In United States v. Stein, the Eleventh Circuit recently decided a novel – but critical – issue for taxpayers.  It held that an affidavit that satisfies Rule 56 of the Federal Rules of Civil Procedure (the summary judgment rule) may create an issue of material fact precluding summary judgment, even if it is self-serving and uncorroborated.  The case centered around an IRS assessment.  IRS assessments are entitled to a presumption of correctness, which can be a difficult burden for taxpayers to overcome.

In 2015, the government sued Estelle Stein for outstanding tax assessments, late penalties, and interest for the 1996 and 1999-2002 tax years.  The government moved for summary judgment and tried to show that Ms. Stein had outstanding tax assessments by submitting her federal tax returns, account transcripts, and an affidavit from an IRS officer.  Ms. Stein responded with her own affidavit, stating that, “to the best of [her] recollection,” she had paid the taxes and penalties at issue.  Her affidavit also explained that she used an accounting firm to file the tax returns, that she remembered paying the taxes and penalties due, but that she did not have bank statements showing these payments.

The district court granted summary judgment for the government because, it explained, Ms. Stein did not produce any evidence documenting payments.  An Eleventh Circuit panel affirmed based on Mays v. United States, 763 F.2d 1295 (11th Cir. 1985).  In Mays, the court affirmed summary judgment for the government, holding that a taxpayer in a refund suit must not only show the government’s assessment is wrong, but also establish the “correct amount of the refund due.”  Mays further held that the taxpayer’s claim “must be substantiated by something other than tax returns, uncorroborated oral testimony, or self-serving statements.”

The Eleventh Circuit sitting en banc in Stein, however, disagreed and overruled Mays “to the extent it holds or suggests that self-serving and uncorroborated statements in a taxpayer’s affidavit cannot create an issue of material fact with respect to the correctness of the government’s assessment.”  Under Rule 56(a), summary judgment may be granted only when “there is no genuine dispute as to any material fact” and the moving party is “entitled to judgment as a matter of law.”  The Eleventh Circuit further held that nothing in the Federal Rules of Civil Procedure prohibit an affidavit from being self-serving.

Stein is a significant win for taxpayers, and it may make it easier for taxpayers to overcome the presumption of correctness that IRS assessments have enjoyed.

The Internal Revenue Code requires employers to withhold certain taxes in “a special fund in trust for the United States” (sec. 7501(a)). IRS regulations require employers to pay these trust fund taxes to the IRS quarterly. Employers who fail to pay withheld taxes to the government are personally liable for the taxes under section 6672 of the Code. In general, the government can recover unpaid taxes if (1) the employer is responsible for collecting and paying withholding taxes, and (2) the individual willfully failed to collect and pay the withholding taxes. What is key is that the IRS can recover from any responsible person, not necessarily the most responsible person.

The trust fund recovery penalty is often a trap for the unwary, including for partners and shareholders of law firms, as illustrated by Spizz v. United States, 120 A.F.T.R. 2d 2017-6719 (S.D.N.Y. Dec. 4, 2017). Spizz and Todtman were shareholders of the law firm Todtman, Nachamie, Spizz & Johns, P.C., from 2009 through September 2012. The court in Spizz held that the government could hold Spizz and Todtman personally liable for the trust fund taxes the firm failed to pay between 2009 and 2012. Despite the fact that the firm was going through serious financial difficulty, the court held that both shareholders were personally liable for the trust fund taxes.

Responsible Persons

The court first turned to whether Todtman and Spizz were “responsible persons” for the firm’s payment of trust fund taxes. The court stated that the payment issue depended on whether, given the individual’s authority over the company’s financial operations, the individual could have prevented the tax delinquency.

The court found that both Todtman and Spizz were responsible persons. Todtman founded the firm, served as its president while holding one-third ownership during the relevant periods and exercised authority over the firm’s finances. Although Spizz did not make financial decisions to the same extent as Todtman, the court stated that the “inquiry focuses on whether an individual could have exerted influence” to avoid tax delinquency. The court found that Spizz was also a responsible person because he held one-third of the firm’s shares and was its vice president.

Willfulness

The second element of tax payment liability under section 6672 is willfulness. A person willfully fails to pay withholding taxes if payment is made to other creditors while knowing that withholding taxes are due. The court found that Todtman was aware of the firm’s responsibility to pay trust fund taxes, and that the firm was paying other creditors before the IRS. While the trust fund taxes were still due, Todtman signed checks on behalf of the firm to disburse funds for payroll and payments to creditors.

The court also held that Spizz willfully failed to remit trust fund taxes. Although he did not learn of the firm’s tax liability until June 2010, he failed to apply the firm’s unencumbered assets to the firm’s tax liability when he found out about it. The court held that this was sufficient to establish willfulness for the pre-June 2010 period. After June 2010, when Spizz became aware of the firm’s tax liability, the court held that he could no longer maintain a reasonable belief that other members of the firm would timely pay its trust fund taxes. Thus, Spizz could not claim that he did not willfully withhold trust fund taxes.

In Mission Funding Alpha, the Pennsylvania Supreme Court recently held that the statute of limitations for a corporation to file a refund claim in Pennsylvania begins to run when the corporate tax return is due, not when the return is actually filed.

