The U.S. Tax Court recently ruled in Avrahami v. Commissioner, involving a captive insurance company under Section 831(b) of the Internal Revenue Code (IRC).
The long-awaited Tax Court opinion was ostensibly a victory for the IRS, stating that the arrangement at issue did not involve “insurance” for federal income tax purposes and therefore denying any income tax deduction for the insured business in connection with its payment of insurance premiums to the “micro captive” insurance company.
For federal income tax purposes, “insurance” is defined by the following four factors:
1) risk shifting,
2) risk distribution,
3) insurance risk, and
4) meeting commonly accepted notions of insurance.
The Tax Court held that the second and fourth factors – risk distribution (essentially, the law of large numbers as it relates to insurance risk, where the insurer does not have all of its “eggs,” i.e., risk, in one basket) and the commonly accepted notions of insurance, respectively – were not satisfied. Therefore, the risk purported to be insured was deemed not to be insurance.
The Court determined that risk distribution was not satisfied since the number of insureds (primarily brother-sister companies owned by a common parent) was not sufficient to satisfy the concept of risk distribution. In addition, the Court also held that risk distribution in this case was not satisfied through a so-called “pooling arrangement,” since the funds that were used to fund the premiums ended up, eventually, being loaned back to the owners of the parent company/insured (i.e., the taxpayers, through a “circular flow of funds”), and because the premiums paid for the insurance that was pooled were deemed to be unreasonable. A pooling arrangement is designed to allow an insurance company that does not have sufficient third-party premium/risk on its own to “share” risk with other insurance companies and therefore distribute its risk among sufficient third parties.
