John Michael Johnston
Attorney & Counselor
PRACTICAL CONCERNS FOR
CAPTIVE INSURANCE COMPANY OWNERS
IN THE WAKE OF AVRAHAMI
by John Michael Johnston
The captive insurance industry is currently trying to grasp the consequences of a landmark Tax Court decision captioned Avrahami v. Commissioner which was announced on August 21, 2017.
It is not an exaggeration to say that the 105 page Tax Court opinion in Avrahami puts at issue the very essence of whether a small captive insurance company, being one that makes an election under IRC §831(b), can safely comply with the traditional insurance tax law requirement of risk distribution.
Captive insurance is an arrangement whereby a parent company or an individual business owner forms an insurance company to underwrite the insurance risks of operating its businesses. Early on, the majority of such companies were created in offshore tax havens, not so much for tax reasons as to avoid being entangled in state insurance regulation. More recently, the majority of states have enacted captive-enabling legislation, such that most captives are now formed domestically.
Legitimate captive programs can lawfully provide significant insurance and tax benefits to their participants. However, questionable captive programs that simply masquerade as legitimate captive insurance companies have steadily proliferated and pose a substantial hazard to the unwary, since they are under intense scrutiny by the Internal Revenue Service as being abusive tax shelters.
Captive insurance imposters, which are often referred to by the industry slang "tax captives", are structured and geared toward providing inordinately large tax breaks to their program participants. Only the barest lip-service is paid to the supposed risk management function of the relationship. The tax sheltering function is accomplished by generating substantial tax deductions through insurance premiums that are usually both unreasonably expensive and which cover risks that are highly unlikely to materialize. The premium amounts and risk coverage cannot rationally be justified to the IRS or to the US Tax Court if they are challenged. Furthermore, these programs usually provide only illusory insurance coverages which, similarly, cannot be justified to any conscientious insurance commissioner or to any informed court that reviews them. The insurance coverages in imposter programs merely serve to act as a front for an illicit tax agenda. Such imposters fit almost perfectly into the IRS's characterization of abusive tax shelters.
The core debate about whether certain Captive Insurance Programs are legitimate or are, instead, abusive tax shelters, is hardly new. The debate far predates Avrahami.
My exposure to the contentious side of the captive insurance industry has been multi-faceted and extensive. Although I was involved in the captive insurance arena since the mid-1990’s, I first became actively involved in captive insurance litigation in 2010. At that time there were already substantial pieces of litigation in several jurisdictions around the country (most notably in New York, Texas, and Pennsylvania) concerning whether certain prominent captive programs were fraudulent or abusive tax shelters instead of legitimate insurance providers.
The first set of battles involved so-called quasi-captive insurance companies. The idea here was that the taxpayer’s company would make large premium payments to the promoter’s insurance company, and in that same year, the promoter’s company would then “loan” back approximately 80% of the premiums to the taxpayer individually or to his company. The upshot was that the taxpayer or his company would get a current-year deduction for 100% of the premiums paid, but would receive back 80% of those premiums by way of non-taxable loans. In other words, the taxpayer would receive a current-year deduction that was four times larger than the amount of money that actually stayed with the insurance company. Or, to think of it differently, the taxpayer’s business would get a deduction for 100% of his premium dollars at a true cost to the taxpayer of only 20%. Such is the essence of a quasi-captive tax shelter.
The participants were often told that after five years they would receive a “refund” of their premium dollars or their reserve pool funds (less any claims, which weren’t really expected). The “refund” was to be partially used to offset and extinguish the loans owed by the taxpayers to the promoter’s insurance company. However, the promoter’s insurance company soon began dipping into the taxpayer’s reserve funds for a number of expenses and deductions which had never been previously mentioned nor disclosed. Worse still, as the five year deadline approached, the promoters often manufactured excuses to unilaterally terminate the anticipated “refund” and then they sued the captive participant (taxpayer) on the unpaid notes.
