Posted by Todd Keator and Murtuza Hussain In a recent case, Benjamin Avrahami v. Commissioner, 149 T.C. No. 7 (August 21, 2017), the Tax Court held that payments, including those to a microcaptive, were not for insurance and therefore were not deductible under Section 162. Furthermore, since less than half of the attempted microcaptive’s business was from issuing insurance contracts, it was not an insurance company and an election under Section 831(b) was not available. Section 831(b) currently provides that if an insurance company, other than a life insurance company, has net written premiums (or direct written premiums, if greater) that do not exceed $2.2 million for the taxable year, it may elect to be taxed on only its taxable investment income (and can exclude insurance premiums). For business purposes, captive insurance companies provide related parties the ability to offer insurance to each other, which allows the premiums to stay within a group. The crux of this issue is the intersection between captive insurance companies and those qualifying under Section 831(b), which are known as “microcaptives.” Combining the business benefits of captive insurance companies with the tax advantages of Section 831(b), microcaptives provide the opportunity to have one company deduct premiums paid as Section 162 business expenses and have the insuring company not include the premiums in its taxable income.Background. The taxpayers in Avrahami were business owners in Arizona. Through 2006, the taxpayers maintained various commercial insurance policies for their businesses with insurance expenses totaling approximately $150,000. In 2007, the taxpayers sought tax advice from professionals, including for estate planning, and their advisors suggested forming a captive insurance company. After confirming with their advisors that a captive insurance company would accomplish their needs, they formed a captive in Nevis (St. Kitts) named Feedback. Feedback sold policies to the taxpayers’ other businesses. Feedback also entered into a terrorism reinsurance policy with Pan American, which consisted of the taxpayers’ businesses purchasing terrorism insurance from Pan American and then Pan American purchasing reinsurance from Feedback. Despite the policies with Feedback, each business continued purchasing insurance from third party insurers and made no coverage adjustments. The taxpayers deducted approximately $1.1 million and $1.3 million for insurance expenses in 2009 and 2010, respectively. The IRS contended that what Feedback sold to the businesses was not insurance and therefore was not deductible under Section 162.Decision. The Tax Court determined that the policies were not insurance contracts. In its analysis of whether the transactions were “insurance” for federal tax purposes, the Court looked at the facts and circumstances to decide whether the arrangements involved risk shifting, risk distribution, and insurance risk, and met commonly accepted notions of insurance. Despite recognizing that microcaptives must operate on a smaller scale for risk distribution, the Court determined that there was neither enough diversification in Feedback to constitute a sufficient number of risk exposures in its affiliates nor enough third party reinsurance since Pan American was not a bona fide insurance company and the policies it issued were not insurance. Despite one of the requirements not being met, the Court looked, as an alternative, at whether the arrangement “looks like insurance in the commonly accepted sense.” While Feedback had some policy characteristics that looked like insurance, there were significant shortfalls that the Court could not overlook, including issuing policies with unclear and contradictory terms, failing to operate like an insurance company, and charging “wholly unreasonable premiums.” Because these conclusions resulted in Feedback’s policies not being insurance for federal tax purposes and Pan American was not a bona fide insurance company, the premiums paid were not deductible by the taxpayers’ businesses. The Court also held that Feedback could not make a Section 831(b) election because it was not an insurance company for federal tax purposes. In a partial victory for the taxpayers, however, the Court was sympathetic towards the taxpayers and declined to impose penalties since there was no clear authority to guide them.Implications. While failing to provide any bright line rules for microcaptives and qualifying the 30% reinsurance safe harbor by testing to see if the issuer was an insurance company, the Court strongly signaled to the IRS the need for further guidance on the issue by failing to sustain the assessed penalties. On the other hand, this decision, in part, provides some potential guidance for taxpayers. Regardless of the penalty defeat though, this case should bolster the IRS’s position on microcaptives at all stages. Taxpayers should also beware that the Court made its determination based on the lack of risk distribution and did not evaluate whether there was sufficient insurance risk or risk shifting, which could potentially provide additional hurdles in the future even if the risk distribution element is met.