owned 100% by the Avrahamis to one owned 100% by Mrs. Avrahami.

Unreasonable Premiums.  The Terrorism policies issued by Pan American were modeled after certain commercial insurance products under the Terrorism Risk Insurance Act of 2002 (“TRIA”).  There were some differences in the TRIA policies and the policy issued by Pan American under its Terrorism Risk Insurance Pool (“TRIP”), but they were similar.[10]  The Court observed the following problems with the TRIP policies.  First, they were a one-size fits all product such that businesses in different locations paid the same amount when the market suggested that terrorism risk could be as much as 10 times higher in large cities.  Second, the Insured did purchase TRIA even in years where it purchased TRIP.  Third, the cost for TRIA was $1,500 in 2009 and $1,600 in 2010.  The cost of TRIP from Pan American for coverage not that much different was $360,000 for each year, an 80 times rate increase.  On this fact alone, the Court could easily find that the premiums were “grossly excessive.”[11]

Arm’s Length Contracts.  The IRS Expert concluded that no reasonable profit seeking business would ever enter into a contract with Pan American under the terms presented absent the tax considerations.  In addition to the exorbitant premiums, was the very real fact that Pan American didn’t have any money to pay claims if they did occur since it paid nearly everything that was paid in, back out a reinsurance premiums to the various captives.  Thus, if a claim did occur, Pan American would be forced to try to get the money for pay the claim from all of the participating captives.

Upon considering the above three factors, the Court held that it was “more likely than not” that Pan American was not a bona fide insurance company.   Therefore the policies terrorism policies issued by Pan American were not insurance and the Captive in this case did not have sufficient third party risk to satisfy the risk distribution requirement.[12]

Insurance in the Commonly Accepted Sense.  The Court identified seven factors in determining whether there is insurance in the commonly accepted sense.[13]

Organization, Operation and Regulation.  Although the Captive was arguably organized in compliance of the jurisdictional requirements, the Court found that the Captive’s “operations left something to be desired” because (i) it dealt with claims on an ad-hoc basis, (ii) invested only in illiquid long-term loans to related parties, (iii) failed to get regulatory approval of such loans, (iv) the Insureds made no claims until after the audit started and approved what claims that were filed inconsistently with the terms of the policies.

Capitalization.  The Captive met the minimum capitalization requirements of St. Kitts.  The Court found that to be sufficient.

Valid and Binding Policies.  The Court found that “some of the policies were less than a model of clarity.”

Reasonableness of Premiums.  As mentioned previously, the Court found that the Actuary’s testimony about the determination of premiums was “often incomprehensible” and “utterly unreasonable.”  The Court noted again that their insurance expenses went from under $100,000 before the Captive to more than $1,100,000 after the Captive.

Payment of Claims.  The Court concluded that claims were paid after they were made.

In summary, the Court held that –

 “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.”

 Accuracy Related Penalties.  The Court found that the Avrahamis reasonably relied upon their estate planning attorney’s guidance and thus no penalties applied.  There are a few cautions in this penalty analysis.  The first is that the Court considered this an issue of first impression.  Second, although the Avrahamis were reasonable to rely of their independent tax attorney, they would not have been reasonable to rely on the promoter attorney.  Finally, to the extent the taxpayer received a distribution and did not include it in income, the adjustment on that amount was subject to an accuracy related penalty.

The Top Six Things that Killed the Taxpayers’ Case.

  1. The Risk Pool was defective. The Court found that the premiums didn’t make sense and were unreasonable.  The Court also concluded that the Risk Pool could not have paid claims if they had occurred and the premiums were circular transactions.
  1. The Underwriting Didn’t Make Sense. The Court found that the method of determining the premiums at both the captive and risk pool were incomprehensible and unreasonable.
  1. The Taxpayers communicated “target premiums”. The Court took issue with evidence suggesting that the Taxpayers were requesting premium amounts that were at or near the maximum deductible amount.
  1. The Insureds’ insurance expense skyrocketed with the Captive. The Court mentioned several times that the Insureds’ insurance expenses were increased 10 fold after the adoption of the Captive.  Of note also was that the Insureds did not eliminate or change any of their outside insurance coverages.
  1. The Captive loaned much of the assets of the Captive back to related entities. This was bad for three reasons.  First, it looked like a circular transaction with money ultimately moving back to the pocket of the Taxpayers.  Second, it put the Captive in a difficult capitalization position such that if substantial claims ever had to be paid, the Captive would have to call the notes.  Third, regular insurance companies don’t loan their assets to their customers, and certainly not to the extent done in this case.
  1. The Insured didn’t submit any claims until after the audit started. From the Court’s view, the Insureds’ spent under $100,000 in business insurance each year until the Captive was created.  Then, the Insureds’ spent more than $1m in insurance expenses, but with all of the insurance provided, did not have a single claim for six years until after the audit commenced.

Summary.  The Avrahami case should be limited to its facts and should not be extended to all micro-captives.  However, the analysis in this case should be considered carefully by the advisors for all micro-captives to identify similarities and distinctions.

Williams Coulson is currently representing taxpayers under audit in IRS Exam, Appeals and Tax Court.   We are providing Pre-IRS Compliance Audits to address this and other captive positions.  For more information or to schedule a call, please call Mike Lloyd at (412) 454-0225 or email him at mlloyd@williamscoulson.com.

[1] Avrahami v. Commissioner, 149 T.C. No. 7, (2017), Docket Nos. 17594-13, 18274-13.

[2] We believe all Captive owners should review their own captive plans in light of this new decision.  Williams Coulson is available to assist in pre-audit captive screenings.

[3] Because the businesses were flow-through entities, the adjustments flowed through to Mr. and Mrs. Avrahami on their personal returns.

[4] See discussion below on how this decision may be more important to the next captives who may be subject to IRS scrutiny.

[5] Benyamin and Orna Avrahami owned three shopping centers and three jewelry stores.

[6] The Court then stated ominously that the actuarial services provided in this case were “somewhat different.”

[7] Avrahami v. Commissioner, 149 TC No. 7, at 60.  Note that this is a mere restatement of the important factors set forth in LeGierse.

[8] Id at 60.

  • [9]“whether it was created for legitimate nontax reasons;
  • whether there was a circular flow of funds;
  • whether the entity faced actual and insurable risk;
  • whether the policies were arm’s-length contracts;
  • whether the entity charged actuarially determined premiums;
  • whether comparable coverage was more expensive or even available;
  • whether it was subject to regulatory control and met minimum

statutory requirements;

  • whether it was adequately capitalized; and
  • whether it paid claims from a separately maintained account.”

 

[10] Id at 36.  Note that the Court later made clear that there were some things about TRIP that would justify a higher premium such as covering biological warfare but also things that should have made it less expensive such as a limitation that it excluded terrorism occurring in a city with more than 1.5 million residents.

[11] Id at 71.

[12] Id at 75.

[13] “To analyze it, we look at numerous factors, including [1] whether the company was organized, operated, and regulated as an insurance company; [2] whether the insurer was adequately capitalized; [3] whether the policies were valid and binding; [4] whether the premiums were reasonable and the result of an arm’s length transaction; [5] and whether claims were paid. [6] We have also looked at whether the policies covered typical insurance risks and [7] whether there was a legitimate business reason for acquiring insurance from the captive.”

 

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