Notably, in the fall of 2013, federal judge Ronald B. Leighton issued a final ruling in one captive insurance case wherein the captive insurance company was the aggressor and had been seeking to recover against my client on his promissory notes. The case was tried for nine days in the Western District of Washington at Tacoma and we had the opportunity to present the details of that captive program to Judge Leighton in great depth. Judge Leighton (who had practiced insurance law for a number of years before he took the federal bench) ultimately described the prominent national Captive Insurance Program as being “at best a scheme and at worst a scam”. Judge Leighton then held that the captive program in question was “inexorably linked in a scheme to defraud the United States from revenues otherwise owed by [the captive participant]”. The entire captive insurance program, including several promissory notes payable to the captive insurance provider by my client, was eventually found by Judge Leighton to be null and void as constituting “an illegal contract”. That ruling spared my client approximately $9.5 million dollars.
However, we next had to defend against an IRS audit seeking to determine if my client owed additional taxes and penalties as a consequence of his participation in such a captive program. Fortunately, we were able to convince the IRS that my client was a victim in regard to the operation of the “scheme” in question. Our good result was, in part, due to the fact that my client was wise enough to voluntarily exit the Captive Insurance Program when he concluded that it was legally suspect. The IRS eventually concluded that a previous “taxable event”, which my client had voluntarily declared when he discovered the true nature of the captive scheme, would suffice for satisfying his tax liability. Bullet dodged.
I was soon called upon to represent the captive insurance participant in a civil action which he had filed in another jurisdiction against the attorney who had put him into the questionable Captive Insurance Program. That litigation proved successful and provided me with a further education about the inner workings of captive insurance programs. It should be noted that attorneys, accountants and financial advisors can be held financially liable to captive participants if they acted as promoters for abusive captive programs. That is especially true if such a professional received any direct or indirect compensation from the originators of the abusive captive program.
The recent Avrahami decision by the U.S. Tax Court was somewhat less critical of the taxpayers' captive insurance program in that case, than was the Tacoma federal judge about the captive insurance program that my clients were caught up in. Nonetheless, the consequences of the Tax Court’s decision were extremely problematic for the Avrahamis and for their companies:
For example, the Tax Court held that the Avrahamis’ offshore captive insurance company (“Feedback”), which had been set up for the Avrahamis by the program’s Captive Provider, was not a legitimate insurance company. The Tax Court reached this conclusion even though Feedback met the minimum requirements of the St. Kitt's regulators, because “it was not operated like an insurance company, it issued policies with unclear and contradictory terms, and it charged wholly unreasonable premiums”. Consequently, millions of dollars of premiums which had been paid to Feedback by various Avrahami companies were found to have been improperly deducted.
The Tax Court also held that an offshore risk-distribution company called Pan American Reinsurance Company, Ltd was “not a bona fide insurance company”. Feedback had purchased third party risk from Pan American, which had likewise been set up by the Captive Provider. The premiums paid to Pan American by the Avrahami’s off-shore company, Feedback, were likewise held “not [to be] insurance for federal tax purposes”. Deductions for those premiums were disallowed as well.
The upshot for the captive participants in Avrahami was that they suddenly had a huge tax bill as a consequence of their expensive micro-captive and (at least in regard to one aspect of the overall transaction), the Avrahamis were also assessed a twenty-percent “accuracy-related penalty” under § 6662(a) of the Tax Code for their treatment of a $200,000 distribution made to themselves from one of their companies.
Remediating Abusive Captive Programs
Where does that leave participants who are already involved in Captive Insurance Programs (including 831 (b) Captives)?
After having had an opportunity since Tacoma to consult for a number of concerned participants in states from California to New Jersey, I believe that there are potential tax problems for many current captive insurance participants in view of the Avrahami ruling. I feel that there are a number of other captive insurance programs which have many of the same weaknesses and flaws as did the one in Avrahami. Unfortunately, I have also learned that having a large potential tax liability is not the end of the story.
The increased scrutiny of the captive industry by the IRS after Avrahami may ultimately provoke a “run” on the Risk Pools for existing §831(b) captive participants. The scenario for such a “run on the bank” could come about in this fashion:
The captive manager for your risk pool might get hit with a promoter audit. You may first learn about the possibility of such an audit when your captive manager sends you a copy of Treasury Department form 8918 which is entitled “Material Advisor Disclosure Statement”. In form 8918, your captive manager identifies your account or micro-captive to the IRS as one to which the captive manager may have provided “material aid, assistance or advice regarding organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction”. You should understand that a promoter’s audit is possible in this instance and it will put you and your micro- captive squarely into the focus of the IRS if it seeks to audit the accounts for each participant in the promoter’s pool.
