By Nick Richards and Keith Buckley
On August 21, 2017, the Tax Court opinion of Avrahami v. Commissioner 149 T.C. No. 7 was issued ruling in favor for the IRS. The long-awaited opinion hoped to bring clarity and guidance to the Internal Revenue Service’s (“IRS”) treatment of insurance companies making a Section 831(b) election.
Section 831(b) insurance companies, also known as micro-captive insurance companies, have recently come under increased scrutiny with the Internal Revenue Service (“IRS”). Last November, the IRS issued Notice 2016-66, which identified certain captive insurance arrangements that qualify under Section 831(b) as transactions of interest. Section 831(b) captives are included on the IRS’s “Dirty Dozen” list of tax scams, and is one of the thirteen issues being targeted by the IRS Large Business and International Division’s new tax compliance campaigns. With this increase in enforcement there were no guidelines for the companies or the IRS to follow.
Avrahami is the first Section 831(b) case to make it to trial. The U.S. Tax Court backed the IRS by ruling that the taxpayer’s micro-captive insurance company and risk-pooling arrangement did not constitute insurance and thereby cannot be respected as such. While the outcome has been much anticipated among the captive insurance industry the results provided no bright line rule.
Justice Holmes, in a 105-page opinion, dissected all the facts and circumstances around the Avrahami’s micro-captive insurance company and the risk-pooling arrangement. The Court followed previous case law to determine whether the arrangement was insurance. In particular, the Court addressed two of the four factors previous cases have used to define insurance: risk distribution and insurance in the common sense of the term.
The Court makes it clear that without risk distribution a company cannot be an insurance company. The issue turned on what is adequate risk distribution? Is a 12 or 35 pool of entities a large enough collection of unrelated risks, as argued by both sides? The Court instead said that it is not about the number of entities, rather the number of independent risk exposures when looking at an arrangement.
Absent risk distribution, any insurance company is dead in the water. But the Court took it one step further to determine if the arrangement “looks like insurance in the commonly accepted sense”. Using a six factor test, it was determined that the Avrahami’s insurance company was organized and regulated as an insurance company. However, it was not operated like an insurance company. A bona fide insurance company would not issue policies with unclear and contradictory terms and charge unreasonable premiums.
Where do we go after Avrahami? The IRS seems embolden to continue their strict effort to regulate insurance companies that make a Section 831(b) election and participate in risk pools. The good news is that there is finally some clear guidelines on how to analyze micro-captive insurance arrangements under Section 831(b).
The IRS has emphasized its intent to stop what it deems abusive arrangements by identifying micro-captive insurance transactions on its annual “Dirty Dozen” list of tax scams. Now with some guidelines it is expected that the IRS is going to continue to move forward with targeting these transactions. If you or any of your entities have made a Section 831(b) election or are involved with any similar transactions, please feel free to contact Dill Dill Carr Stonbraker & Hutchings, PC. Our tax attorneys will strive to protect your interests and ensure that a fair solution is achieved.
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