US Tax Court Holds For The IRS In Avrahami, But Not All Bad News For Micro Captives

Judge Holmes delivered his long-awaited judgment on the Avrahami case August 21, upholding the Internal Revenue Service’s (“IRS”) positions in a 105-page opinion.

The primary issue the court considered was whether amounts paid to the Avrahami’s captive were deductible as insurance payments for Federal tax law purposes.

The Tax Court ultimately concluded that neither the Avrahami’s captive (“Feedback”) nor the offshore insurer that facilitated a risk-distribution program (“Pan American”) were bona fide insurance companies. Thus, payments made by the Avrahami’s operating companies to their captive were not deductible.

Additionally, the Tax Court concluded that the captive insurance company’s Code Sec. 831 (b) election (to be taxed only on net investment income and not underwriting income) and Code Sec. 953 (d) election (to be taxed as a domestic corporation) were invalid, and that certain transfers were not qualified dividends subject to lower rates.

Though this case is certainly of importance to the 831(b) captive insurance sector, the conclusion was based on highly bad facts particular to the Avrahami’s, which must be considered when evaluating the overall relevance of the case.


Benyamin and Orna Avrahami (‘Avrahami’s”) owned three shopping centers and three jewelry stores in Arizona.  In 2007, they formed Feedback, a captive insurance company from which they purchased millions of dollars’ worth of various insurance coverage.  They also purchased terrorism insurance from an insurance company established by the promoter, which would then reinsure a portion of its terrorism insurance with Feedback.

The Avrahami’s and Feedback argued all their actions complied with the Internal Revenue Code (“Code”) and relevant case law.  Thus, they argued Feedback was a valid insurance company that qualified and properly elected to be taxed under Code Sec. 831(b), all of its policies covered insurable risks, premiums were actuarially determined, and the captive sufficiently distributed risk.

However, the IRS believed that Feedback was organized to provide tax deductions. The IRS presented a number of arguments; however, the case turned primarily upon whether Feedback had a sufficient pool of insureds, i.e. was there risk distribution, which is a long-standing tax law requirement

While the Tax Court agreed with some of the Avrahami’s arguments, it ultimately held against the taxpayer on the risk distribution requirement, but did so in a very fact-specific manner.  When it comes to risk distribution, significant reliance to meet this requirement is often placed on the actuary involved and their work in determining the pricing of risk.  Avrahami was no different. 

Arrangement did not provide insurance

Judge Holmes concluded that the arrangements between Feedback and the Avrahami’s pass through business entities did not constitute insurance.  Feedback’s risk exposures fell short of meeting the threshold for risk distribution and Judge Holmes ruled “we cannot find that [Feedback] covered a sufficient number of risk exposures to achieve risk distribution merely through its affiliated entities.”

Though the Court acknowledged that risk distribution can be achieved by the number of independent risk exposures, it found that Feedback’s in particular were insufficient. This is an important distinction from the Court, since the IRS has always maintained that risk distribution should be evaluated based purely on the number of insureds rather than the number of risk exposures (a position that the IRS continues to argue and has been regularly losing in recent court cases).

However, the court felt Feedback fell significantly short when it came to pricing its policies.  First, the actuary for Feedback appeared to adjust industry pricing in order to hit a “target premium” given to him by the Avrahami’s advisor after consulting with the promoter of this program.  Second, the actuary appeared to solely work with the promoter of this captive program, so the actuary’s independence was called into question. Third, the actuary consistently adjusted the standard risk pricing solely upwards to account for unexplainable adjustments based on the professional experience of the actuary.  Finally, at several points, the Court questioned the actuary about his methods and the actuary provided responses that were not understandable to the Court, leading the Court to find the IRS’ actuary more credible.

The court also had issues in that Feedback paid more than $3.8 million in premiums by the end of 2010 and had loaned out more than 65% of its assets indirectly to various members of the Avrahami family, which were long-term and primarily unsecured. Due to all of these high-dollar loans made to related parties, the Tax Court questioned whether Feedback remained sufficiently capitalized to meet its potential claims obligations.

In the view the Court, Feedback simply did not operate like an insurance company in the “commonly accepted sense.”  The Tax Court said in supporting this conclusion that the insurance company issued policies with unclear and contradictory terms, made investment decisions that “only an unthinking insurance company would make,” and charged unreasonable premiums. 

