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Avrahami Panel: "A Captive Is Not a Piggy Bank"

Avrahami CICA panel 480 x 377
March 26, 2018

In the wake of the Avrahami decision, micro-captives have found themselves on the Internal Revenue Service (IRS) 2018 "Dirty Dozen" tax scam list for the fourth year in a row. (See IR-2015-26, IR-2016-025, IR-2017-31, and IR-2018-62.) An Avrahami panel at the Captive Insurance Companies Association conference provided beneficial insights for small captive insurers. (For the details of the Avrahami case, watch Insights into the Avrahami and Feedback Decision.)

The panelists said that taxpayers should distinguish their facts from Avrahami and emphasized that the facts and intent surrounding the creation and operation of a captive insurance company are important.

According to panelist Chaz Lavelle, attorney at Bingham Greenebaum Doll LLP, "The IRS has been ratcheting up its concerns over time." This began with the IRS's 2015 "Dirty Dozen" list, which includes micro-captives (aka small captives or 831(b) captives) in its list of tax scams. 

Next, on November 1, 2016, the IRS issued Notice 2016–66, designating as "transactions of interest" most captive insurance arrangements in which the insurance company elects to be taxed under Internal Revenue Code § 831(b). The notice required most participants in a transaction of interest to file a Form 8886; "material advisors" had to file a Form 8918. Failing to file these forms resulted in substantial penalties, and the forms required substantial work to complete. The IRS subsequently extended the due date for these forms to May 1, 2017. (See "'Notice 2016–66 Remains Intact' as Court Dismisses CIC and Ryan Lawsuit" and "Disclosure of 831(b) Transactions of Interest Required by IRS in Notice 2016–66.")

This increased interest from the IRS has led to an increase in audits of captive insurance companies and promoter exams for captive managers. According to Mr. Lavelle, some captives are selected for an IRS audit because their captive managers are under tax shelter promoter investigation. Others emerge from the normal IRS audit processes. For instance, the operating company may get picked up for audit and asked if it has a captive insurance company. In other instances, there is no clear explanation for why a captive is chosen for audit.

Mr. Lavelle said that, while he has heard the IRS has used Form 8886 in an ongoing audit, there has been no clear indication that Form 8886 is used to pick captives for audit. According to remarks from the other panelists Brandon Keim, tax attorney with Frazer Ryan Goldberg & Arnold LLP, and John Dies, managing director of tax controversy services with alliantgroup, many of the 8886 forms have not yet been indexed by the IRS (archaic IRS systems make it hard to organize and use data); however, in the future, audit selection may come out of some of these forms.

When the IRS actually comes in and does an audit, the local IRS agent will coordinate with one or more of the captive management firm insurance specialists, depending upon which captive management firm is being utilized, according to Mr. Lavelle. Taxpayers under audit can expect a list of 45 questions for the insured and a different list of 45 questions for the insurance company. The client will also need to undergo an interview with the IRS.

Mr. Lavelle said that the IRS approaches captives with considerable skepticism out of the gate, and the tax court judges' antennae are up for tax scams as well. He explained that the benefit of the doubt will not be given by the court in captive cases, unless the case proves to the court that the captive is being set up a for non-tax business purpose and that the taxpayer's intent for forming a captive is about insurance, not about tax.

Mr. Keim added, a small captive insurer should be sure that the captive has a great narrative surrounding its formation. Two great narratives for forming a captive are: (1) the captive eliminates commercial coverage and (2) the captive reduces the total cost of risk. He also added that having substantial claims is important and having custom-written policies that make sense for the insureds is key.

Furthermore, Mr. Lavelle gave many, but not all, of the items that a taxpayer may expect to see examined in audit. The captive must have insurable risks—the kind that are fitting for a tax deduction. The IRS and the courts will also look at insurance claims and investments or loaning money to related parties (loan backs). As a second tier, there are regulatory aspects and the need for a clear explanation surrounding any estate planning aspects—which is something that needs to be clarified before technical tests. Post Avrahami, the IRS will also look at the captive's actuarial approach, feasibility study, and policy terms. Both Mr. Lavelle and Mr. Keim concurred that, ultimately, pricing will become preeminent, assuming that there is a non-tax business purpose.

Mr. Lavelle said that, typically, when the IRS makes a disallowance, it is on the grounds that the captive is not valid insurance. A disallowance may lead to the following.

  • A deficiency in tax
  • Constructive dividends
  • Negligence or a substantial understatement penalty
  • A 40 percent penalty for lack of economic substance

Again, it is imperative for the taxpayer to show that the purpose of forming its captive insurance company is to mitigate liability.

(Avrahami panelists in front of a packed crowd pictured above from left to right are John Dies, managing director of tax controversy services with alliantgroup, Chaz Lavelle, attorney at Bingham Greenebaum Doll LLP, and Brandon Keim, tax attorney with Frazer Ryan Goldberg & Arnold LLP. Photo above is courtesy of Captive Insurance Companies Association.)

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