A Checklist for 831(b) Captives in Light of the Avrahami Tax Case

By now, most of you are familiar with the Avrahami v. Commissioner tax case involving an 831(b) microcaptive in an offshore domicile. In 2015, Congress updated Internal Revenue Service (IRS) Code Section 831(b) allowing small property and casualty insurance companies to be taxed solely on net investment income when gross annual premiums are less than $1.2 million. Interest skyrocketed, but so did the IRS's level of scrutiny, so much so that the IRS added captive insurance to its annual "dirty dozen" list of tax scams for the 2015 filing season. To help you mitigate the chance of drawing the interest of the IRS, we have prepared the following Avrahami checklist for 831(b) captives.

The genesis of this story was an article by Sean King, JD, CPA, MAcc, principal for CIC Services, LLC, called " The Empire Strikes Back (Part 2)." In finding for the IRS, the Tax Court considered whether the Avrahami captive was operated like an insurance company and determined it was not. While there is no one clear definition of the key facets of an insurance company, the following checklist provides a useful starting point. It will not guarantee that your 831(b) captive insurer will pass muster with the IRS, but it certainly addresses some of the major problems the Tax Court found with the Avrahami captive.

Capitalization

Every captive domicile has minimum capitalization regulations. There is, however, a significant difference between meeting minimum capital requirements and being adequately capitalized, especially when the minimum capital requirements take the form of lines of credit. 831(b) captives should use an independent actuary to analyze their lines of business and develop a minimum and target level for necessary capital. Going further, the captive may even want to run a risk-based capital analysis.

Risk Distribution

Every captive insurance company must demonstrate, among other things, that it has sufficient "risk distribution" to qualify as an insurance company for tax purposes. This determination is critical since the ability of the policyholder to deduct premiums paid to a captive is dependent on a finding that the captive qualifies as an insurance company. The article " A Cautionary Tale about Captive Risk Distribution" describes risk distribution in the following manner.

Risk distribution, also known as risk sharing, is a fundamental feature of insurance. I think that the best definition of risk distribution is this: The (actuarially credible) premiums of the many pay the (expected) losses of the few. This is the essence of insurance.

Pricing

Insurance pricing or rate making is the art/science behind determining how to develop the correct premium/price to charge for the insurance being offered. Insurance differs from most businesses in that the price set for the product being delivered cannot be known in advance. For insurance companies, it will take months or even years to know for sure whether the price of the coverage sold was adequate to cover the costs associated with the product. In the Avrahami case, the court determined that "actuarial pricing of the policies issued by the captive was utterly unreasonable." To better understand pricing, read the following article: "Getting Captive Insurance Pricing Right."

Claims Handling

One of the main reasons for establishing a captive in the first place is to have more control over the handling and payment of claims arising from losses to the policyholders. In the Avrahami case, the Tax Court found that the captive lacked even rudimentary claims handling policies and practices, noting that claims payments only started once the captive was under audit by the IRS. All captives should have written claims handling and payment policies and procedures in place. An excellent starting point to develop these necessary documents is " Claims Handling in Captives" by Lynn C. Sheils, general counsel, EWI Re, Inc.

Investments

Captive insurers collect premiums in order to pay claims as they arise over time. In the interim, these premiums need to be invested in order to generate additional income. Therefore, the main asset of a captive insurer is likely to be its investment portfolio. The Avrahami case is an excellent illustration of potential self-dealing with regard to the handling of the investment portfolio. The Tax Court found that "the insurance company had invested nearly two-thirds of its assets in long-term, illiquid and partially unsecured loans to related parties and failed to obtain advance approval from its regulators for such loans." Similar to the need for claims handling practices and procedures, all 831(b) captives should develop at least a de minimis investment policy. We discuss investment policies in detail in the following article: " Captive Insurance Assets and Investment Policies."

By following the recommendations contained in the checklist above, 831(b) captives are better prepared to withstand the scrutiny of the IRS and find themselves subject to having to appear before the Tax Court.