Captive Insurance Companies after Avrahami: What Happens Next?

Transcription

1 Captive Insurance Companies after Avrahami: What Happens Next? Insurance Companies Committee ABA Tax Section San Diego Feb 9, 2018 Kacie Dillon, Woolston & Tarter P.C., Phoenix, AZ Chaz Lavelle, Bingham Greenebaum Doll LLP, Louisville, KY Rachel Partain, Caplin & Drysdale, Chartered, New York, NY 1

2 Table of Contents All Small Cases Litigated in U.S. Tax Court to Date Avrahami v. Commissioner Avrahami: Motion for Reconsideration The Immediate Effect of Avrahami in Other Tax Court Cases The Long Term Effect of Avrahami on Section 831(b) Captives The Use of Experts in Small Captive Cases Potential Litigation Targets for IRS 2

3 All Small Cases Litigated in U.S. Tax Court to Date 3

4 Avrahami, et al. v. Commissioner, 149 T.C. 7 (2017) Caylor Land and Development v. Commissioner, Docket No (tried in May 2016 before Judge Mark V. Holmes) Wilson, et al., v. Commissioner, Docket No (tried in August 2016 before Judge Mark V. Holmes) Reserve Mechanical Corp f.k.a. Reserve Casualty Corp. v. Commissioner, Docket No (tried in May 2017 before Judge Kathleen Kerrigan) Syzygy Insurance Co. Inc., et al., v. Commissioner, Docket No (tried in December 2017 before Judge Robert Ruwe) 4

5 Avrahami v. Commissioner 5

6 Overview 105 page opinion by the United States Tax Court issued on August 21, 2017 o First court case involving an insurance company taxed under section 831(b) o Based on the facts and circumstances Court held that the Taxpayers did not enter into a valid insurance transaction o No risk distribution o Not insurance in its commonly accepted sense Not operated as an insurance company Policies had unclear and contradictory terms Premiums were wholly unreasonable o Apparently, premiums not otherwise deductible as a section 162 deduction o No penalties on the insurance transaction o Foreign domiciled captive lost its elections, but parties agreed no U.S. income 6

7 Facts Stated in the Opinion Insureds were three jewelry stores and three shopping centers o Owned by Mr. and Mrs. Avrahami Mrs. Avrahami owned Feedback, a St. Kitts insurance company Insureds purchased insurance from Feedback o Premium paid from 2006 was $150,000; it increased to more than $1.1 million in 2009 Insureds purchased terrorism coverage from Pan American o Pan American insured other unrelated companies for terrorism risk, 85 and 101 for the years before the Court o Pan American reinsured a pro rata share of all risks to Feedback and other insurance companies, affiliated with Pan American s insureds o Policy covered terrorism NBCR o Policy excluded acts of terrorism in a city with more than 1.5 million residents o Pricing for each insured used the same rate on line 7

8 Facts Stated in the Opinion Feedback risks o Direct (related) roughly 70%; Reinsurance (unrelated) roughly 30% Mr. Avrahami was under the impression that only the amount of premium paid into Pan American was at risk No claims paid by Feedback until after IRS audit began Claims Feedback did receive were dealt with in questionable ways o Approved despite being filed late o Lack of evidence about the cause of damage Feedback loaned $2,530,000 (about 65% of its assets) to Belly Button Center LLC owned by the Avrahami s children o Neither principal nor interest was due for several years o Did not seek approval by the Kittian regulators as required by the St. Kitt s Captive Insurance Companies Act of

9 Risk Distribution Related Insureds The Court first looked only at affiliated risks o Government s Expert must insure 35 entities o Taxpayers Expert must insure 12 entities o Court: The 3 or 4 insureds were not enough in this case The Court did not discuss the favorable authorities The Court said having sufficient exposure units is more important o Not enough exposure units looking only at those from the affiliates o 3 jewelry stores, 2 key employees, and around 35 employees 9

