Reading between the Lines of Avrahami – Silver Linings and Dark Clouds for Micro Captives©

Reading between the Lines of Avrahami –
Silver Linings and Dark Clouds for Micro Captives
By Michael Lloyd, Esq.

August 25, 2017


On August 21, 2017, the United States Tax Court filed the long-awaited opinion in the case Avrahami v. Commissioner of Revenue.[1]  The Taxpayer lost.  This is the first opinion addressing the qualification of a micro-captive and its use of a risk pool.  The aftermath will likely be that the IRS will consider this a major victory and will ramp up its mass audits of captive promoters and their clients.  The micro-captive industry will construe the decision narrowly and consider it a “bad facts case.”  A close inspection of the Tax Court Opinion uncovers possible silver linings for taxpayers in future cases and dark clouds that should be immediately addressed by anyone connected with a captive insurance company.

Silver Linings.

  1. Foreign Tax Treatment. Tax practitioners who represent clients in captive audits were most concerned about the aftermath of a Taxpayer loss.  We all understand that the deductions would be denied for open years and that we may have to address possible constructive dividend treatment and accuracy related penalties, but the big stick that the IRS has been waving has been the resulting treatment of the captive in the event the 831(b) and 953(d) elections are found to be invalid.  Our concern is over the possible taxation at the captive level under Code Sections 881 and 882 and possible non-filing disclosure penalties.  The Court in this case recognized the issue, but didn’t need to address it as:

      “[i]t appears, however, the parties have resolved this issue themselves by stipulating that the ‘Taxable Premiums Earned’ by  [Feedback] in the amounts of $1,090,000 and $1,170,000 for taxable years 2009 and 2010, respectively, are not U.S. source fixed or determinable, annual or periodical income under section 881, or income that is effectively connected with a U.S. trade or business under section 882.” (emphasis added).

What does this mean?  Is the IRS backing off on that position, or was there a procedural problem that caused them to give it away.  If the IRS is backing off on that position, it will be a significant boost to taxpayers trying to resolve cases currently in IRS Appeals.

  1. Types of Policies. The Court didn’t oppose necessarily the types of insurance policies issued by the Captive.  The Captive issued policies for Business Income, Employee Fidelity, Litigation Expense, Administrative Actions and Tax Indemnity.  The Court acknowledged that the parties agree that policies related to Administrative Actions and Employee Fidelity were insurable risks.  The Court was at least not negative to the description of the other policies, with the exception of the Tax Indemnity insurance, but focused its negative views on the underwriting methods of determining the premium amounts.  Even the terrorism insurance provided by the risk pool was considered as a respectable type of insurance coverage.  Though it is dangerous to rely on things not said in a Tax Court Opinion, one could conclude that non-traditional insurance risks if properly underwritten may be acceptable.
  1. Penalties. There are several bright spots in the Court’s decision not to apply accuracy-related penalties.  First, even though the estate planner worked with the promoter and shared a part of the start-up fee, he was considered independent for purposes of their reasonable reliance.  Second, the estate planning attorney had worked with the promoter previously, yet was still viewed as independent.  Third, there is no information provided to suggest that the estate planning attorney had any knowledge or expertise in the areas of captives.  All of these facts could have been used to conclude that the Taxpayers were not reasonable and penalties should apply – but the penalties nevertheless did not apply.
  1. Dividends on Loans. The best case win for the IRS is when amounts are found not deductible at the business level, but then treated as taxable dividends to the shareholders.  This double taxation applied in this case, but only with respect to a $200,000 distribution that the Taxpayers agreed should have been taxed but had been missed inadvertently.  More important though, the Captive loaned $2,330,000 in two separate transactions to an entity controlled by the Taxpayers who then used the money to repay loans back to the Taxpayers resulting in the amounts flowing directly back to the Taxpayers.  The IRS urged the Court to treat these amounts as dividends in the same way as the $200,000 and to apply the substance-over-form and step-transaction doctrines to construe the transfers as constructive dividends.  The Court declined to follow the IRS position and concluded that although it was a close call, the transfers should be treated as loans and not constructive dividends.
  1. Shift to Risk Exposures. This is also on the list of dark clouds as it cuts both ways.  For captives that provide insurance for brother-sister affiliates, a shift of focus to the number of independent risk exposures may make risk distribution easier to accomplish.
  1. Offshore not Criticized. Other than a few barbs about the lack of regulations in St. Kitts, the Court stated no major objections to an offshore captive.  Again, it is best not to read too much into the Court’s silence on this matter.

Dark Clouds.

