A few days ago, the United States Tax Court handed down its long-awaited decision in Avrahami v. Commissioner, 149 T.C. No. 7 (August 21, 2017). The 105-page opinion is not the slam-dunk for the IRS that most commentators anticipated, nor does the Tax Court give the taxpayer anything such as a free pass. Rather, Avrahami reflects a considerable evaluation of the facts and a reasonable application of the law to those facts. While the taxpayer lost on the merits, expect many in the captive insurance industry to take comfort in some of the points made by the Tax Court in its ruling.
The Facts
The Avrahamis owned several shopping centers and a jewelry store. While their typical expense on insurance ran $150,000 per year, this expense ramped up to $1.1 million in 2009, when they established their own captive insurance company. At no time prior to any tax audit did their captive ever entertain or honor an insurance claim. The result was $3.8 million in accumulated earnings, of which $1.7 million had been “loaned” by the captive to a business venture owned by the Avrahami family. Additionally, while the captive spent $720,000 reinsuring terrorism risk underwritten by the captive, the full $720,000 was returned to the captive almost immediately. Meanwhile, the Avrahamis continued to maintain their traditional insurance coverage with third-party insurers.
The captive came about after the Avrahamis had met with their tax advisor, who had put them in touch with Celia Clark. Ms. Clark is a lawyer out of New York who, despite limited experience in insurance, had managed to boost her marketing appeal by drafting captive insurance legislation for the government of St. Kitts. In addition to directing the work on the Avrahami captive project, Clark’s family participated in the reinsurance carrier in which the captive participated. That reinsurance carrier was licensed in Nevis and, per its business plan, maintained no loss reserves… Any claim brought against the reinsurance carrier would necessarily require the reinsurance carrier to enlist contributions from its participating captives.
The Law
The general rule of thumb is that amounts paid for insurance are deductible under IRC § 162(a) as ordinary and necessary expenses paid or incurred in connection with a trade or business. See Treas. Regs. § 1.162-1(a). By contrast, amounts set aside in a loss reserve as a form of self-insurance are not. See Harper Grp. v. Commissioner, 96 T.C. 45, 46 (1991), aff’d, 979 F.2d 1341 (9th Cir. 1992). However, neither the Code nor the regulations define “insurance.” Securitas Holdings, Inc. v. Commissioner, T.C. Memo. 2014-225, at 18. Rather, the Supreme Court has stated that insurance is a transaction that involves “an actual ‘insurance risk’” and that “[h]istorically and commonly insurance involves risk-shifting and risk-distributing.” Helvering v. Le Gierse, 312 U.S. 531, 539 (1941).
Incorporating the Tax Court’s latest analysis of “insurance” under RVI Guaranty, the Tax Court outlined an expanded set of requirements for “insurance” under the LeGierse approach. Such coverage must reflect:
- Risk-shifting
- Risk-distribution;
- Insurance risk; and
- Commonly accepted notions of insurance.
Avrahami, at 49, citing: Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1, 13 (2014); R.V.I. Guar. Co. v. Commissioner, 145 T.C. 209, 225 (2015); Harper Grp., 96 T.C. at 58; AMERCO & Subs. v. Commissioner, 96 T.C. 18, 38 (1991), aff’d, 979 F.2d 162 (9th Cir. 1992); Securitas, at 18. The Tax Court further confirmed its holdings in Rent-A-Center and Securitas which analyze the number of independent risks, as opposed to the arbitrary number of participants in a risk pool, in evaluating risk distribution. Avrahami at 65.
Tax Court Analysis
As applied to the captive itself, the Tax Court found inadequate risk distribution where only seven risk policies were issued at any one time. Id. Although the Avrahamis argued that their captive’s participation in a reinsurance pool should permit the pool’s participating risks to be included in this analysis, the Tax Court found the reinsurance company not to be a bona fide insurance carrier. Among the objections were an atypical fee structure, a circular flow of funds between the carrier and its participants, an “ultralow” probability of claims ever being paid, and excessive premiums. Id. at 75. Accordingly, the captive’s participation in the reinsurance pool did not achieve any greater risk distribution for the captive. Id.