10 Risk Distribution Pool/Unrelated Taxpayers risk distribution roughly 30% unrelated business o In Harper Group (9 th Circuit), there was 29% unrelated business The Court stated that to find that Feedback s 30% unrelated business achieved risk distribution, Pan American must be bona fide o The Court stated that the Pan American arrangement looked suspiciously like a circular flow of funds The industry believes this is a standard arrangement o The Court found the terrorism premiums to be grossly excessive Questioned the one size fits all rates o The Court found that it was unlikely that a covered loss would occur o The Court found Pan American would have trouble paying claims o Pan American was compensated by fixed fee, rather than a percent The Court stated: We have to make a finding of fact on this The Court concluded that Pan American is more likely than not not a bona fide insurance company o Industry: but isn t Feedback still liable for those unrelated risks? 10

11 Insurance in its Commonly Accepted Sense Lack of risk distribution would itself result in no insurance Finding the arrangement is not insurance in its commonly accepted sense, is an alternative ground The Court looked at five factors: 1. Organized, operated and regulated as an insurance company 2. Adequate capitalization 3. Valid and binding policies 4. Reasonable premiums as the result of arm s length transaction 5. Claims are paid The Court identified, but did not address o Whether policies covered typical risks o Legitimate business reason for acquiring insurance from the captive Earlier in the opinion, the Court had identified some tax oriented reasons to insure with an affiliate, but did not further discuss them 11

12 Organized, Operated and Regulated Organized, operated and regulated as an insurance company o Organized and regulated as an insurance company in St. Kitts o Does not address if captive should be regulated by the insureds domicile Not operated as an insurance company left something to be desired o Investments that only an unthinking insurance company would make o Illiquid, long term loans to related parties (65% of Feedback s assets) o Failed to timely receive regulatory approval for loans o No claims from its 2007 inception until March 2013, two months after the Insured s income tax audit commenced o Claims were dealt with on an ad hoc basis o Late claims approved o One claim that was paid was either potentially covered by commercial insurance or not a valid claim against Feedback 12

13 Common Notions Of Insurance Capitalization; Policies; Premiums; Claims The Court found Feedback was adequately capitalized Prior case law implied that having minimum capitalization meant that the insurance company was adequately capitalized The Court accepted this standard, which Feedback met The policies should be valid and binding The policies identified the insured, premium and were signed The policies required the occurrence and claim be in the same year The Court found that to be unclear and contradictory, because it contained elements of both claim and occurrence policies The industry thinks the policies are standard, valid and binding The Court found the policies to be utterly unreasonable, aimed at a target and the actuary s explanations often incomprehensible The Court questioned the factor and judgment adjustment factors The Court found that Feedback met the requirement of paying claims 13

14 Not Addressed By The Court Because the Court found that the arrangement was not insurance, the Court did not comment on: o The number of affiliates needed to distribute risk o Other two insurance tests Risk Shifting Insurance Risk o Government s other arguments Economic substance Substance over form Step transaction doctrines 14

15 No Penalties The Court did not impose a penalty on the Taxpayers for insurance o Taxpayers had reasonable cause to deduct the premium o And acted in good faith o Taxpayers had consulted an estate planning lawyer Competent to evaluate the arrangement Knew all the facts o The attorney was not treated as a promoter He received part of the set up fee, but the rest of the work was on an hourly basis The Taxpayers and the attorney had a prior relationship The attorney did not give unsolicited advice o The Court was sympathetic to the Taxpayers position o It was the first time the Court addressed sections 162, 831(b) and 953(d) in the same case 15

16 Avrahami: Motion for Reconsideration The Tax Court issued an order on November 14, 2017 denying Taxpayers Motion for Reconsideration in which Taxpayers raised two primary issues: o Captive relied on professionals to operate as an insurance company in the commonly accepted sense The court stated that an arrangement is categorized as insurance based on the facts o Court was incorrect in finding that a policy was both a claims made and occurrence policy o The court stated that some policy language was not clear and that the actuarial analysis did not reflect the policy language 16

