IRS Obtains Favorable Ruling in Captive Insurance Case

Taxpayers with established captive insurance companies, or those considering such arrangements, should take notice of a recent Tax Court decision denying a captive insurance company’s election to be treated as a small insurance company under Section 831(b) of the Internal Revenue Code (the “Code”). The decision in Avrahami v. Commissioner may pave the way for the Internal Revenue Service (the “IRS”) to escalate its attacks on captive insurance arrangements.

By way of background, a captive insurance company is an insurance company formed to insure the risks of a group of related operating entities. Once established, the captive insurance company functions just like any other commercial insurer by issuing policies, collecting premiums, and paying claims. Like other insurance companies, a captive is licensed as an insurance company in the domicile where it is formed. A key difference is that, unlike other insurance companies, a captive offers insurance only to companies within the family group and not to the public.

Business owners have compelling tax and non-tax reasons to consider captive insurance arrangements. First, under Code Section 831(b), captives meeting certain requirements can elect to be taxed only on their investment income and not on their underwriting profits. In addition, premiums paid by the insured operating companies to a captive may be deductible as insurance expenses. A captive can also be used to stabilize insurance budgets, reduce insurance administrative costs, and even serve as an estate planning vehicle.

Captives have historically been of interest to the IRS and have been viewed as a sham to create tax-deductible reserves in the captive when none could be created in the operating company. In late 2016, the IRS issued Notice 2016-66, which designates certain captive insurance companies that have made the Section 831(b) election as “Transactions of Interest,” thus triggering extensive disclosure requirements for owners of captives that fall within the purview of the Notice.  

On August 21, 2017, the IRS landed a victory in the Tax Court. In the Avrahami case, the taxpayers owned several shopping centers and jewelry stores, and established a captive to insure these businesses. The captive filed an election to be taxed as a small insurance company under Code Section 831(b). Premiums were paid to the captive, and the operating entities claimed deductions for insurance expenses. However, during the years in question, no claims were filed on the policies issued by the captive, and the operating entities continued to purchase insurance from third-party carriers, making no changes in coverage.

The IRS challenged the deductions for the premiums paid to the captive, and the Tax Court ruled against the taxpayers. First, because the captive insured only a handful of related businesses, there was insufficient risk distribution to establish true insurance. In addition, the premiums charged were determined to be commercially unreasonable, and the captive made certain business decisions that were deemed imprudent, such as making unsecured loans to related parties. Finally, the fact that no claims were filed and that the taxpayers continued to purchase insurance from third-party providers was further evidence that the arrangement did not constitute true insurance in the commonly accepted sense. The Section 831(b) election was ruled invalid, and deductions for premiums were denied.   

Make no mistake, the Avrahami case is not good news for captive insurance companies. However, the opinion doesn’t really tell us anything we didn’t already know. When scrutinizing a captive arrangement, what the IRS wants to see is a real insurance company acting like a real insurance company. What the IRS does not want to see is a thinly capitalized corporate shell masquerading as an insurance company so that a tax deduction is artificially created without any real risks actually being underwritten. The Avrahami case does not in any way hold that all captive arrangements are rendered invalid. It merely reinforces the IRS’s position that it will aggressively challenge shams.

For more information, contact Schneider Downs or visit the Our Thoughts On blog.

You’ve heard our thoughts… We’d like to hear yours

The Schneider Downs Our Thoughts On blog exists to create a dialogue on issues that are important to organizations and individuals. While we enjoy sharing our ideas and insights, we’re especially interested in what you may have to say. If you have a question or a comment about this article – or any article from the Our Thoughts On blog – we hope you’ll share it with us. After all, a dialogue is an exchange of ideas, and we’d like to hear from you. Email us at [email protected].

Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

© 2021 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

our thoughts on
Tax Reform 2021 - Build Back Better: Excess Business Losses Further Limited than Under 2017 Tax Cut and Jobs Act
Tax, Tax Reform BY Kirk Mitchell
Tax Reform 2021 – Build Back Better: Proposed Changes to Increase Net Investment (NII) Income Tax on S Corporation Shareholders and Limited Partners
Tax, Tax Reform BY Kirk Mitchell
Tax Reform 2021 – Build Back Better: Temporary Rule for S-Corporation Conversions to Partnerships
Tax, Tax Reform BY Kirk Mitchell
Tax Reform 2021 – Build Back Better: Surcharge on High Income Taxpayers and its Impact on Capital Gain Rate Taxes and Planning
Proposed Legislation Targets Estate and Gift Tax Planning
Tax, Tax Reform BY Kirk Mitchell
Tax Reform 2021: Build Back Better Act Update as of Wednesday September 15, 2021
Register to receive our weekly newsletter with our most recent columns and insights.
Have a question? Ask us!

We’d love to hear from you. Drop us a note, and we’ll respond to you as quickly as possible.

Ask us
contact us

This site uses cookies to ensure that we give you the best user experience. Cookies assist in navigation, analyzing traffic and in our marketing efforts as described in our Privacy Policy.