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An Arizona jeweler set up a “micro-captive” arrangement to insure itself against terrorist attacks. The IRS calls it a tax-avoidance maneuver.
If a U.S. Tax Court judge agrees, and delivers a far-reaching opinion, he could strengthen the agency’s hand against such small captive insurers.
“For the IRS the question is, will the decision be broad enough that they’ll be able to use it as leverage industry-wide against promoters of so-called ‘tax shelter captives,’” said Jay Adkisson, a founding partner of Riser Adkisson LLP who practices in the captive insurance area.
Micro-captives qualify under tax code Section 831(b), allows insurers with $2.2 million or less in premium income to be taxed only on their investment income. In recent years, the Internal Revenue Service has ramped up its scrutiny and audits of these structures in the belief that small businesses are using them to insure against improbable risks that they never pay claims on, and the premiums return to the business owners or heirs with little to no tax.
The Tax Court case, Avrahami v. Commissioner, embodies these concerns. Benyamin and Orna Avrahami owned a Section 831(b) captive that insured their Arizona jewelry stores against chemical and biological terrorist attacks. Attorneys previously told Bloomberg BNA that a decision in the case is anticipated this spring ( Avrahami v. Commissioner, T.C., No. 17594-13, complaint filed 7/31/13 ).
David J. Slenn, chair of the American Bar Association’s Captive Insurance Committee, said the IRS would benefit most if Tax Court Judge Mark V. Holmes takes the stance that the Avrahamis’ arrangement lacked “economic substance” because the pair chose coverages and policies with the sole purpose of getting a tax break but never having to pay out claims. Economic substance is a tax law doctrine that is applied when a taxpayer seeks to claim tax benefits that weren’t intended by Congress through transactions that serve no economic purpose other than tax savings.
Slenn said that once the court starts attacking the use of policies using an economic substance argument, “that’s where you’re going to have the problem. That is going to be the route that could have far-reaching effects in sectors of that industry.”
Adkisson said that invalidating the way the Avrahamis structured their risk pool would be the most favorable decision for the IRS. A risk pool is a device used by captives to pool risk with similar companies, usually to meet the IRS’s test that 50 percent of risk exposure is derived from insuring third parties.
Steven Miller, a former acting IRS commissioner who now works at Alliantgroup LP representing captives in agency audits, said a complete win for the agency would include a combination of both critiques.
But scoring such a win won’t be easy for the IRS, Adkisson said. Holmes “is apparently well-known for decisions that are not broad,” he said. “The judge may rule in favor of the IRS but be reticent about giving an opinion that the IRS could use against other taxpayers.”
Adkisson said that’s the million-dollar question: “What sort of opinion is this judge going to write?”
The Tax Court could rule in favor of the taxpayer by adhering to a strict reading of the changes to Section 831(b) enacted in the Protecting Americans from Tax Hikes Act of 2015, Slenn said. In the legislation, Congress made technical changes to the ownership requirements of captives in order to stem the use of those structures for estate-planning purposes.
The court could say that as long as captives meet those new requirements, they are legitimate under Section 831(b), Slenn said.
Outside of a ruling in favor of the Avrahamis, a decision that says certain coverages or transactions that they used were bad for very specific reasons—but the captive arrangement itself is legitimate—would be a victory for the industry, Miller said.
Such a ruling would also be a step forward for the IRS, but would seem to be limited to the Avrahami case or captives with very similar facts and circumstances. It wouldn’t give the IRS the leverage it seeks to go after a wide range of Section 831(b) captives, Adkisson said.
A broad decision in Avrahami would be a boon to the agency’s recent enforcement activities involving captives.
Miller pointed out that micro-captive insurance is one of the IRS Large Business and International Division’s 13 tax compliance campaigns, officially rolled out in January. The agency is providing details on these campaigns in a series of webinars that began March 7. “We’re going to find out much more about what they’re worried about and what they’re thinking about,” Miller said.
Additionally, both Notice 2016-66, which made micro-captives “transactions of interest,” and the 2017 “Dirty Dozen” tax scams listing for 831(b) captives ( IR-2017-31) offered insight into the characteristics that the IRS finds potentially abusive.
A decision in favor of the Avrahamis “would ignore all of those issues,” Slenn said.
(August 23, description of Section 831(b) clarified in fourth paragraph)
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