Additionally, the Tax Court also reviewed the pooling entity, Pan American, and held that it was not a bona fide insurance company. The Avrahami’s previous commercial terrorism coverage charged approximately $1,500 per year, which increased to $360,000 in premium once the Feedback/Pan American structure began.  The terrorism risk distribution pool did not have any substantial number of claims over a period of years, and the policies included only vaguely-described and uninsurable risks. In fact, one of many unique provisions in the insurance contacts from Pan American was that it was allowed to make claim payments in the form of a three year promissory note. This is not typical in the insurance industry and was most likely due to the facts that Pan American retained very little cash compared to the amount of claims to which it was exposed.

The Court was also concerned that the actuary for Pan American, which was the same actuary for Feedback, used a “one size fits all” approach when pricing the claimed insurance coverage for all of the promoter’s clients that participated in Pan American. In particular, the court was troubled by the testimony of the actuary who testified that he could not name any event in history that would have triggered a claim under the terrorism coverage.

In regards to Pan American, Judge Holmes looked at the overall terms and concluded no reasonable business would have purchased it, that the probability of a claim being triggered was extremely low, and that the payments were of a circular nature (as the same amount of premiums paid to it shortly ended up with a client’s captive).

Hence, the Tax Court held that the premiums paid by the Avrahami’s business entities to Feedback and Pan American were not for insurance for tax purposes and were not deductible expenditure. Additionally, the Tax Court held the taxpayer’s beneficial tax elections were invalid, which led to all distributions or loans to the Avrahami’s to taxable income at ordinary income rates.

Implications moving forward

The Avrahami decision is the latest development in the IRS’s recent efforts to scrutinize and crack down on 831(b) captives, in the belief that some small businesses are using them in abusive ways.

In November 2016, the IRS issued Notice 2016-66, which identified certain captive insurance arrangements that qualify under Code section. 831(b), and any similar structures, as “transactions of interest.”  These arrangements have also been on the agency’s “Dirty Dozen” list of tax scams for the past several years, and are one of the first thirteen issues being targeted by the IRS Large Business and International Division’s new tax compliance campaign.

The Avrahami decision turned on highly fact specific issues. It is important to note that not all 831(b) captives involve abusive tax avoidance and most are legitimate insurance companies benefiting from a congressionally sanctioned tax break. The IRS and courts have recognized 831(b)-captives as legitimate in the past and continue to do so. In fact the Avrahami Court pointed out that tax benefits in one form or another have been in the U.S. tax laws since 1924.

The facts in the Avrahami case likely do not reflect the majority of 831(b) captive insurers and insureds. However, the Tax Court’s opinion still provides guidance in regards to operating legitimate 831(b) captives.  The Tax Court once again confirmed numerous recent cases acknowledging that risk distribution can be achieved by the number of independent risk exposures, rather than just the number of insureds.  The Court emphasized that it is not sufficient to look at the number of brother-sister entities, but more important to figure out the number of independent risk exposures.  Additionally, the Tax Court again confirmed that compliance with regulatory capital requirements is generally sufficient.  This is ultimately good news for other 831(b) captives facing litigation with the IRS.

Fortunately for the Avrahami’s, they did escape some of the penalties originally assessed by the IRS.  The Tax Court found the couple acted in good faith and relied on independent advice.  However, one of the attorneys from whom they sought counsel was deemed a “promoter” of captives and not a reliable source for sound legal advice.

In sum, the IRS has escalated scrutiny of 831(b) captives and unfavorable decisions like Avrahami emphasize the importance of complying with the Code, the IRS, and relevant case law in form and in substance when operating a captive insurance company.  Additionally, retaining independent, competent counsel and not relying solely on the advice of a promoter, even if an attorney, is crucial.


DUGGAN BERTSCH, LLC has broad experience working with and counseling clients on their captive insurance operations, structure, and corresponding compliance obligations, and has successfully represented clients with Captives, including 831(b) electing Captives, in tax controversies with the IRS as well as in the proper preparation of the required filings with the IRS.  We would be happy to independently review your situation and provide our experienced insight on your particular situation and available options.

Team Members: