In a 109-page Tax Court ruling, the IRS recently won its case against a wealthy husband-and-wife business team and their questionable captive insurance company.
Benyamin Avrahami and Orna Avrahami wrongly claimed as business-expense deductions under Internal Revenue Code Section 162 for tax years 2009 and 2010 amounts paid by their pass-through entities to captive insurance company Feedback Insurance Co. Ltd. in St. Kitts (owned by Orna Ovrahami) and to Pan American Reinsurance Co. Ltd., also in St. Kitts, that was partially owned by the Avrahamis’ attorney’s children.
The IRS denied the deductions, saying that Feedback’s elections under Internal Revenue Code Section 831(b) to be treated as a small insurance company and under Internal Revenue Code Section 953(d) to be taxed as a domestic corporation were invalid because the amounts paid didn’t qualify as insurance premiums for federal income taxes.
The IRS also determined that $200,000 transferred from Feedback to Orna Avrahami was actually an ordinary distribution, while $1.5 million transferred indirectly from Feedback to the couple was a loan repayment and untaxable. But another payback of $1.2 million is to be considered excess as either taxable interest or an ordinary dividend.
The agency also said that the couple was not liable for accuracy-related penalties under Internal Revenue Code Section 6662(a) except for the amounts determined to be dividends or taxable interest.
The IRS sought deficiencies of $380,000 for 2009 and $990,000 for 2010. In addition, the IRS claimed $275,000 in penalties.
The case turned on exactly how insurance is defined for federal tax purposes – because neither the Internal Revenue Code nor regulations define insurance, wrote Judge Mark Holmes. Instead, case law is relied upon. Thus, the U.S. Supreme Court’s definition of insurance often is used: The arrangement must involve risk-shifting and risk-distribution, insurance risk and meet commonly accepted notions of insurance, Holmes writes.
But “insurance taxation gets slightly more complicated when the insurer and the insureds are related because the line between insurance and self-insurance begins to blur,” Holmes states in his opinion. “A pure captive insurance company is one that insures only the risks of companies related to it by ownership.”
Though the Avrahamis’ case is the first Section 831(b) to reach trial, the couple is hardly the first to be audited because of interactions with a captive insurance company. The IRS put such dealings on its “dirty dozen” list of tax scams in 2015 and also declared them as transactions of interest in 2016.
Unless the IRS and Avrahamis reach an agreement, the case can be appealed to the Ninth Circuit Court.