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Avrahami Showcases Unusually Unfit Captive Planning

Capstone 480x377
September 08, 2017

The US Tax Court ruled on August 21, 2017, against captive owners and jewelers Benyamin and Orna Avrahami in its long-anticipated case, Avrahami v. Commissioner (149 T.C. No. 7).

A Primer on Poor Design and Weak Implementation

Capstone Associated Services reports, "The Tax Court's opinion is a primer on poorly designed and weakly implemented alternative risk structures. If there were a captive [planning and management] team in place for the Avrahamis, it appears not to have evaluated or operated the planning to any meaningful degree. The so-called 'captive program' described by the U.S. Tax Court was divorced from the fact situation presented, with the Court finding that the captive was devoid of adequate risk distribution and was improperly formed and managed. These are basic tenets of alternative risk planning."

The Arizona-based Avrahamis enlisted the help of a certified public accountant (CPA), Craig McEntee, and an actuary, Allen Rosenbach, apparently both solo practitioners, among others, to form a captive insurer, Feedback Insurance in St. Kitts, a small, independent nation in the Caribbean.

Feedback attempted to satisfy the risk distribution requirement through a risk pool operated by Pan American Insurance. However, the "risk pool" only included terrorism risks, while the other risks insured by Feedback were not pooled. The Court held that the Avrahami's captive did not satisfy the risk distribution required of insurers. The Court further held that the operations of the Avrahami's captive were not within the "commonly accepted notions of insurance." Essentially, the court ruled that Feedback and Pan American both failed to operate as bona fide insurance companies.

Steven Lonergan, Chartered Property Casualty Underwriter (CPCU), who manages Capstone's Midwest and Great Plains region from Capstone's Minneapolis office, commented: "While there are captives formed by unsophisticated managers that have some issues, this case is unusual in that the structure failed in almost every possible area. The Avrahamis and their advisors got almost everything wrong."

Questionable Choices

"The opinion highlights multiple questionable choices by the Avrahamis in operating their captive insurer," said Coby M. Hyman, a tax attorney who focuses on captive operational issues in support of Capstone. As reported by Mr. Hyman:

  • "The Court noted that the insureds took out loans of approximately 65% of the captive's assets that were insufficiently secured or were unsecured, with funds passing through shell entities back to the captive's owners.

  • "Additionally, records produced reflected that the client's lawyer, Celia Clark, directed the actuary (Rosenbach) to arrive at a dollar-specific premium that fit the client's targets. The semi-retired actuary couldn't articulate for the Court how the premiums charged by the captive were calculated and thus failed to follow generally accepted actuarial standards.

  • "The opinion commented that the possibility of a covered loss being triggered under the carefully designed terrorism risk pool was so low that the Avrahami's actuary admitted that he did not know of any event in history that would have triggered coverage.

  • "Additionally, the St. Kitts domicile is a small domicile having little regulatory history or experience, unlike more common domestic or UK-controlled domiciles. Despite such, the captive operated at odds with the St. Kitts regulatory requirements in that the required pre-approval for loans was never obtained."

Improper Servicing and Unqualified Captive Management

"Recent scrutiny of captive insurance companies by the Internal Revenue Service is derived in large part from the practices of so-called 'captive managers' providing only clerical and administrative skills. As an example, one Delaware trust company touts 'conference room, messenger services and a mail drop,' as key components of its captive services," commented Stewart A. Feldman, CEO and general counsel for Capstone. "This is hardly a comprehensive offering reflecting the wide variety of 'captive management' services which are needed to successfully carry out captive/alternative risk planning. The clerical and administrative offerings by many sponsors are often insufficient to carry out valid and proper captive planning."

David Osbourn, CPCU, Capstone's Pittsburgh-based director of Northeast and Mid-Atlantic operations for Capstone, noted: "I've met with 'captive managers' who have limited insurance knowledge and no legal or tax expertise. They were run by administrative types whose planning is destined to fail. Hiring a captive manager that lacks the professional insurance, tax, and legal experience is the equivalent of hiring an 'accounting firm' with no CPAs on staff."

