The US Tax Court has backed the Internal Revenue Service’s (IRS) decision to deny Benyamin and Orna Avrahami access to the Internal Revenue Code Section 831(b) election for certain financial years.
Judge Mark Holmes ruled on 21 August that payments made to the Avrahamis by their micro captive, Feedback, amounted to taxable dividends outside of the scope of certain tax elections.
Feedback insured the Avrahamis’ Arizona jewellery stores and shopping centres against chemical and biological terrorist attacks.
But the IRS believed that the micro captive was organised to provide tax deductions under Section 831(b) of the Internal Revenue Code and lacked insurance risk, and that risk was not shifted to the captive.
There were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis and their various entities' returns.
Feedback accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which was transferred back to the Avrahamis, as loans and loan repayments, or as distributions.
Judge Holmes agreed with the IRS in his long-awaited 105-page judgement, finding that certain amounts paid by Feedback were not insurance premiums for federal income tax purposes.
The Avrahamis argued that Feedback is a valid insurance company that qualified and properly elected to be taxed under Section 831(b), all of its policies covered insurable risks and premiums were actuarially determined, and the captive distributed risk.
Feedback’s risk exposures fell short of meeting the threshold for insurable risk, according to Judge Holmes. He ruled: “While we recognise that Feedback is a micro captive and must operate on a smaller scale than [other insurance companies the Tax Court has examined], we can't find that it covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities.”
In particular, Judge Holmes held that the pooling entity was not a bona fide insurance company, and that the captive did not operate like an insurance company because it issued policies with unclear and contradictory terms, and charged wholly unreasonable premiums.
Tax attorney Tim Tarter of Woolston & Tarter, which represented the Avrahamis, said: “The Avrahamis are very disappointed with the US Tax Court’s disallowance of their claimed deductions for captive insurance premiums, but appreciate that the court did not find their captive was a sham nor did the court determine that they were negligent in claiming the deductions at issue. The taxpayers are currently considering their options going forward.”
In recent years, the IRS has increased its scrutiny and audits of micro captives in the belief that small businesses are using them to insure against improbable risks that they never pay claims on, and the surplus returns to the business owners or heirs with little to no tax.
The IRS escalated that scrutiny last year with the release of Notice 2016-66, which formally labelled micro captives as ‘transactions of interest’ and required them to report to the federal agency by 1 May 2017 due to their potential for tax avoidance or evasion.