IRS Focuses Its Audit Priorities on Captive Insurance
The terms "captive insurance" and "federal income tax code" are anything but captivating. Yet, captive insurance has captivated the attention of the Internal Revenue Service ("IRS"), which has placed captive insurance on its list of the "Dirty Dozen Tax Scams"—an annual list of the most abusive positions taken by taxpayers.1 The IRS’s aggressive stance on captive insurance has become more focused after the IRS’s victory in Avrahami v. Commissioner, 149 T.C. No. 7 (Aug. 21, 2017).
What is "Captive Insurance"?
Savvy tax promoters will recommend that their clients create a captive or microcaptive insurance company that sells the taxpayer insurance for its business. Thus, the taxpayer (or a related party) owns his insurer. Once the newly established insurance company is created, it obtains the opinion of an underwriter who helps prepare new policies, which the taxpayer then uses to supplement or replace his pre-existing insurance. The taxpayer (or a related party), however, owns the insurance company and is therefore selling himself insurance.
The shelter aspect of the transaction lies in the fact that Section 831(b) of the Internal Revenue Code permits insurance companies to make certain elections and exclude up to $1.2 million in net premiums from their income. Thus, the taxpayer gets the benefit of a deduction for insurance premiums, and the captive insurance company does not pay income tax on the first $1.2 million in premiums. The captive insurer may invest the money, and in some cases return the money to the taxpayer in the form of loans or dividends. Instantly, through the creation of a wholly owned insurance company, the taxpayer has obtained a $1.2 million tax deduction.
Year after year, the tax benefits add up quickly. Not surprisingly, shelter promoters use captive insurance companies as part of an overall structure that can provide additional tax benefits. For example, the captive insurer could be owned by the taxpayer’s Roth IRA, thereby ensuring that the investment profits of the captive insurer are never subject to federal income tax. Other captive insurance companies may be owned by the taxpayer’s children, thereby avoiding potential gift and estate tax liabilities.
What Has the IRS Done?
- Recent Policy Announcements
The IRS has listed captive insurance as one of its “Dirty Dozen” abusive transactions for the last three years. This list identifies some of the IRS’s top audit priorities. In 2016, the IRS also listed microcaptive insurance companies as transactions of interest, meaning that taxpayers involved in these transactions must disclose these transactions when they file their tax returns.2
In August 2017, the Tax Court handed down a 105-page decision in Avrahami, disallowing the deductions from a captive insurance program. The Avrahamis were Arizona-based jewelers who entered into a captive insurance shelter. The court noted that, as a result of the Avrahamis’ participation in this program, their annual insurance bills (and deductions) soared from $150,000 per year to $1,100,000. Some of the additional line items were even more suspect—such as the increase from $1,500 to $360,000 for terrorism risk insurance premiums paid by the taxpayers.
In disallowing the deductions, the court also noted, among other things, that the Avrahamis’ company did not have a sufficient "number of risk exposures to achieve risk distribution," because the only entities that the Avrahamis insured were their companies. The court was also critical of a reinsurance program that the Avrahamis used to meet their risk distribution requirements. Risk distribution is a prerequisite for a transaction to be deemed as insurance. The court determined that the reinsurance company was not a bona fide insurer, because the funds paid by the Avrahamis (and the promoters’ other clients) were simply funneled back to the clients each year. For example, during their two years under audit, the Avrahamis paid $720,000, which was ultimately returned to other entities under their control.
The Avrahamis returned all of the money from the captive insurance company to a U.S.-based partnership called Belly Button Center, LLC, which owned real estate in Arizona. The funds were returned in the form of loans, which were never paid back.
Critically, although the IRS disallowed the premium deductions and treated the loans as income, it only assessed an accuracy-related penalty (i.e., a negligence penalty) on the decision to disregard the loans. The Tax Court did not impose the fraud penalty. Furthermore, the far more substantial deduction for the premiums paid to the captive insurance company were not subject to any penalty. The court found that the Avrahamis relied in good faith on their tax advisers—who created this structure—and should not be required to pay a negligence penalty.
What Does Avrahami Mean?
The Avrahami decision will provide a guidepost for future audits. Taxpayers who use captive insurance may be subject to audit and substantial adjustments. While the Avrahamis avoided most of the accuracy-related penalties, other taxpayers may not be as fortunate. Taxpayers who have used captive insurance should seek an independent review of their specific structure to evaluate their options in light of the IRS’s recent victory.