By Tingting Zhang, CPA, Tax Senior
ASL Tax Group
The U.S. Tax Court issued its final decision on captive insurance arrangements in Avrahami v. Commissioner, 149 T.C. No. 7 (2017). The Court held that the payments made by the Avrahamis to a micro-captive insurance company wholly-owned by Mrs. Avrahami are not insurance premiums for federal income tax purposes; therefore the deduction was not allowed for the federal income tax calculation. The captive insurance company’s elections under Section 831(b) to be treated as a small insurance company and under Section 953(d) to be taxed as a domestic corporation were also held to be invalid. This is the first Section 831(b) case that made it to trial and here is what you should know.
Purpose of captive insurance arrangements
A captive insurance company is wholly-owned and controlled by its insureds. The main purpose of this arrangement is to insure the risk of its owners and enable the owners to benefit from captive’s underwriting profits. Normally, taxpayers may choose to adopt this captive arrangement because:
1. There is no readily available commercial policy in the market, mainly because of the rare nature of the business or the risk.
2. The premium of the commercial policy offered by the insurance marketplace is much higher than forming one’s own captive insurance company.
3. The tax savings on a micro-captive insurance company, because once an insurance company qualifies to be taxed under Section 831(b), it only pays income tax on investment income and not on premiums collected.
What does this case mean to your captive insurance company?
Even though the court opinion specifically targets the facts in this case, it serves as an important reminder to all taxpayers to reevaluate your own captive insurance structure. The IRS has applied increased scrutiny to these arrangements, adding them to the “dirty dozen” list of tax scams for three years in a row (2015-2017). The IRS also issued Notice 2016-66 regarding “Transaction of interest – Section 831(b) Micro-Captive Transactions”. This notice requires proper disclosure of transactions similar to the one described in the notice.
Criteria to be considered:
According to the court’s opinion, in order to be considered as insurance, the captive arrangement must:
1. Involve risk-shifting
2. Involve risk-distribution
3. Involve insurance risk
4. Meet commonly accepted notions of insurance
Some other facts to be considered:
1. Is the captive financially capable of meeting its obligations?
2. Is the captive organized, operated and regulated as an insurance company under local laws?
3. Is the insurance premium reasonable compared to similar commercial policies if available?
4. Are there any claims made or paid by the captive?
5. Are the claims paid with proper administrative processes?
6. Does the captive have a sufficient pool of insureds?