A jewelry store taking out an insurance policy to protect against chemical terrorist attacks is pretty unusual. If that highly unusual insurance policy results in significant tax savings, then the federal government will probably have something to say.
That is why the Tax Court case, Avrahami v. Commissioner, may be a death-knell for the use of “micro-captive” insurance companies for tax avoidance purposes.
Some definitions may be helpful:
- Captive: An insurance company that is wholly owned and controlled by its insureds.
- Micro-captive: A captive insurance company that operates with an annual written premium income of less than $1.2 million.
- Tax shelter: A way for individuals and companies to reduce their tax liability.
The tax treatment of micro-captives
In the U.S., micro-captives that meet certain requirements under Internal Revenue Code § 831(b) only have to pay tax on investment income.
This tax treatment has made micro-captives attractive for business tax avoidance and estate planning purposes (situations that the IRS frowns upon as “transactions of interest.”)
The tax-free underwriting income is sometimes then returned to the shareholder (which owns the micro-captive anyway) as a dividend or loan. Or, in the case of estate planning, the micro-captive could be owned by a trust that benefits the children of the shareholder to avoid estate taxes.
How it works
A (very) simplified version of this formula is:
- A business creates a micro-captive insurance company.
- The micro-captive issues an expensive policy for something that is unlikely to happen (like a chemical attack at an Arizona jewelry store).
- Premiums paid to the micro-captive are then deducted by the business.
- The micro-captive also doesn’t pay taxes on the premiums by electing under § 831(b) to be taxed only on its investment income.
- The premiums are never used to cover losses because the original item being insured was unlikely to happen, or part of a low-risk pool charging unreasonably high premiums.
- Then, instead of using the funds to administer its insurance plan, the micro-captive instead uses the funds for something else, like giving a loan or dividend to its shareholder.
The jewelry store case
In Avrahami v. Commissioner, the owners of Arizona jewelry stores insured themselves against chemical and biological attacks through a micro-captive using a low-risk pool.
The IRS views this insurance arrangement as a tax avoidance scheme and wants to void its effects under, among other things, the economic substance doctrine. This legal doctrine that disallows the tax benefits of arrangements that lack any business purpose beyond providing tax benefits.
The question is how broad the judge will rule in the Avrahami case. A broad ruling could be used by the IRS to aggressively go after similar micro-captive arrangements. A narrow ruling could only apply to this case.
A decision in the case is anticipated this spring.
“Court Ruling May Arm IRS for Micro-Captive Insurer Crackdown,” Allyson Versprille, Boomberg BNA.
“Transaction of Interest — Section 831(b) Micro-Captive Transactions,” Internal Revenue Bulletin: 2016-47, Nov. 21, 2016.
“Captive Insurance – Lessons to be learned from the Avrahami Case,” Goralka Law Firm PC.
“The Sum Of All Fears About IRC 831(b) Tax Shelter Captives In Avrahami,” Jay Adkisson, Forbes.
Photo: Wu Yi.