If this happens, a prudent response on your part might be to (1) start looking for a new captive manager for your micro-captive who isn’t tainted by a promoter audit and hope that it will accept you –which isn’t a given because a clean captive manager may not want your micro-captive in its pool, since your micro-captive may draw IRS scrutiny due to the pending or prospective promoter’s audit, (2) try to exit your existing captive program and get all of your money back from your current risk pool.
The problem with trying to get all of your money back from your captive manager is that many others in your risk pool will want to do the same thing. They may try to terminate or move their own micro-captives. That is a scenario destined to create tension between the captive manager and each party wanting out. Worse, is the reality that one way for captive participants to get money out of the current risk pool is to start making claims against their policies. Unfortunately, many of the policies in question are probably broadly worded so that, for example, a wide variety of things might qualify as a "business interruption" under the language of someone’s business interruption policy. It may even be the case that the value of such a claim could exceed the amount that the claimant in question has contributed to the group pool reserves. A sudden number of large claims might even exceed the assets which currently remain in the group risk pool. Just like in the game musical chairs—those who grab a seat before the music stops are going to be in a lot better shape than those who wait.
Captive insurance participants should also be aware that there are captive insurance programs which do not necessarily have their participants’ best interests at heart. The promoters of such programs can become adversarial if a participant seeks to question the program's structure, including its calculation of the amounts of quoted insurance premiums or the meaning of unfathomable language found in its captive insurance policies or the terms of any loans made to the captive participants.
Problems frequently arise when a participant tries to exit the captive program. Sometimes a promoter will try to exact a pound of flesh from the participant by assessing previously undisclosed fees and penalties, including institutional “dormancy fees”, those being fees are fees ordinarily only charged by the incorporating sovereign. Other promoters may seek to impose significant “surrender penalties” on a participant who dares to try to leave the program. More commonly, the promoter will insist on retaining a large portion of the captive participants’ funds as a “reserve” for possible future expenses or for future losses of the risk pool.
Occasionally, even more draconian measures might be unveiled, including the use of a particularly nasty device called a “retrospective assessment of premium”. Retrospective assessments occur when substantial additional premiums are billed after-the-fact for coverages which have already expired. Retrospective assessments are sometimes issued even if there were no claims made during the coverage period. The supposed justification for such an assessment can be solely because the actuary or the management of the promoter decrees that more premium dollars should have been charged to support the participants’ various coverage limits. Moreover, it is not unheard of for a promoter to unilaterally increase the amounts of a participants’ existing insurance coverage limits in order to later justify making a substantial retrospective assessment of premium against the captive participant. Captive owners should look to see whether a retrospective assessment of premium is possible under the terms of their agreement with the promoter.
There are several immediate and important practical and legal considerations that should be addressed in connection with a prudent evaluation of a captive participant’s existing or prospective captive program (which I will list infra). As a starting point for my suggestions, however, I would adopt the advice given by David J. Slenn, a partner in the Tampa Florida office of Shumaker, Loop, & Kendrick (who is the immediate past chair of the Captive Insurance Committee of the American Bar Association). In an article written in the fall 2017 issue of the Insurance Coverage Law Report, David Slenn observed:
“…business owners that are currently in microcaptive arrangements (or prospective purchasers of such a business) may consider having their program reviewed by an independent advisor or actuary to ascertain whether the issues in Avrahami could impact their current structure.”
Considerations Upon Exit
For those who are considering exiting a captive, numerous issues must be considered, such as the form of exit (e.g., a liquidation), the formal requirements and documentation necessary to exit a captive, and the tax consequences of ceasing to be an insurance company for tax purposes.
