Update 8/21/2017 -- The U.S. Tax Court has ruled in favor of the IRS and against Avrahami, see the Opinion.
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The old saying posits that:
If it walks like a duck, and quacks like a duck, it's a duck.
But what if the duck can't fly, swims very awkwardly, has a weird quack, and weighs 225 pounds?
Then it is not a duck, but somewhat obviously, a man in a duck suit.
Whether it is a duck or a man in a ducksuit is the question now facing the U.S. Tax Court in the Avrahami v. Commissioner case.
When the case is distilled past the fluff, you basically have an Arizona jewelry store owner purchasing copious amounts of terrorism insurance against the possibility of a chemical or biological attack.
So that I don't inadvertently taint the outcome of the case by commenting on the facts, I'm simply going to refer readers to the very detailed and lengthy briefs of the parties, which are linked at the bottom of this article.
However, I would be remiss if I didn't point out the importance of this case to the so-called small captive insurance sector, or at least a subset of that sector which some might refer to as tax shelter captives. The latter is a captive insurance company that facially appears to have a real insurance purpose, but in fact the insurance is little more than a sophisticated façade to disguise the real purpose of the captive owner in artificially generating a large business deduction.
In other words, the man in a duck suit.
As I have previously written here, the Treasury Department and the IRS, the Senate Committee on Finance, and the Joint Committee on Taxation have all expressed concern at the proliferation of tax shelter captives, which have been typically identified as having four common elements:
- The captive is a small insurance company that has made an election under IRC § 831(b), which allows a captive which earns less than $1.2 million in premiums to avoid taxes on its premium income.
- The captive meets one of the two IRS "safe harbors" for risk distribution by having the captive participate in a risk pool (I wrote about these here) having few or no claims.
- The captive is sold by a promoter who emphasizes the tax benefits of the captive, while only paying lip service to what should be the true insurance purpose of the captive. As I also wrote about here, the IRS is currently conducting promoter audits of captive managers who they suspect of having sold tax shelter captives. But a promoter could also be a tax professional, such as a tax attorney, CPA, or financial adviser, etc., who is involved in the sales process.
- The captive arrangement also attempts to accomplish what amounts to a tax-free wealth transfer, by passing the premiums and investment income to future generations outside of the federal estate & gift tax regime, most often by having the captive owned by a trust for the owner's children and/or through the purchase of life insurance. This has caused the Joint Committee on Taxation to examine, among other things, whether the 831(b) election should be available to a captive that is owned by a trust for the business owner's heirs.
The proliferation of tax shelter captives exploded in the mid-2000s, and quite possibly as many of half of the captives making the 831(b) election could meet these criteria. Many of the tax shelter promoters whose clients were ensnared in earlier tax shelters, such as the Enron- and KPGM-type tax shelters, and employee benefit program tax shelters (those operating under IRC § 412(i) and 419) simply migrated over to tax shelter captives when the IRS designated those other transactions to be "listed transactions" (read: presumed tax shelters) in the mid-2000s.
The focus of the Avrahami case is the risk pooling arrangement used by the promoter of the captive in order to meet one of two IRS safe harbors for risk distribution, in this case being the so-called 50% third-party insurance safe harbor. These pools ostensibly distribute risk by taking in premiums from unaffiliated businesses, holding those premiums for some time to pay claims, and then passing the premiums (less claims, if any) to the owner's respective captives by way of paying reinsurance premiums.
The salient issue is whether the premiums paid to the pool were actuarially reasonable. While the promoter in the Avrahami case was able to get an actuary to sign off on the premium levels paid, the tax court can of course look past that to see whether the actuary's calculations bore a reasonable relationship to reality. If the risk pool is invalidated, then the insureds in the pool will not have enough third-party insurance to meet risk distribution, and the entire captive arrangement will fail from a tax perspective -- for everybody in that particular pool.
The Avrahami case may be the first in a protracted and long battle before the U.S. tax court. There are, literally, thousands of audits which have been commenced against captives that the IRS believes to meet their criteria of an abusive captive arrangement, and several tax court cases are currently percolating to follow Avrahami.
On the other hand, if the tax court comes down with a series of consistent rulings in the early cases, then the matter might be effectively decided one way or the other, thus putting additional pressure on Congress to take some definitive action that may decide the fate of tax shelter captives -- since ultimately, as Congress almost always does, by enabling 831(b) captives, which undoubtedly serve a very important and very real insurance purpose for many small businesses that have trouble acquiring insurance at affordable prices, Congress was the one who created the potential for abuse.
The benefits of 831(b) captives to the national economy are indisputably real. The abuses of 831(b) captives by numerous taxpayers are indisputably real. Where and how the dividing line will be determining are the real questions facing Congress. There is also possibility that in the absence of congressional action, Treasury might ultimately be incentivized to take matters into its own hands, and doubtless few will find that solution to be wholly satisfactory either.
So what do we really know? We know that at this stage that the Avrahami case has not been decided, and in fact is unlikely to be decided before mid-2016 at the earliest (the U.S. Tax Court is notorious for taking literally years to rule on cases that most other courts would crank out a decision in a couple of weeks).
We know that upon the limited facts of the Avrahami case that a decision in that case is unlikely to affect either larger non-831(b) captives, or 831(b) captives that have not involved a low-claims risk pooling structure to attempt to meet risk distribution. Most folks in the legitimate, non-tax shelter captive sector will find whatever happens in that case to be little more than a passing curiosity.
But we also know that the Avrahami case has been at least initially briefed (the Reply Brief of the taxpayer is still forthcoming), and that the briefs in the case put many of these issues involving aggressive risk pooling issues squarely before the tax court.
And for that they are well worth reading. See below links, and enjoy!
CITE AS
Opening Brief (Avrahami) at http://goo.gl/7dbGfp (76 mb)
Answer Brief (IRS) at http://goo.gl/ULriJF (149 mb)
This article at http://onforb.es/1QNMn2N and http://goo.gl/dHC8GZ