17 The Immediate Effect of Avrahami in Other Tax Court Cases 17

18 Reserve Mechanical Corp. f.k.a. Reserve Casualty Corp. v. Commissioner, Docket Number Background Four day trial in Houston, Texas beginning April 27, 2017 Post trial briefing Respondent s Opening Brief on August 4, 2017 Petitioner s Opening Brief on August 5, 2017 Respondent s Answering Brief on October 6, 2017 Petitioner s Answering Brief on October 11, 2017 On October 16, 2017, the Court ordered the parties to submit a memorandum after the Avrahami decision Respondent s Issues Memorandum on October 31, 2017 Petitioner s Issues Memorandum on November 1,

19 Caylor Land & Development v. Commissioner, Docket No Background o 12 cases consolidated for trial, briefing, and opinion o Five day trial in Phoenix, Arizona beginning May 1, 2016 o Does not involve a risk pool o Involved 12 brother/sister entities, similar to Rev. Rul safe harbor Post trial briefing o Petitioners Seriatim Opening Brief on September 30, 2016 o Respondent s Seriatim Answering Brief on December 16, 2016 o Petitioners Seriatim Reply Brief on April 4, 2017 On September 11, 2017, the Court ordered supplemental briefing after the Avrahami decision o Petitioners Supplemental Opening Brief filed on October 30, 2017 o Respondent s Supplemental Answering Brief filed on December 13, 2017 o Petitioners Supplemental Reply Brief filed January 12,

20 Arguments in Caylor After Avrahami Petitioners Supplemental Brief on October 30, 2017 Risk distribution was satisfied o 12 sibling entities o Numerous independent risk exposures Construction 347 projects/injuries, violations and hazards, default by subcontractors, administrative action, construction defects Property management and real estate ownership six buildings, real estate, 3,000 leases, cyber, compliance and operational, 1055 of tenant, injury, legal action Investment failure to make meeting payments, financing construction project, liability for signing loans 20

21 Arguments in Caylor After Avrahami Insurance in the commonly accepted sense o Premiums were reasonable Comparing the total cost of insurance after forming a captive to the cost before forming the captive is not a valid comparison because of the additional covered risks No unreasonable assumptions were made to reach $1.2M o Petitioners expert calculated reasonable premiums as higher than those paid by the insureds o Buying to budget is not improper Policies covered actual risks of the insureds o Taxpayers motivations for forming the captive The captive was formed for non tax reasons o Commercial insurer denied large claim because outside scope of coverage o Other gaps in commercial coverage Tax motivation is not improper where the Code provides a specific benefit. See Summa Holdings v. Commissioner, 848 F.3d 779 (6th Cir. 2017). 21

22 Arguments in Caylor After Avrahami Insurance in the commonly accepted sense (cont d) o Policies were valid Identified insured, effective period, clear scope of coverage, stated premium, signed by authorized rep No speculative risks (such as terrorism) o Claims were filed and paid prior to the IRS commencing the audit There was a claims administration process The captive s loss ratios was similar to the loss ratios under the Insureds commercial policies during the same years o The captive s capital usage No related party loans or investments in years at issue Obtained regulatory approval No penalties because first impression to independent advisors 22

23 Arguments in Caylor After Avrahami Respondent s Supplemental Answering Brief on December 13, 2017 Not insurance in the commonly accepted sense o Claims Ad hoc claims No significant claims prior to audit o Policies Priced after coverage period No proof regarding following Anguillan law Failed to follow state law Captive made loans in years after those at issue Calendar year policies issued in December No involvement by taxpayer s insurance broker 23

24 Arguments in Caylor After Avrahami o Unreasonable premiums Target premium drove pricing and premiums were about $1.2M 1% loss ratio Total insurance cost after formation of the captive vs. before formation significantly exceed the ratio in Avrahami Policies covered non existent risks 24

25 Arguments in Caylor After Avrahami Risk distribution was not satisfied o The Avrahami opinion examines the number of insureds and the number of independent risk exposures The captive issued 11 policies The insureds had minimal activity and thus risk exposures The exposures were not independent o High correlation o No geographical diversity o Relationship between insureds 25

