The Tax Court recently issued a much-anticipated decision in Avrahami v. Commissioner (a copy of the opinion is available here). At issue: an IRS challenge to deductions taken by the taxpayer for premiums paid to a “micro-captive” insurance company. In a victory for the IRS, the Tax Court denied the deductions at issue, finding that the amounts paid did not qualify as insurance premiums for federal income tax purposes. In the process, the court also determined that the captive’s elections under section 831(b) (to be treated as a small insurance company) and section 953(d) (to be taxed as a domestic corporation) were invalid.
But not every issue went the way of the IRS. While holding against the taxpayers on the substantive tax issues, the court nonetheless refused to impose penalties for the disallowed deductions. The line drawn by the court could, perhaps, signal a potential basis for micro-captive settlements in the future.
So, for those wondering, how does this “micro-captive” thing work? Well, it’s complicated, but here’s a nutshell summary: Generally, a taxpayer can deduct premiums paid for insurance as “ordinary and necessary” expenses. The insurance companies that receive those premiums are generally taxed on the premiums. “Small” insurance companies that are eligible to make an election under section 831(b) of the Internal Revenue Code, however, are given preferential treatment: they are only taxed on their investment income, not the premiums that they receive.
Captive insurance companies, as the name implies, generally insure risks for related companies (e.g., a corporate parent may own a captive insurance company that insures certain risks). In other words, the related party pays premiums to the captive insurance company. Those premiums are deducted by the related party for tax purposes.
So what is a “micro-captive?” Captive insurance companies that make a valid section 831(b) election are referred to as “micro-captives.” Under section 831(b), the micro-captive does not have to include the premiums that it receives in income. That’s right, the related party gets a deduction for premiums, and the micro-captive does not have to recognize the amount paid as taxable income. All of this works, however, only if the premiums are paid for “insurance”—a term that is not explicitly defined in the Code or the Regulations. And therein lies much of the rub.
Despite its central role, the term “insurance” is not defined by the Code or the Regulations. Instead, the development of the concept has been left to the courts. Over time, courts have primarily looked to four criteria to determine whether an arrangement constitutes “insurance” for Federal income tax purposes: (1) does the arrangement involve insurable risks?; (2) does the arrangement shift the risk of loss to the insurer?; (3) does the insurer distribute the risks among its policyholders?; and (4) is the arrangement “insurance” in the commonly accepted sense?
The 105-page, highly fact-specific opinion in Avrahami only explored two of these criteria: risk distribution and commonly accepted notions of insurance. Thus, future decisions in this context, will put more flesh on the contours of these requirements. But for those still reading along and figuratively sitting on the edge of your seat … we are in luck: There are several captive cases still in the pipeline—e.g., James L. Wilson & Vivien Wilson v. Commissioner—so we may not have to wait too long. These cases are being followed closely by the captive industry.
In the meantime, the Avrahami decision is likely to embolden the IRS in its attack on micro-captives that it views as abusive. The IRS certainly considers it a critical win. That means practitioners and clients should consider actively reviewing and evaluating captive arrangements in light of the recent decision, and, where appropriate, take proactive steps to strengthen their position against potential future challenges on the heels of Avrahami. After all, risk mitigation is the name of the game here.
Freeman Law works with tax clients across all industries, including manufacturing, services, technology, oil and gas, financial services, and real estate. State and local tax laws and rules are complex and vary from state to state. As states confront budgetary deficits due to declining tax revenues and increased government spending, tax authorities aggressively enforce state tax laws to recapture lost revenues.
At Freeman Law, our experienced attorneys regularly guide our clients through complex state and local tax issues—issues that are frequently changing as states seek to keep pace with technology and the evolution of business. Staying ahead requires sophisticated legal counsel dedicated to understanding the complex state tax issues that confront businesses and individuals. Schedule a consultation or call (214) 984-3410 to discuss your Local & State tax concerns and questions.