Tom Jones Finds Taxpayer-Positive Interpretation of "Avrahami" Decision

News of the US Tax Court's August 21, 2017, decision on Avrahami v. Comm'r and Feedback Ins. Co., Ltd. v. Comm'r, 149 T.C. 7 (2017), has been concerning to many in the captive insurance industry. While the court's decision qualifies as a taxpayer loss, Tom Jones of McDermott Will & Emery LLP brought our attention to the decision's positive elements. Along the larger continuum of tax concerns relating to captives, this decision provides further clarity and should be beneficial to larger captives, said Mr. Jones.

In determining whether premiums paid by Avrahami-owned entities to Feedback Insurance Company (Feedback) were deductible under Internal Revenue Code (IRC) Section 162, Mr. Jones said the Tax Court's analytic methodology applied the long-standing principles previously used to identify insurance for federal income tax purposes. Of these principles (namely, risk shifting, risk distribution, common notions of insurance, and insurance risk), the opinion focused specifically on common notions of insurance and risk distribution.

Mr. Jones said that in applying the insurance and risk distribution tests, it was clear that the Avrahamis, Feedback, and the Pan American Re risk pool did not measure up to past or present standards. For example, the policies appeared to be written so that there would rarely if ever be a claim payment. In fact, a claim was never reported on a policy until the Internal Revenue Service (IRS) audit, at which point, five claims were filed. Also, the Pan American Re pool was deemed not effective to distribute risk largely due to the circularity of cash flow. In summary, the pool was fundamentally flawed, effectively killing the adequacy of Feedback's risk distribution. 

Mr. Jones pointed out the following quotation from the opinion. "The Avrahamis were apparently confused about the terms of this policy. Mr. [Benyamin] Avrahami was under the impression that Feedback was at risk only for the amount of premiums put into Pan American—$360,000 each year—and testified that it would 'be weird' to lose money and if Feedback did he would 'freak out.'"

Mr. Jones observed that generally, Judge Mark V. Holmes was fair, seemingly open-minded, and opting not to challenge the transaction on every taxpayer deficiency. In addition, the judge did not impose certain penalties because he noted that the Avrahamis apparently acted in good faith in relying on the professional advice they were given.

"The IRS chose to litigate this case because it thought it would win," Mr. Jones said. "On the taxpayer risk continuum, the facts and circumstance in this case taken together are a dark shade of gray."

Mr. Jones emphasized that "of key importance to all captives stemming from this decision is that in analyzing risk distribution the focal point was not on the number of covered entities but rather on the number of independent risks."

He said the principle, enunciated in Rent-A-Center, Inc. v. Comm'r, 142 T.C. 1 (2014), and Securitas Holdings, Inc. v. Comm'r, No. 21206–10, 2014 Tax Ct. Memo LEXIS 225 (U.S. T.C. Oct. 29, 2014), "has beneficial implications for all captives but especially benefits larger captives."

While the Tax Court stated that "since Feedback was insuring only three affiliated entities in 2009 and four in 2010 ... when analyzing the number of related insured companies, Feedback failed to adequately distribute risk." The court said, "it isn't just the number of brother-sister entities that one should look at in deciding whether an arrangement is distributing risk. It's even more important to figure out the number of independent risk exposures."

Mr. Jones remarked that the IRS has not changed its official position, set forth in a 2002 revenue ruling, that no single brother-sister entity insured should account for more than 15 percent of the captive's risk, notwithstanding that in Rent-A-Center and Securitas, the largest brother-sister contained about two-thirds of the risk.

What about small captives? Mr. Jones stated that "when done right, micro-captives will be successful and will work just as intended when Congress enacted IRC Section 831(b)."

According to Mr. Jones, some key questions remain.

• Will the Avrahamis appeal this loss?
• Two other cases were heard last year by Judge Holmes (Caylor Land & Development, Inc. v. Comm'r and Wilson et al., v. Comm'r).

Let's see how they fare. Mr. Jones said it is possible that the Tax Court might issue a "memorandum" decision (considered of lesser importance) because the issues of the Caylor and Wilson cases may have already been decided in Avrahami. Or, possibly, these cases may well be settled using the same principles as enunciated in the Avrahami decision, although, given its victory, the IRS settlement terms offered undoubtedly would be harsh on the taxpayers.