HOUSTON, Aug. 23, 2017 /PRNewswire/ -- The U.S. Tax Court has issued its long awaited decision in Avrahami v. Commissioner, and while many had hoped for a wide-ranging opinion providing a clear path forward on micro captives, alliantNational (alliantgroup's Washington, D.C. based office) sees the ruling as falling short in this regard. The facts in Avrahami led the court to issue a very fact intensive ruling, meaning taxpayers should be cautious when trying to extract general rules or holdings from the case.
As part of its broader ruling on the Avrahami's micro-captive, the court held that the risk distribution requirements for insuring either related or unrelated entities were not met and that the arrangement was found to not constitute insurance. However, when it comes to the decision over risk distribution, there are two key takeaways for taxpayers. First, the court did not offer its opinion on the number of related entities that would constitute proper risk distribution for a micro-captive (just that the three to four related entities in this instance were not enough). Second, the court indicated that it was interested in the overall number of independent risk exposure units involved, but refused to opine on the number of risks that would be sufficient to cover. Finally, while the court held that the risk distribution requirement was not met through the particular risk pool in the case, the court did not prohibit or even speak negatively about the use of risk pools more generally. Instead, the ruling focused on the totality of the facts such as unreasonable premiums, unlikelihood of claims and thin capitalization. As a result of this methodology, alliantNational recommends that taxpayers review how their risk distribution arrangements compare to Avrahami.
When deciding that the micro-captive arrangement did not constitute insurance, the court analyzed a variety of factors including if the company was organized, operated, and regulated as an insurance company; whether it was adequately capitalized; whether policies were valid and binding; whether premiums were reasonable and at arm's length; and whether claims were paid. However, it should be noted that not one variable caused the court to rule against the Avrahamis. Rather, these factors were judged in their totality—and together, the arrangement didn't add up to commonly accepted principles of insurance. This once again points to the fact specific nature of the case and that Avrahamiwill not necessarily serve as the end-all standard for future micro-captive insurance cases. The court also left for another day how it will view risk shifting or insurable risk. These issues remain untouched.
The final decision however was not all bad for the taxpayers. The court abated most section 6662(a) penalties, determining that the taxpayer relied on professional advice and acted in good faith given the dearth of IRS guidance in the area.
While this decision was not favorable to the Avrahamis, there is a long way to go before the controversy around micro-captives is settled. As discussed before, the case is very fact specific, it does not cover all issues and there is a very high probability it will be appealed. While we now know that the Tax Court has a very unfavorable view of certain facts, the Avrahami decision is seemingly isolated to those unfavorable facts. We do however think that based on the facts the court focused on, it will be vital for all captives to undergo a thorough review of their program, and to implement immediate changes. We will keep you posted as things develop and feel free to contact us should you need further guidance on the impact of the court's decision.
A division of alliantgroup, alliantNational provides subject matter expertise on complex and emerging federal, state and international tax issues as well as legislative and regulatory affairs to help taxpayers receive timely and precise guidance on all their tax matters. For more information, please follow alliantgroup on LinkedIn, Facebook and Twitter.