Background

The issue before the Pennsylvania Supreme Court was whether the three-year statute of limitations for a corporate taxpayer to file a refund claim begins when the tax is paid or when the annual return is filed.  Corporations like Mission Funding Alpha that are subject to franchise taxes must pay estimated taxes at the end of every quarter.  Any remaining franchise tax liability must be paid when the corporation files its annual return.  If the corporation overpays its estimated taxes, it may file a refund claim.  The refund claim, however, must be made within three years of “the actual payment of the tax.”

Mission Funding Alpha filed its Pennsylvania franchise tax return on September 19, 2008 – after the due date.  It overpaid its estimated franchise taxes, however, so on September 16, 2011, Mission Funding Alpha filed a claim for refund with the Pennsylvania Board of Appeals.  The Board of Appeals, however, dismissed the claim as untimely because it was filed more than three years after April 15, 2008, the due date for the return.  Mission Funding Alpha appealed, arguing that the statute of limitations is three years from the date the return is filed.

Commonwealth Court Decision

The Commonwealth Court agreed with Mission Funding Alpha.  The court held that whether a refund claim is timely depends on the meaning of “the actual payment of tax.”  It explained that “the common and approved usage of the phrase ‘actual payment’ means the delivering of money in the acceptance and performance of an obligation.”  The court noted that corporations must pay estimated taxes and make final payments of taxes due with their annual corporate returns.  According to the court, a corporate taxpayer makes its “final” tax payment only when it files its annual return.  Thus, the court reasoned that a corporation’s franchise tax liability is not established until it files its annual return and “the actual payment of the tax” does not happen until the annual return is filed.

Supreme Court Decision

The Pennsylvania Supreme Court disagreed and reversed the Commonwealth Court.  The Court explained that “the actual payment of the tax” happened on April 15, 2008, the date the tax was due and payable, and when the Pennsylvania Department of Revenue accepted Mission Funding Alpha’s estimated payments and credits for its 2007 liability.  Importantly, the Court also held that, when a return is filed late, the triggering event for determining when the statute of limitations begins to run for a refund claim is not when the return is filed.  Thus, the Court concluded that Mission Funding Alpha’s refund claim was not timely because the three-year refund period ended before the claim was filed on September 16, 2011.

Consequences

As a result of the Pennsylvania Supreme Court’s decision, the statute of limitations for refund claims in Pennsylvania is significantly different than many other states.

We have all heard the old proverb “if it’s too good to be true, then it probably is.” In the tax world, this proverb might as well be referred to as the economic substance doctrine. Generally, taxpayers are free to structure their business transactions in a manner of their choosing. However, the economic substance doctrine permits a court to disregard a transaction for Federal income tax purposes if the transaction has no effect other than generating an income tax loss.  In the case of Smith v. Commissioner, T.C. Memo. 2017-218, the taxpayers violated this doctrine by trying to transform cash and securities into a loss through a series of transfers involving an S corporation and a limited partnership.

The Plan

In Smith v. Commissioner, Mr. Smith retired from National Coupling in 2009. Upon retirement, he received a bonus and total employee compensation of approximately $664,000. Mr. Smith’s financial adviser referred him to a tax and estate planning attorney (who was also a CPA) for tax planning services. With the intention of offsetting the compensation income Mr. Smith received from National Coupling, the attorney recommended the following tax planning structure:

  • In 2009, Mr. Smith and his wife (the “taxpayers”) would create an S corporation (wholly owned by the taxpayers) and a family limited partnership.
  • The S corporation (along with a management company) would own the family limited partnership.
  • The taxpayers would transfer cash and marketable securities to the S corporation. The S corporation, in turn, would immediately transfer the cash and marketable securities to the family limited partnership.
  • The S corporation would dissolve in 2009 (the same year it was created). Upon dissolution, the S corporation would distribute limited partnership interests in the family limited partnership to the taxpayers.
  • The fair market value of the distributed partnership interests would be discounted for lack of marketability and lack of control, generating a tax loss equal to the difference between the fair market value of the discounted partnership interests that were distributed over the cash and marketable securities the S corporation transferred to the family limited partnership.

The taxpayers agreed to the structure, and in 2009 they transferred a total of approximately $1.8 million in cash and marketable securities to a newly formed S corporation. The S corporation transferred an approximately equal amount to the newly created family limited partnership. At the end of 2009, the taxpayers and the attorney dissolved the S corporation. In the dissolution, the S corporation transferred a 49% limited partnership interest to each Mr. and Mrs. Smith. The attorney determined that the fair market value of the distributed partnership interests were approximately $1.1 million after discounting the value for lack of marketability and lack of control. The S corporation reported a loss of approximately $700,000 ($1.1 million in gross receipts (equal to the discounted value of the distributed partnership interests) less $1.8 million cost of goods sold (equal to the cash and marketable securities transferred to the family limited partnership)).