Technically, the Tax Court’s opinion should have stopped here. However, the Tax Court went on – arguably in dicta – to analyze whether the insurance issued by the captive constituted “insurance in the commonly accepted sense.” Id. Looking first to the organization, operation, and regulation of the captive, the Tax Court criticized the manner in which the captive had been operated. It dealt with claims on an ad hoc basis, and it invested only in loans to Avrahami personal ventures. Claims were processed well beyond any deadlines in the policies, and certain claims that were of questionable validity were honored by the carrier. Limits on related-party loans were ignored, and the captive manager did not notify the regulator when those limits were exceeded. Id. at 80.
On capitalization, the Tax Court helpfully concluded that adequate capitalization under St. Kitts law was satisfactory for its analysis. Id. By comparison, the policy contract terms were ambiguous, and premium calculations unreasonably reflected a targeted premium budget rather than actual costs of coverage. Id. at 85. While the captive paid its claims, overall the Tax Court faulted the captive for (i) not operating as an insurance company, (ii) issuing policies with ambiguous terms, and (iii) charging unreasonable premiums. Id. Thus, the policies offered by the captive did not constitute “insurance” in the commonly accepted sense. Id.
The consequences of the Tax Court’s findings were devastating for the taxpayer and the captive:
- No Deduction Under § 162: The Tax Court found that the premiums paid to the captive were not deductible by the Avrahamis’ businesses.
- No § 953(d) Election: The captive was ineligible to qualify for an IRC § 953(d) election to be taxed as a domestic insurance company.
- No § 831(b) Election: Because the captive was not a domestic insurance company, the captive was ineligible for the § 831(b) exemption on small insurance company earnings.
Id. at 87.
Our Analysis
The Tax Court decision in many ways is helpful to the insurance industry. By reaffirming the analysis outlined in RVI Guaranty, the Tax Court decision offers comfort to those developing innovative insurance products. We expect to see more creativity and increasing sophistication in the breadth and scope of products insuring against financial risks.
The Tax Court also lends a helpful hand for taxpayers engaged in captive insurance. The decision continues to uphold the “number of risks” analysis for risk distribution, rather than the artificial “number of participants” analysis which the IRS has exclusively advocated in its Revenue Rulings.
The chief problem with the Tax Court decision is its analysis of “insurance in the commonly accepted sense.” This analysis was unnecessary – the Tax Court had already concluded that there was inadequate risk distribution – and should be considered dicta. Yet, construing the second part of the opinion as dicta vaults the risk distribution analysis to a position of prominence that is undeserved. RVI Guaranty (for which Judge Lauber and his staff utilized our research and commentary in formulating the Tax Court’s ruling) focused on the bona fide nature of the insurance company and its business, consistent with Judge Easterbrook’s simplified sham analysis in Sears, Roebuck & Co. v. Commissioner, 972 F.2D 858 (7th Cir. 1992).
It is the second part of the Tax Court ruling in Avrahami – sham analysis – which should be taking precedence here. Unfortunately, the Tax Court’s opinion is written in a way that will continue to lead taxpayers and their counsel down the blind alley of counting risks for an arbitrary risk distribution test which will always favor large captives over their smaller brethren. This is not good tax policy, and we deserve better from the Tax Court.
Are We at Judge Easterbrook’s Sears Analysis Yet?
We have consistently argued that the insurance analysis first set forth in LeGierse is hopelessly flawed, creating problems for the IRS as much as for taxpayers and their advisors. R.V.I. Guaranty Co., Ltd. follows many similar rulings that define “insurance,” whether for tax law purposes, securities regulation, or in antitrust enforcement matters, utilizing the two key elements of Le Gierse: Risk shifting and risk distribution. However, Le Gierse was a 1941 opinion, and the world of insurance has changed radically from the days when Le Gierse was first decided.
