Yesterday the Tax Court issued a long-anticipated opinion on a fully-litigated micro-captive insurance company. Micro-captive insurance companies have long been a popular means of self-insuring for closely-held businesses but recently have come under additional scrutiny by the IRS. This case long preceded the IRS’s formal announcement focusing on micro-captive companies and was supported on brief by the Self-Insurance Institute of America, Inc.Micro-captive insurance companies are specifically provided for under IRC Section 831(b) but, as demonstrated by the Court’s opinion, they must meet certain factual criteria to maintain that preferred tax status. In a detailed and precedential division opinion authored by Judge Holmes, the Tax Court found that the insurance company formed by business owners Benyamin and Orna Avrahami was not operated like an insurance company, issued policies with unclear and contradictory terms, and charged wholly unreasonable premiums. Because the company was not an insurance company as required by section 831(b), its election to be treated as a micro-captive insurance company was invalid. As such, the premiums paid to the company by the Avrahamis were not deductible business expenses.
The Avrahamis also owned an entity called Belly Button Center which received funds from their insurance company and made loans to them personally. After its “omphaloskeptical review” the IRS challenged the validity of the loans alleging that they were a sham. The Court declined to reach that conclusion but did treat a little less than $300,000 of the $1.5 million transferred between the related parties as taxable dividends.
Finally, the Court considered whether negligence penalties applied to the Avrahamis. Based in part on the fact that this was a case of first impression with regard to micro-captive insurance, the Court found that the taxpayers had reasonable cause for the position taken on the returns and thus avoided penalties on the disallowed insurance premiums. The Court did, however, impose penalties on the portion of the loan treated as a dividend and another dividend of $200,000 that the taxpayers failed to report on their return.
Read the entire opinion here: Avrahami.