By Sean King, JD, CPA, MAcc
This is the third and final part of our series on the United States Tax Court’s recent Avrahami decision.
Recently the United States Tax court issued the long-awaited opinion in the Avrahami captive insurance case. And after more than 30 years of losing most every captive insurance case of consequence, the IRS finally got a win.
In Part 1 of this series we discussed the court’s decision that the Avrahami captive insurance arrangement failed for lack of sufficient risk distribution. In Part 2 we considered other factors that the court decided were sufficient to undermine the captive’s status as an insurance company.
In this final part of our series we will discuss the implications of the court’s ruling on the Avrahami’s tax liability and summarize the main lessons of the Avrahami case.
Effect of Ruling
The Avrahami captive was domiciled in a foreign jurisdiction but had made an election under Internal Revenue Code Section 953(d) to be taxed as a US corporation. Also, it had subsequently made an election to receive favorable tax treatment under IRC Section 831(b). However, the 953(d) election is available only to insurance companies. Once the court ruled that the captive was not a valid insurance company, it was ineligible to be taxed as a US corporation and therefore also ineligible for the favorable tax treatment under IRC Section 831(b).
Effectively, by ruling that the captive was not an insurance company, the corporation in question became taxed as a “controlled foreign corporation” (CFC). However, the parties to the lawsuit had previously stipulated that no tax was due from the captive under the CFC rules, so this ultimately had no effect on the Avrahamis’ tax liability. The IRS may or may not make similar stipulations in future cases.
Regardless (and most importantly) because the payments of “premiums” were not payments for valid insurance policies, the court found that they were not deductible business expenses. Thus, the court denied the premium deductions taken by the Avrahamis’ businesses for the years in dispute. This did, of course, substantially increase their tax liability for those years.
Bona Fide Loans
Importantly the court ruled that the loans taken by the Avrahamis and/or related businesses from the captive insurance company were bona fide (subject to exceptions and particulars not worth mentioning here) and not merely constructive dividends. Consequently, the Avrahamis and/or their businesses generally owed no additional tax on the monies borrowed from the captive insurance company (again, subject to minor exceptions not worth mentioning). Though it was a “close call”, the court deemed the loans valid because the borrower had the ability to repay and the loans were evidenced by a valid debt instrument that specified the required interest rate and repayment schedule.
The IRS argued that, in addition to owing taxes on the denied deductions, the Avrahamis should be subjected to accuracy-related penalties for negligence and/or disregarding the tax rules.
One of the defenses to assessment of such penalties is the taxpayer acting in “good faith” or with “reasonable cause”. Reasonably relying in good faith upon the un-conflicted, professional advice, such as from a competent and un-conflicted attorney or CPA who had an accurate understanding of the facts, is generally sufficient to avoid penalties.
The court found that the Avrahamis could not reasonably rely on the advice of the captive attorney in order to avoid penalties because the captive attorney structured and benefited from the transaction. The advice of the captive attorney was not sufficiently neutral in the court’s mind.
Fortunately, the Avrahamis were also advised about the transaction by their estate planning attorney who had no interest in the transaction. Because there was no clear contrary authority, the court found that the Avrahamis’ reliance on their estate planning counsel was sufficient to avoid application of any accuracy-related penalties related to deduction of the captive premiums.
Takeaways and Conclusion
The Avrahami case turned upon facts that were atypical. So, it’s hard for most captive insurance companies to take much guidance from it. However, it is possible to draw some helpful conclusions that should protect your captive from the failings that undermined Avrahami. Here are our Top Takeaways From Avrahami:
- Captives should generally pool all or virtually all risks and not only a small subset of them. Relying on only a single risk to achieve risk distribution is ill-advised since, if the court deems that coverage invalid, risk distribution fails completely.
- The actuarial pricing of the policies must be sound. Protective second opinions (from regulators or other actuaries) may be advisable.
- Sound actuarial pricing means among other things that the premium calculation must be informed by each insured’s specific circumstances (loss runs, location, etc.), the unique language of the policy in question, and the insured’s contemporaneous commercial coverage. (For instance, is the captive coverage primary or excess?). Actuaries should always double check that pricing in each instance is consistent with the unique policy terms and existing commercial coverage.
- Policy language cannot be vague and must avoid contradiction.
- Captive coverage should dovetail with commercial coverage and not duplicate it (unless the former is priced as “excess” coverage only).
- Each captive should have established claims paying procedures.
- Insureds should always submit timely claims for any insured losses.
- Large claims should be reviewed and approved by an independent claims adjuster before being paid.
- Assets of the insurance company must be sufficiently liquid and invested so as to support the claims-paying ability of the captive insurance company.
- Insider loans should be avoided or limited to a reasonable percentage of the captive’s assets. Regulator approval should always be obtained before any such insider loans are made.
- Domestic domiciles may be preferable to foreign ones since the IRS seems to have less leverage over taxpayers with regard to the former (no threat of being deemed a CFC).
- When possible, have independent professionals such as the insured’s tax return preparer or the captive’s CPA auditor advise the client (even if just verbally) on the legitimacy of the insurance arrangement and the resulting deductibility of the captive premiums each year. Such advice should be based upon their understanding of statutes, regulations and case law – and not merely the IRS’ position in audits.
We are thrilled to say that none of the captives that we manage seem to suffer from the fatal flaws of Avrahami. All of our captives pool all (or most all) of their risks (many risks, not just one or a few risks). The actuarial pricing of each has generally been reviewed by state insurance regulators at least once. We have repeatedly engaged additional actuaries to review the main actuary’s work on an ad hoc basis and have found no significant discrepancies. All of our captives have adopted formal claims paying procedures, and (if they have been around for more than 12 months) have incurred claims. Large claims are reviewed by independent claims adjusters. Each domestic captive operates under an Asset Policy Statement that has been reviewed and approved by regulators, thus insuring sufficient liquidity. Few captives have made insider loans, and even fewer have made insider loans of a substantial amount. All new captives are generally formed in domestic domiciles and the few foreign captives we manage are taking steps to re-domicile to the US.
We welcome any questions about the significance of the Avrahami decision.