The Internal Revenue Service has prevailed in U.S. Tax Court in a case involving an Arizona jewelry store business that received a tax break by insuring itself for millions of dollars, in part against the risk of terrorism.

Benyamin and Orna Avrahami, a couple who own three jewelry stores and three shopping centers in the Phoenix area, spent more than $1.1 million in 2009 and $1.3 million in 2010 insuring their businesses. They set up an insurance company called Feedback, but there were no claims made on any of the company’s policies until the IRS began auditing them, according to the court.

Tax Court Judge Mark V. Holmes summarized the competing claims of the Avrahamis and the IRS in a colorfully written opinion Monday. “With money flooding in and none going back to pay claims, Feedback accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which ended up back in the Avrahamis’ bank account—as loans and loan repayments, say the Avrahamis; as distributions, says the Commissioner,” he wrote. “Also included in Feedback’s surplus was $720,000 that the Avrahamis’ jewelry stores sent down to a Caribbean company for terrorism-risk insurance. The full $720,000 then flew right back to Feedback after—the Avrahamis argue—it distributed enough risk for the whole plan to constitute insurance as that term is commonly understood.”

They set up the captive insurance company in 2007 on the advice of their longtime CPA, Craig McEntee, who brought in a local estate-planning attorney, Neil Hiller, and a New York-based attorney, Celia Clark. She specializes in captive insurance and helped draft legislation on the subject for the Caribbean island of St. Kitts, where they ultimately established Feedback Insurance. Mrs. Avrahami was the sole shareholder in the company, as well as the treasurer and bookkeeper, though both she and her husband had signature authority over Feedback’s bank account. They elected to have the company taxed as a small insurance company under section 831(b) of the tax code.

The Avrahamis argued they relied on the advice of McEntee, Hiller and Clark. “We have no doubt that all three were competent professionals with sufficient expertise,” the judge wrote. “McEntee is a CPA with more than 25 years of experience, Hiller is a reputable Phoenix-based estate planning attorney with more than 30 years of experience, and Clark is a New York lawyer with more than 35 years of experience who focuses her practice on small insurance companies. We also find that the Avrahamis provided their advisers with all the relevant data needed to assess the correct level of tax. The parties dispute, however, whether the Avrahamis actually relied in good faith on the advice of McEntee, Hiller and Clark.”

The judge agreed with the Avrahamis not to impose some accuracy-related penalties related to loans they made with the insurance company and another entity the family owned called Belly Button, but agreed with the IRS’s position on others. “Therefore the section 6662(a) penalties should not be imposed to the extent they are related to repayment of the $1.2 million loan,” the court wrote. “But there is no reasonable explanation for why any underpayment flowing from the failure to report $300,000 in interest and dividends for the overrepayment of that loan from Feedback should be penalized. The Avrahamis don’t even make that argument, so the Commissioner wins on this one. We also have the penalty related to the $200,000 distribution directly from Feedback to Mrs. Avrahami, which we held should have been reported as an ordinary dividend. The Avrahamis argue that this was an inadvertent omission caused by their accountant’s error. The Avrahamis, however, are sophisticated and successful business owners, and we find they acted at least in careless disregard of the Code in their treatment of this item.”

Ms. Avrahami declined to comment on the case when contacted by Accounting Today and said she wasn’t sure whether she and her husband would appeal the ruling. McEntee, Hiller and Clark did not immediately respond to requests for comment. An IRS spokesperson declined to comment, noting that federal law prohibits the IRS from commenting on any cases.

Reactions to Ruling

However, a former IRS commissioner, Steven T. Miller, who is now national director of tax at alliantgroup, a Washington, D.C.-based tax consulting firm, sees some significant repercussions from the case. “We start from the perspective that this was the first case invoking an 831(b) captive,” he told Accounting Today. “The IRS began its journey with respect to micro captives a few years ago. The IRS has been auditing many captives. The IRS put out at the end of 2016 a ‘transaction of interest’ notice in which they’re making people disclose if they have captives. There’s been a lot of friction in the industry between the captives industry and the IRS. This will be the first Tax Court case, and is really quite significant in terms of being the first real guidance coming out of the Tax Court.”

