A couple who owned three shopping centers and three jewelry stores in Phoenix, AZ lost big in the U.S. Tax Court in August 2017. In a long-awaited decision, Avranhami v. Commissioner, the Court found that amounts paid by the couple’s passthrough entities to an off-shore captive insurance company in St. Kitts owned by the wife were not deductible insurance premiums. Also disallowed were deductions for payments made to an offshore insurer who facilitated a risk-distribution program.
The Avrahamis attempted to deduct $2.4 million in insurance expenses for their businesses to protect their stores against chemical and biological terrorist attacks. No claims were ever filed against the insurance company, and the surplus accumulated in the companies were later transferred to the wife and to an entity owned by the couple’s children. The couple did not report most of the income.
Risk Distribution is Key
In ruling against the taxpayers, the Court held that the arrangements did not constitute insurance because there was no real risk distribution, with only 3-4 entities insured by the companies and a low level of risk exposures. Risk exposures include such things as individual people, properties, stores, automobiles, etc. The Court also believed the premiums were unreasonably high because the couple spent $1 million more on insurance a year once the captive insurance company was created than they had spent in previous years.
The taxpayers attempted to make elections that allowed their insurance company to be considered a qualified small insurance company and a domestic corporation, which would have resulted in favorable tax treatment. Because these elections were not effective, the Court held that the funds transferred to the wife were not dividend income, but instead were ordinary income and should be taxed at higher rates. The money received by the children was deemed to be a taxable distribution. On top of all of this, the couple had to pay penalties on a portion of the deficiency.
Captive Insurance Company Rules
A captive insurance company is one owned and controlled by its insureds. These companies insure the risks of their owners, and the insureds share in the captive insurer’s profits. In recent years, these arrangements have been used to obtain tax deductions and then to transfer untaxed amounts back to the owners through small, microcaptive insurance company distributions. These microcaptives are attractive because they can make an election to allow up to $1.2 million in net written premiums to be nontaxable. However, the IRS believes these structures have been abused by taxpayers, so it has subjected them to stricter scrutiny and more audits to identify captives that insure against improbable risks, that never pay claims, and that return the premiums to the owners or family members tax free.
What Constitutes Insurance?
In the Avranhami case, the Tax Court found that a true insurance arrangement must involve the following elements:
- risk shifting
- risk distribution
- insurance risk
- meet “commonly accepted notions of insurance.”