  1. Risk Pools – Risk Distribution. Many captive arrangements use risk pools to satisfy risk distribution.  A common method is to have the captive cede a portion of its risk to the pool and then have the pool cede back a portion of the pool’s risk to the captive.  Generally, the determination of the risk ceded and shared is based on a goal of having some meaningful percentage of the total premium expense be considered “third party insurance.”  This case muddies the water for these reasons:
  •   Circular Funding. Before the Court addressed whether the risk pool satisfied risk distribution, it reviewed factors to determine if the risk pool was a bona fide insurance company.  One of the factors that was considered by the Court unfavorably to the Taxpayer was the circular nature of amounts ceded to the risk pool and then the same value in pool risk ceded back to the captive.  This is a very common method of funding for risk pools and should be reexamined in light of this case.
  • Shift to Risk Exposures. It is a simple mathematical calculation to make the total percentage premium of a captive relate to third party risk.  This is typically how risk pools operate.  The total amount of premium amount from the insureds to the captive is determined and then some percentage from 31 – 51% of that value is ceded to the risk pool in exchange for the same amount of third party risk back to the captive.  This case makes clear that more important than the percentage of premiums is the number of third party risk exposures.  Thus, a million dollars of third party risk representing a handful of risk exposures is not as useful as a must lesser amount of third party risk from thousands of risk exposures.  For captive promoters who mostly have captives that provide insurance with minimal risk exposures, this could be a big problem.
  • Captialization and Ability to Pay. In this case, the Court recognized that by paying out nearly all of the premiums taken in for the terrorism insurance, that the risk pool had little money with which to pay claims.  This may be a problem even if the risk pool technically meets the capital requirements of the jurisdiction.
  1. The Achilles-Heal I – Risk Pools. The IRS recognizes that the easiest way to victory is to attack a promoter’s risk pool.  If the risk pool is not recognized as an insurance company, then there is no third party risk and risk distribution is failed.  This is important because an IRS win on this point will spell trouble for every customer of the promoter using that risk pool.  It is also very possible that a taxpayer could have done everything right, but lose because of the qualification of the risk pool.
  1. The Achilles-Heal II – The Underwriting. The Court summed it up well in discussing the underwriting and actuary process to determining premiums – No one thinks this process lacks all subjectivity, but the work of an actuary must be reproducible and explainable to other actuaries.  In this case, the Actuary did a poor job of explaining how he determined the premiums for the policies issued by the captive and the risk pool.  If this can’t be done in a way that another actuary can understand and believe it, there is a problem.  It is suggested that if the business owner can’t make sense of how the insurance premiums are determined, that a Judge won’t understand it either.
  1. Watch Out for Traps. It is always easy to look back on a case and see that certain facts are harmful to a case.  In this case, there were several points that were identified by the IRS that made this case look worse than necessary.  A review of these facts may help others not to repeat them.
  • Substantial Increase in Premiums with the Captive. It is expected that when a captive is created the total insurance expense is going to go up, but care should be given to have a story why it has increased and maybe not have it increase to the maximum deductible limit.  The reasons for increase could be addressing a previously unaddressed risk that has caused or may cause significant loss.
  • View Business Insurance in the Totality. Risk management involves the consideration of all business insurance.  Nothing looks worse than a business that adds captive policies that cover redundant risks that are already adequately covered by the commercial coverage.  Alternatively, it looks great when a business can demonstrate that with the captive, they were able to reduce commercial insurance costs and eliminate coverages that are now covered by the captive.
  • Target premiums are bad. The focus should never be on an intended deduction amount.  The focus is on the management of risk and reasonable premiums to insure that risk.  It looks bad when either the underwriter appears to work backwards by first learning of the intended deduction and then finding the policies and premiums to add up to the intended deduction.  For this reason, total captive insurance premiums that are at or near the maximum deductible limit of Section 831(b) may be a red flag.
  •  Make Sure the Policies Make Sense. In this case, there were a few head-scratchers, such as the loss of a key employee policy that identified the husband and wife as the “key employees” but then the policy excluded owners, or a policy covering construction liability for a company that did no construction.  Also, when you purchase a terrorism policy for $1,600 and then purchase another one not that different from the captive for $360,000, someone is going to raise an eyebrow.
  •  Be Careful of Add-On Policies. It is very common for a business owner to have a very real need to cover a risk that is not currently insured, but then be talked into several additional policies that are often used by captive owners, but don’t fit for that business.
  •  Be Careful of Loans. Some may read this Opinion to validate the use of loans back to business owners in a captive.  While the loans were not treated as taxable dividends, the loans were still a problem in this case as it demonstrated that the captive was not operating like a bona fide insurance company.


Summary.  The Avrahami case will be lauded by the Government as a huge victory over micro-captives and considered by the captive industry to be a bad result from bad facts.  The reality is that the IRS won this case handedly and will likely be more aggressive in targeting what it perceives to be problem promoters.  Though a victory today, there are many lessons to be learned to make sure that the next captive case results in a victory for the taxpayer.

Captive owners and their advisors should consider the status of their captive in light of this new case, together with their promoter and risk pool.  Williams Coulson is available to assist clients in pre-audit compliance reviews and is currently representing customers from difference promoters in audits before the IRS.  For more information, call Mike Lloyd at (412) 454-0225 or email him at

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