John Dies, managing director of tax controversy at alliantgroup’s Houston office, is an expert on captive insurance and believes the IRS scored a big victory. “In my judgment it’s a decisive win for the IRS,” he said. “The only aspect that the IRS didn’t have a clear win on was the penalties. They would have been substantial.”

However, the court pointed to the advice the Avrahamis received from Hiller and the others, along with the lack of clear guidance from the IRS. “The court mentioned that there was not guidance on this issue,” he said. “If you’re going to seek to penalize folks, first provide guidance on what compliance looks like.” He believes the penalties would have been much larger without those mitigating factors.

However, the precedent for other captive insurance cases may be limited. “It’s very specific to the facts of the case,” said Miller. “The court laid out the four factors to define what is and isn’t insurance. The court found there wasn’t good risk distribution. These types of captives require that the risk they have be shifted to a third party and be distributed across a number of people. The court said the latter didn’t happen. The court said you’re not operating as an insurance company and what you’ve done is not sufficient.”

Dies noted that the opinion was very colorful in terms of its discussion of the pricing of premiums, and the court attacked the way some of the distributions were being made, pointing out it didn’t conform to a model that was cited as being used by Chubb Insurance. Judge Holmes has two other cases involving captives that are being tried, and Dies expects rulings to be issued by the same judge that could provide further guidance on how the court will view captive insurance.

“The cases are all a little bit different,” said Miller. “It may be that the court will use the future cases to point out different issues.”

Risk shifting may be one issue where the rulings in the other cases may shed more light.

“That was one of the challenges of this ruling,” said Dies. “The IRS in comments they made to us were looking for a bright line from the court in terms of this issue. Instead the judge dove very deeply, but you don’t have that high-level guidance. There’s going to be considerable distance between the IRS and the taxpayers and their representatives.”

Miller believes the ruling will give the IRS a stronger hand. “There’s nothing in this opinion that will limit the IRS’s activity in any way,” he said. “If anything, it will embolden them.”

But he admitted it’s hard to say if the ruling will have a material impact on the captive insurance industry. “These were very specific facts and in some ways outlier facts,” said Miller. “I don’t know that the industry will overreact. I would expect it to be appealed. We’ll see what happens.”

“This court was very careful not to attack 831(b) captives,” said Dies. “The criticisms that the court urged really had to do with the analysis in the sense that other captives were created with another approach.”

Next IRS Commissioner

Accounting Today asked Miller, as a former IRS commissioner, about what direction the IRS might take in the future on the matter, once Commissioner John Koskinen’s term ends in November. He responded that these sorts of enforcement activities generally fall outside the day-to-day responsibilities of the IRS commissioner, although one former IRS commissioner who also now works for alliantgroup, Mark Everson, did get heavily involved in cracking down on LILO and SILO tax shelters.

“I would not expect a large wholesale change out of the new commissioner,” said Miller. “You never know, but it would surprise me about a material change.”

Miller declined to speculate on who the next commissioner might be and when the announcement might come. “There are rumors floating around, but they’re just rumors; nothing solid enough,” he said. “It could happen tomorrow. It’s going to be an interesting time.”

He thinks the next IRS commissioner is likely to be more occupied with other matters besides captive insurance, including tax reform and the attitude of Congress and the administration toward the IRS.

“A new commissioner is going to be worried about the budget, the upcoming filing season, and the impact of legislation on the organization,” he said.

Identity theft is also likely to continue to be a top priority for the next IRS commissioner, although Miller pointed to a recent report from the Treasury Inspector General for Tax Administration that found the IRS making progress on the issue, with the help of the tax preparation industry and preparer organizations.

In terms of the Avrahami case, however, he believes it represents a victory for the agency. “The case is clearly a win for the IRS, and the IRS will run with it,” said Miller. “But practitioners will argue correctly they’re limited to the facts in the Avrahami case.”

“My sense is that this case will increase the divide between the IRS and taxpayers,” said Dies. “I agree with Steve’s comment that the IRS is unlikely to back off seeking penalties.”

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