The US Tax Court’s decision to back the Internal Revenue Service (IRS) in its dispute with Benyamin and Orna Avrahami over their micro captive should encourage those involved in similar arrangements to revisit them.
Judge Mark Holmes issued his long-awaited ruling on 21 August, confirming that payments made to the Avrahamis by their micro captive, Feedback, fell outside of the scope of certain tax elections, including 831(b) for investment income up to $1.2 million.
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.
Charles Lavelle, senior partner and member of the tax and employee benefits department at Bingham Greenebaum Doll, suggested that this opinion should “incentivise those involved in captive insurance arrangements to assure that the premiums are appropriately computed, and that the policies are properly drafted”.
Lavelle added: “The pooling mechanism must also be valid. Conducting insurance operations in the same manner as commercial companies will assist taxpayers in satisfying the court’s tax tests.”
The Self Insurance Institute of America (SIIA), which weighed in on the case, stated that it “will continue to work with members to strengthen the enterprise risk captive industry through promotion, education and advocacy of appropriate captive compliance, management, and oversight practices”.
Ryan Work, vice president of government affair for SIIA, stated: “The Federal Tax Court’s ruling in Avrahami is consistent with SIIA’s long-time message. The fact pattern presented in the case is not representative of SIIA members and the best practices that we support. In addition, the ruling does not address a number of issues faced by the industry.”
“In an effort to gain clarity on one such issue, SIIA’s amicus brief with the court in Avrahami was intended to illustrate how a properly run enterprise risk captive can mitigate catastrophic risk of loss for small to mid-size businesses via general risk pooling arrangements, an issue not ultimately addressed with any detail in the decision.”
“Rather, the court’s decision focused on the specifics of a pooling arrangement with attributes that are not representative of SIIA membership nor current captive best practices.”
Although the captive industry did not get the win it was hoping for, Jeffrey Simpson, director at the Delaware law firm of Gordon, Fournaris & Mammarella, said that the decision is “an important first step toward the industry’s getting the guidance it needs to move forward constructively.”
Simpson said: “Unfortunately, some operators who may have thought they were doing the right things are learning that they may have to change their ways or exit the industry. But there are many operators who can comfortably say the structures they work on have very few facts in common with the negative facts spotlighted by the court. Those operators may actually feel more comfortable now.”
“In any event, I am looking forward to seeing the industry use this case to refine its practices and advance the dialogue with the IRS as we seek more complete guidance regarding micro-captives.”
This “definitely does not spell the end of risk pools”, Simpson added.
Simpson explained: “Again, the court’s analysis was fact intensive, and the court in this case was moved by a number of features of the pooling facility that are not present in many other pool designs. I expect that pool operators will use what they can glean from this case to distinguish their pools as much as possible from the design used here.”
He added: “Perhaps more importantly, the court’s analysis seemed to focus more on how the coverages were priced. In my view, pricing is independent of pool design, and pricing is the real concern. I anticipate seeing continued use of pools but with much more focus on process and documentation in pricing.”