This sound advice is seconded in an article written for Forbes Magazine’s October 11th Issue by Jay Adkisson (Las Vegas, Nevada) of the firm of Riser Adkisson LLP who is also a previous chair of the Captive Insurance Committee of the American Bar Association and a regular contributor to Forbes magazine on the topic of Insurance in general and on Captive Insurance in particular:
“Suffice it to say that the captive owners will probably require legal assistance by counsel who are experienced in this area to get them out of their captives while still preserving all of their rights. But getting an independent review of the entire arrangement and how it was operated was never the worst idea anyway.”
So whether you may be involved in a single parent captive program, or whether you have created, or had created for you, an “incorporated cell”, a “syndicate”, a “series” (or some other type of integrated entity within an over-arching captive program) here are some significant issues which must be addressed in deciding whether to stay in, or to exit from, your captive insurance program. This is not meant to be an exhaustive list.
• Policy Review. Have you had someone knowledgeable about Captive Insurance policies evaluate whether the policies involved in your Captive Program are sound and consistent with recognized legitimate insurance principles? (Remember that the Tax Court in Avrahami was critical of both the terms, the scope, and the language of the policies therein).
• Policy Exposures. Are your policies “indemnification policies” or “general liability” policies?
• Timely Claims. Are your policies “claims made policies” or “occurrence policies”?
• Deductibles and Excess. Do your policies offer “primary liability” coverage or are they instead “excess” coverage policies?
• Reasonable Risk, Reasonable Premiums. Have you had someone who has access to independent actuaries or independent underwriters to evaluate whether your captive insurance coverages are commercially justifiable and whether your coverage limits are reasonable in a captive insurance setting? (After Avrahami, the IRS and the courts will be looking closely at these questions).
• Control. Have you previously given a power of attorney to your Captive Insurance Provider or to your captive provider’s attorney? (This is almost never a good idea--I have personally seen how a Captive Insurance Provider’s attorney used a captive participant’s own power of attorney in order to attempt to release the Captive Insurance Provider and its subcontractors from any liability to the captive insurance participant).
• Offshore Law. If your Captive Insurance Provider utilizes an offshore jurisdiction for any part of its’ program, have you had anyone who is knowledgeable evaluate whether or not that offshore jurisdiction offers any semblance of due process consistent with established local law (including whether or not there is a recognition of the concept of “good faith and fair dealing” in the insurance policies or whether or not there is the right to a jury trial regarding any disputes that you may have with the captive provider)?
• Documentation. Have you been given (and have you kept) copies of all significant documents in your Captive Insurance Program? (It is common that a number of different program documents attempt to specify, modify, and define your rights under the Captive Insurance Program and you must have all of them in order to know what your rights actually are).
• Claims Procedures. Are claims against your captive insurance policies being investigated and handled in an objective and commercially reasonable manner? (The Tax Court touched directly on this issue in Avrahami, and other courts have gone even further to look at whether claims that were being made against the captive insurance policies were legitimate claims or were simply manufactured for appearance sake).
• Beware The Releases. Are you being asked by the Captive Insurance Provider to sign a “release”, or an “indemnification” agreement (or clause), or a “ratification” agreement (or clause) in order to exit the Captive Insurance Program or in order to dissolve your incorporated cell, syndicate, or series? (What do these agreements do and under what circumstances, if any, should you be willing to sign such agreements)?
• Conflict Resolution. What is the situation in your Captive Insurance Program in regard to “forum selection” clauses and “choice of laws” provisions? (If you are not well-versed or well advised on these subjects you may have some real surprises coming should any litigation ever arise on account of your participation in a Captive Insurance Program).
• Tax Consequences. What are the tax consequences if you exit the Captive Insurance Program and what are the tax consequences if you stay in.
In conclusion, being found liable for additional taxes plus penalties is bad, but also forfeiting large sums of money to your Captive Insurance Provider or being found by a federal court to be part of a fraudulent scheme, or being judicially held to be part of an illegal contract, could prove to be disastrous. I, therefore, suggest that it is prudent to review and possibly proactively rectify your current Captive Insurance situation before someone else does it for you.
OFFICE: 620 Court Plaza Building, 228 Robert S. Kerr Ave., Oklahoma City, OK 73102, Ph: 405-235-4074, Fax: 405-235-4084
© 2018 John Michael Johnston. All rights reserved.