The Tax Court issued its long-awaited decision in Avrahami v. Commissioner, 149 T.C. No. 7 (August 21, 2017), agreeing with the IRS that amounts paid to a captive/reinsurer that elected to be a treated as “micro-captive” pursuant to §831(b) were not deductible insurance premiums because the arrangement failed to qualify as insurance.
The Tax Court held that the captive insurance company lacked adequate risk distribution and thus failed to qualify as a valid insurance company entitled to make the §831(b) election. The Tax Court found that inadequate risk distribution existed where 30% of the captive’s annual premium consisted of a third-party terrorism risk pooling arrangement which the court deemed not to be insurance, with the remaining premiums covering the dubious risks of 3 to 4 affiliated pass through entities. The court determined that for risk distribution purposes the captive did not insure a sufficient number of affiliated entities nor did it insure a sufficient number of independent risk exposures. The Tax Court further noted that the captive arrangement in Avrahami did not comport with commonly accepted notions of insurance where the captive only dealt with claims on an ad hoc basis, did not appear to function as an insurance company in its daily operation, did not actually receive any claims until the audit began, issued policies with confusing and conflicting terms, failed to get regulatory approval for illiquid/long-term loans, and offered premium pricing that was “wholly unreasonable” and actuarially unsustainable.
Avrahami is the first ruling in a line of many cases dealing with 831(b) micro-captives. The Tax Court’s ruling emphasizes the importance of having proper documentation of valid insurance arrangements and demonstrates the Tax Court’s intolerance of marginal insurance arrangements set up primarily for estate planning purposes. Micro-captives continue to be a viable insurance alternative, but must be properly designed, capitalized and operated in order to withstand IRS and judicial scrutiny.