We find the more modern opinion of Sears, Roebuck & Co. v. Commissioner, 972 F.2D 858 (7th Cir. 1992), to offer a better analysis of where modern insurance tax law should be. Authored by Judge Easterbrook, the Seventh Circuit opinion says the following about Le Gierse:
What is “insurance” for tax purposes? The Code lacks a definition. Le Gierse mentions the combination of risk shifting and risk distribution, but it is a blunder to treat a phrase in an opinion as if it were statutory language. Zenith Radio Corp. v. United States, 437 U.S. 443, 460-62, 98 S.Ct. 2441, 2450-51, 57 L.Ed.2d 337 (1978). Cf. United States v. Consumer Life Insurance Co., 430 U.S. 725, 740-41, 97 S.Ct. 1440, 1448-49, 52 L.Ed.2d 4 (1977). The Court was not writing a definition for all seasons and had no reason to, as the holding of Le Gierse is only that paying the “underwriter” more than it promises to return in the event of a casualty is not insurance by any standard.
Picking apart the two-factor test of Le Gierse, Judge Easterbrook transposed the concept of “insurance” for tax purposes to the more pragmatic discussion of substance-versus-form, bringing us back to the relevancy of sham doctrine case law such as in Moline Properties:
Power to recharacterize transactions that lack economic substance is no warrant to disregard both form and substance in the bulk of cases. The Tax Court has given up the effort to find a formula, instead listing criteria such as insurance risk, risk shifting, risk distribution, and presence of forms commonly accepted as insurance in the trade. 96 T.C. at 99-101 (this case); Harper, 96 T.C. at 57-58 (opinion by Judge Jacobs describing this as a “facts and circumstances” test); AMERCO, 96 T.C. at 38 (opinion by Judge Korner rejecting any unified “test” and remarking that the considerations “are not independent or exclusive. Instead, we read them as informing each other and, to the extent not fully consistent, confining each other’s potential excesses.”). * * * No set of criteria is a “test.” Lists without metes, bounds, weights, or means of resolving conflicts do not identify necessary or sufficient conditions; they never prescribe concrete results. Perhaps a list is all we can expect when the statute is silent and both sides of a dispute have solid points. * * * Suppose we ask not “What is insurance?” but “Is there adequate reason to recharacterize this transaction?”, given the norm that tax law respects both the form of the transaction and the form of the corporate structure. It follows from putting the matter this way that the decision of the Tax Court must be affirmed.
Id. at 863-864 (emphasis added).
Had the Tax Court instead used Judge Easterbrook’s formulation, the risk distribution analysis would be tossed out the window and we would be – most practically – looking simply at the merits of the transactions conducted by the Avrahamis. The Tax Court simply disbelieved the transactions due to the unrealistic premium pricing, the lack of formalities or compliance by the captive, and the ambiguous terms of the captive’s policies.
Toward a Better Tax Law Doctrine
What is most interesting about Sears, Roebuck is that, by turning the question from, “Is this ‘insurance?,” to “Should the IRS be able to recharacterize this transaction?,” we can say that risk shifting and risk distribution are hallmarks of economically substantive activity. Accordingly, as long as that activity occurs irrespective of tax effects, that activity should not be recharacterized for tax law purposes. Judge Easterbrook pinpoints the Service’s problem when he declares:
Perhaps disputes of this kind do little more than illustrate the conundrums inherent in an effort to collect a tax from corporations, as opposed to a tax measured by the changes in wealth of corporate investors (or measured by their withdrawals for consumption, so as to encourage investment). The experts who labored during this trial to define “insurance” all would have agreed that this dispute is an artifact of the corporate income tax, which by divorcing taxation from real persons’ wealth, income, or consumption is bound to combine tricky definitional problems with odd incentives.
Id.
We are therefore left with the general principle that most anything can constitute “insurance” for purposes of deductibility and that sham analysis is perhaps the only limit to the establishment of a captive insurance arrangement. The Avrahami opinion wanders a bit off course and invites an appeal. We again believe that the courts, taxpayers, and practitioners would be better off by eliminating the artificial test of LeGierse and moving forward instead with Judge Easterbrook’s sham-based Sears analysis.