According to Capstone's Lance McNeel, CPCU, Associate in Risk Management (ARM): "We've seen one-man, captive insurance shops purport to be captive managers, while disclaiming in their contracts all legal, tax, and insurance responsibilities. As demonstrated by Avrahami, captives that are poorly designed and half-heartedly managed are destined to fail. A captive insurer is a risk bearing entity and must be designed and operated as such. In Avrahami, it was not difficult for the IRS to recognize that no matter how you dress it up, the captive was not a bona fide insurer."

Capstone: Highly Qualified with Deep Experience and Comprehensive Expertise

"Our team of captive professionals includes five, full-time, on staff Chartered Property & Casualty Underwriters having more than a century of combined experience, along with licensed claims adjusters, Associates in Risk Management, CICs, CPAs, risk managers, P&C actuaries, independent auditors, and a dozen lawyers with expertise in tax, corporate, financing, regulatory, and related litigation specialties, along with other insurance professionals. This is far afield from having a one-person 'captive manager' shop or an administrative services company supplemented by a retired actuary," continued Mr. Feldman. "The Avrahami's type of conduct gives the industry a black-eye."

Capstone has long supported substantive industry licensing of captive managers and is a founding member of the Institute for Captive Insurance Planning.

"Captive insurance planning is sophisticated business planning that has many moving parts," said Steve Cohen, senior tax attorney with The Feldman Law Firm LLP. "The planning should be addressed using a multi-disciplinary approach, leveraging the expertise of insurance experts with professional designations like CPCUs and ARMs. It should also be overseen by qualified professionals, including insurance regulatory, corporate, financing, and tax attorneys who are experienced in the legal aspects of the planning. Underwriters, claims administrators, independent auditors, CPAs, and experienced regulatory professionals are also critical in the design and on-going administration of the captive."

Captives Are Complex Risk Management Vehicles, Not Tax Deduction Devices

"A captive insurance company is, before all else, an insurance company. It is, or rather, should be a regulated financial institution. When a company ceases to be operated as an insurance company, it will not withstand challenge," said Logan R. Gremillion, also a senior tax attorney with The Feldman Law Firm.

Mr. Gremillion continues: "As a complex risk management vehicle, care should be taken at all phases of planning and implementation to ensure that the captive is formed and operated in a manner that is consistent with laws, regulations, and industry best practices. In Avrahami the IRS found the low-hanging fruit that embodies its concern with captives being used for tax-motivated planning rather than as a legitimate risk management tool."

According to Capstone's John Williamson, CPA (inactive), director of business development (south), "If there is one thing to learn from the Avrahami decision, it is that a captive should be operated as an insurance company and not simply as a device to generate tax deductions."

Simply Calling a Captive an Insurance Company "Is Hardly Sufficient"

"Mid-market businesses with genuine risks are certainly able to benefit from captive planning. However, an on-site feasibility study is a critical up-front step in identifying if these risks exist and documenting the same," reports Capstone's David Overbeck, CPCU, ARM.

Capstone's Mr. Feldman continues: "Captives operating under the Internal Revenue Code pursuant to Sections 831(a), 831(b), and 501(c)(15) benefit from various federal income tax benefits favoring insurers. However, these benefits only exist for companies that meet the requirements of (i) risk shifting, (ii) risk distribution, (iii) insurance risk, and (iv) the common notions of insurance. These are long-recognized concepts, which were sorely lacking in the case of the Avrahamis' operations. In this regard, there is nothing new in this court decision. Lacking in this case was proper respect for the captive's injudicious design and operation so as to be within the boundaries of twenty-year-old case law. Calling an entity 'an insurance company' is hardly sufficient."

Read also on Captive.com: "Capstone Responds to Hurricane Harvey Disaster."

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