26 Arguments in Caylor After Avrahami The court should address the economic substance doctrine that the court did not in Avrahami Summa Holdings was corporate form transaction that did not require a business purpose Penalties should apply even in a case of first impression No reliance on advisors Taxpayer did not provide advisors with information Advisors did not provide advice on structure Any reliance was not in good faith Marketed as tax shelter Taxpayer concealed the transaction in its books and records 26

27 Arguments in Caylor After Avrahami Petitioners Supplemental Reply Brief on January 12, 2018 The IRS is arguing for an additional requirement, namely that premiums must in hindsight be on par with claims experience More insureds than in Avrahami 27

28 Syzygy Insurance Co. Inc., et al., v. Commissioner Tried December 11 14, 2017 On December 14, 2017, the Court ordered post trial briefing Simultaneous Briefing on February 27, 2018 Simultaneous Answering Briefing on April 13,

29 Wilson v. Commissioner On January 10, 2018, the Court ordered post trial briefing: Petitioners Seriatim Opening Brief on May 15, 2018 Respondent s Seriatim Answering Brief on August 15, 2018 Petitioners Seriatim Reply Brief on November 15,

30 The Long Term Effect of Avrahami on Section 831(b) Captives 30

31 Risk Distribution After Avrahami Although the judge recognizes that 831(b) captives will have less exposure units than a large captive, the decision suggests that achieving the law of large numbers in the 831(b) context will be very difficult or potentially impossible 31

32 Insurance in the Commonly Accepted Sense After Avrahami The judge stresses as a bad fact that the insureds total insurance expense increases significantly subsequent to forming the captive o One purpose of forming a captive is to provide coverage where an insured was previously selfinsuring risks. Therefore, as almost a general rule, total insurance expense will increase after forming a captive o The proper comparison is not total premiums, but uninsured vs. insured risks 32

33 Tax Liability and Penalties After Avrahami In Avrahami, the parties stipulated that the foreign captive s income was not U.S. source or ECI It is not clear whether the court would have reached this result absent the stipulation The Court did not address other potential issues when a foreign domiciled captive loses its election made under Section 953(d) See Chapman Glen Limited v. Commissioner, 140 T.C. 294 (2013). 33

34 The Use of Experts in Section 831(b) Cases 34

35 The IRS s Experts The IRS has used several experts in the section 831(b) captive cases that have been tried, both during their case and as rebuttal witnesses. General insurance and risk management Dr. David Babbel (Avrahami/Caylor) Lydia B. Kam Lyew (Wilson) Professor David Eckels (Wilson) Donald J. Riggin (Reserve) Neil Rector (Syzygy) James McDonald (Syzygy) Actuarial Roberta Garland (Wilson/Caylor) Economist Dr. Mark F. Meyer (Caylor) 35

36 Taxpayer Experts Avrahami General Insurance Daniel Spragg and Sheila Small, Alvarez & Marsal Caylor Dr. Stanley J. Feldman Rebuttal Actuary Robert Walling Wilson General Insurance Daniel Spragg and Sheila Small, Alvarez & Marsal General Insurance and Actuarial Michael Angelina Reserve S. Lance McNeel Robert L. Snyder II Steve W. Kinion David B. Liptz Syzygy General Insurance Michael Angelina Actuarial Robert Walling 36

37 Potential Litigation Targets for IRS 37

38 There are certain factors whose presence the IRS may view as better candidates for litigation 38

39 Contact Information Kacie Dillon, Woolston & Tarter P.C E. Arizona Biltmore Circle, Suite B 218, Phoenix, AZ (602) Kacie@woolston tarter.com Chaz Lavelle, Bingham Greenebaum Doll LLP 3500 National City Tower, 101 South Fifth Street, Louisville, KY (502) clavelle@bgdlegal.com Rachel Partain, Caplin & Drysdale, Chartered 600 Lexington Avenue, 21 st Floor, New York, NY (212) rpartain@capdale.com 39