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Court Concludes Tax Elections Invalid in Avrahami and Feedback Decision

tax wooden blocks with gavel SF
August 22, 2017

By P. Bruce Wright

Eversheds Sutherland (US) LLP

On August 21, 2017, the US Tax Court decided in a lengthy decision two companion cases, Avrahami v. Commissioner and Feedback Insurance Company, Ltd., v. Commissioner, 149 T.C. No. 7, which involved various issues surrounding the formation and operation of a captive insurance company in Saint Kitts that made elections under Internal Revenue Code (IRC) sections 953(d) (i.e., to be treated as a domestic insurance company) and 831(b) (i.e., to be taxed as a small insurance company, which, for the years at issue, would not be taxable on underwriting income if premiums in general were less than $1,200,000). The cases involved issues relating to whether the premiums paid by various entities owned by the Avrahamis were deductible under IRC Section 162, whether Feedback should be treated as an insurance company for federal income tax purposes, the characterization of certain distributions from Feedback to Mrs. Avrahami, and, among other things, the imposition of certain penalties. The cases involved significant federal analysis by the Tax Court, which did the following.

  • Concluded there was inadequate risk distribution

  • Concluded that Feedback had not adhered to various regulatory requirements in its domicile

  • Questioned whether the policies written could be characterized as insurance for federal income tax purposes

  • Questioned the process utilized by the actuary in determining the pricing of the policies issued by Feedback

  • Questioned the coverages being pooled under the pooling agreement that had been entered into by Feedback, and as such, the efficacy of the pooling agreement

Although the Court did not impose certain of the penalties that the IRS sought to impose, it did seem to leave the door open for the imposition of these penalties in future similar cases.

Thus, it was concluded, among other things, that the various entities that had made payment characterized as premium to Feedback would not be entitled to a deduction with respect thereto as ordinary and necessary expenses. Feedback was held not to be an insurance company for federal income tax purposes, and its elections were apparently held to be invalid. Certain distributions characterized as dividends from Feedback were considered not to be paid by a US entity, and thus were taxed as ordinary income and not at the more favorable rate applicable to dividends paid by US corporations to individuals.

For related stories, see also "The Basics of the 831(b) Election for Captives" and "IRA Tax Ruling Favors Captive Insurance"

Mr. Wright is a partner in the New York office of Eversheds Sutherland (US) LLP.

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