On August 21, 2017, the Tax Court issued its opinion in Avrahami v. Comm'r, a case of first impression relating to the taxpayers' use of a microcaptive insurance company. The Avrahami decision also addressed the proper characterization of related party loans and whether I.R.C. § 6662(a) accuracy-related penalties applied. While the court rejected the taxpayers' use of the microcaptive structure, the court respected certain related-party loans and declined to impose an accuracy-related penalty on the understatement attributable to the microcaptive issue.

Mr. and Mrs. Avrahami are entrepreneurs who operate jewelry stores and commercial real estate companies in Arizona. In 2007, given the success of their business ventures, they asked their long-time certified public accountant (CPA) for assistance with estate planning. The CPA recommended Neil Hiller, a tax and estate planning lawyer and also suggested that the Avrahamis look into starting a captive insurance company to manage the risk from their business entities. The CPA introduced the Avrahamis to Celia Clark, an attorney specializing in microcaptives. After discussions with Ms. Clark, the Avrahamis consulted with Mr. Hiller and formed Feedback Insurance Company, Ltd. (Feedback), in St. Kitts. Feedback elected to be treated as a domestic corporation under I.R.C. § 953(d) and also elected to be taxed as a small insurance company under I.R.C. § 831(b). For the years in issue, an insurer could elect to be taxed as a small insurance company under I.R.C. § 831(b) if it had less than $1.2 million of annual written premiums (currently the maximum amount is $2.2 million of annual premiums). As an I.R.C. § 831(b) company, Feedback was subject to tax only on its investment income.

Prior to the formation of Feedback, the Avrahami entities paid approximately $150,000 per year in insurance expenses. After establishing Feedback, the Avrahami entities continued to purchase commercial insurance policies, but also purchased additional policies from Feedback. For 2009 and 2010, the Avrahami entities paid $730,000 and $810,000 in premiums to Feedback. Feedback issued the following policies: administrative action indemnity, business risk indemnity, business income, employee fidelity, litigation expense, loss of key employees (Mr. and Mrs. Avrahami), and tax indemnity. During the two years in issue, there were no claims filed against Feedback under any of its direct policies.

In addition, the Avrahami entities paid $360,000 per year for terrorism insurance to Pan American Reinsurance Company, Ltd. (Pan American)—an entity partially-owned by Ms. Clark's children. Pan American was created to distribute risk among the microcaptive insurance companies that Ms. Clark formed for her clients. Feedback participated in Pan American's terrorism risk insurance program by "reinsuring" a certain percentage of Pan American's terrorism risk reinsurance pool. Not coincidentally, the premium Feedback received for its participation in the reinsurance pool—$360,000—was the same amount that the Avrahami entities paid Pan American for terrorism risk insurance.

Around the same time that the Avrahamis set up Feedback, they also formed Belly Button Center, LLC (Belly Button), which borrowed $1.2 million from Mr. Avrahami to purchase land in Arizona. In 2010, Feedback was flush with cash and Mr. Avrahami arranged for a related-party loan between Feedback and Belly Button. Feedback transferred $1.5 million to Belly Button in exchange for an unsecured promissory note signed by Mr. Avrahami on behalf of Belly Button. Two days later Belly Button transferred $1.5 million to the Avrahamis to repay the original $1.2 million loan to Mr. Avrahami.

The court began by considering whether the Feedback contracts were insurance for federal tax purposes. In general, insurance contracts must result in risk distribution and risk shifting. Risk distribution occurs when an "insurer pools a large enough collection of unrelated risks." The taxpayers argued that Feedback achieved risk distribution through its policies with three related party entities in 2009 and four related party entities in 2010. The court declined to directly address the question of how many related party insureds are sufficient to establish risk distribution. Instead, the court held that "we will simply agree that when analyzing the number of related insured companies, Feedback failed to adequately distribute risk." But the court went on to stress that it was "even more important to figure out the number of independent risk exposures" insured by the captive insurance company. The court recognized that microcaptives must operate on a smaller scale than the insurance companies in other cases in which the Tax Court has respected captive insurance relationships. But the court held that it could not "find that [Feedback] covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities."

The court next addressed the taxpayers' argument that Feedback distributed risk by participating in the terrorism reinsurance pool through Pan American. The taxpayers argued that Feedback distributed risk because it received more than 29 percent of its gross premium revenue from unrelated parties (through the Pan American contracts). The court rejected this argument and held that Feedback's relationship with Pan American did not distribute risk because Pan American was not a bona fide insurance company. In so holding, the court cited Pan American's circular cash flows, unreasonable contractual terms, and excessively high premiums. Therefore, the court held that Feedback failed to adequately distribute risk and that "[t]he absence of risk distribution by itself is enough to sink Feedback."

The court considered an alternative ground for finding against the Avrahamis and also rejected the taxpayers' structure because it did not meet commonly accepted notions of insurance. The court concluded that the contracts were not insurance in the commonly accepted sense because Feedback "was not operated like an insurance company, it issued policies with unclear and contradictory terms, and it charged wholly unreasonable premiums." The court declined to address the Internal Revenue Service's arguments relating to the economic substance, substance-over-form, and step-transaction doctrines.

The court also analyzed the related party loans between Feedback, Belly Button, and Mr. Avrahami. A loan is generally respected for tax purposes if both parties had an actual intent to establish a debtor-creditor relationship at the time the funds were advanced. The court found a few factors supporting the conclusion that the loans were legitimate: (1) Belly Button had the ability to repay the loan at the time it was made; and (2) all of the loans were "papered properly by promissory notes signed by Mr. Avrahami." The court determined that the contractual terms of the loans were a neutral factor because they included "defined interest and repayment schedules." But the court noted that the loans were unsecured and that neither the Avrahamis nor Belly Button reported interest when the $1.2 million note was allegedly repaid in 2010. Ultimately, the court held that the loans were bona fide. However, the court also found that there was a $300,000 distribution made to the Avrahamis in connection with the loan repayments and some of that amount should be treated as a taxable dividend and interest.

The case also involved the assertion of the I.R.C. § 6662(a) accuracy-related penalties for understatements relating to the microcaptive issue, the $300,000 excess payment associated with the loans, and an additional $200,000 distribution made to Mrs. Avrahami that was not reported as taxable income. In addressing the underpayments associated with the microcaptive structure, the taxpayers argued that they acted with reasonable cause and in good faith because they relied on competent advisers. The court dismissed their reliance on Ms. Clark because she was "a promoter of the microcaptive transaction." And the Avrahamis could not rely on their CPA because he did not provide advice regarding Feedback. But the court held that the taxpayers reasonably relied on Mr. Hiller in determining whether to proceed with the Feedback structure. The taxpayers' reliance was in good faith because: "[t]his is a case of first impression. . . [a]nd we have previously declined to impose accuracy-related penalties when there is no clear authority to guide taxpayers." However, the court imposed the accuracy-related penalty on the underpayments attributable to the $300,000 distribution from the loan that was not reported on the taxpayers' return, as well as the $200,000 distribution that should have been reported as a dividend. 

For more information, please contact:

Maria O'Toole Jones, mjones@milchev.com, 202-626-6057

Nicholas Metcalf*

*Former Miller & Chevalier attorney

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