The Problem

The S corporation did not have any business activity whatsoever. It did not have a bank account, did not issue stock certificates, did not keep minutes of meetings, and did not follow corporate formalities. The S corporation existed solely to generate an artificial tax loss to offset Mr. Smith’s income. Consequently, the Court determined that the economic substance doctrine prevented the taxpayers from claiming the loss.

The Kicker

The IRS also asserted that the taxpayers were liable for a $125,000 accuracy-related penalty for a substantial understatement of tax. Taxpayers have a defense to accuracy-related penalties for reasonable reliance on the advice of a tax professional if they can prove three elements: (1) the taxpayer reasonably believed that the professional was a competent adviser with sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Further, due care does not require that the taxpayer challenge his or her attorney’s advice or independently investigate its propriety. Surely, the taxpayers would be able to establish that they reasonably relied on the faulty advice of their attorney, right? The Court determined that the taxpayers proved the first two elements of the defense, but not the third. What was the taxpayers’ fatal flaw? The Court thought they lied during trial. In the Court’s own words:

“They understood, early in the process, that [the S corporation] would be organized and dissolved in 2009 but continued to represent, even at trial, that [the S corporation] had a business purpose. This is not acting in good faith. They knew from the beginning that [the S corporation] would not last past 2009, it did not have a genuine business purpose, and its sole purpose was tax avoidance. That knowledge alone negates a reliance defense.”

Consequently, the Court determined that the taxpayers were liable for the accuracy-related penalty.

We highly recommend that taxpayers understand every aspect of transactions they enter into, especially when targeted to tax planning.  If a proposal seems too complicated or if you can’t make sense of something, get a second opinion, or…RUN!

Tax Court

The issue before the Tax Court in Huzella v. Commissioner, T.C. Memo. 2017-210, centered around a coin business on eBay, and whether the petitioner, Thomas Huzella, could substantiate his cost of goods sold and expense deductions for his business.

The petitioner had been collecting coins as far back as 1958.  The problem was that the petitioner did not keep records to establish the basis in any of his coins.  In 2013, the petitioner actively bought and sold coins on eBay and was paid through PayPal.  PayPal issued the petitioner a Form 1099-K, Payment Card and Third Party Network Transactions, which reflected the payments he received from PayPal.  The petitioner earned $37,000 from almost 400 separate transactions in 2013.  But he also incurred eBay fees and Paypal fees, as well as packaging and shipping costs.

When he filed his tax return, the petitioner did not report anything on his Schedule C, and the IRS audited his return and issued a notice of deficiency.  The IRS alleged that the petitioner had unreported income of $37,000 from his eBay business and asserted penalties.  At trial, the IRS conceded that the petitioner was engaged in a trade or business in 2013.  The IRS also conceded that the petitioner was entitled to deduct the eBay and PayPal fees, and the Tax Court held that he was entitled to deduct $700 of postage and packaging costs.  The petitioner conceded that he earned – but did not report – gross proceeds of $37,000 from his eBay business.

The court then turned to the cost of goods sold issue.  Taxpayers are required to substantiate any amount they claim as cost of goods sold, and they must maintain sufficient records.  If a taxpayer with insufficient records, however, proves he incurred expenses but cannot substantiate the exact amount, the Tax Court may, in certain circumstances, estimate the amount.

Here, the Tax Court (and the petitioner) relied on the Cohan decision.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).  In that case, the taxpayer was an actor, playwright, and producer who spent large sums travelling and entertaining actors, employees, and critics.  Although Cohan did not keep a record of his spending on travel and entertainment, he estimated that he incurred $55,000 in expenses over several years.

The Board of Tax Appeals, now the Tax Court, disallowed these deductions in full based on Cohan’s lack of supporting documentation.  On appeal, however, the Second Circuit concluded that Cohan’s testimony established that legitimate deductible expenses had been incurred, holding that “the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”  The Cohan rule has been followed by the Tax Court and other federal courts in numerous decisions.

The petitioner in Huzella did not have any records to establish his cost or bases in the coins.  He purchased some coins and inherited others.  But the Tax Court relied on Cohan and, after evaluating the evidence and the petitioner’s testimony, held that the petitioner could substantiate a cost of goods sold of $12,000.  Thus, the petitioner had taxable income of just under $20,600 (gross receipts of $37,000, less cost of goods sold and deductions).

Today, the Tax Court issued its opinion in Feinberg v. Commissioner, a case involving an ongoing and hard fought battle between the IRS and a medical marijuana dispensary, Total Health Concepts, LLC.  The IRS examined THC’s 2009 through 2011 tax returns.  As a result of the examination, the IRS adjusted the member taxpayers’ returns to reflect a cost of goods sold allowance in excess of the amount originally claimed on the return by reclassifying expenses that were originally claimed as below-the-line expenses.  However, the IRS also disallowed expenses not reclassified as cost of goods sold.  Accordingly, the IRS computed deficiencies on the member’s individual tax returns.

During earlier phases of this case, the taxpayer argued that the Commissioner did not have jurisdiction to administratively determine whether petitioners committed a federal crime outside of the U.S. tax code, that section 280E as applied by the Commissioner is unconstitutional as it violates petitioners rights against self-incrimination under the Fifth Amendment of the Constitution, and that section 280E exceeds the authority granted to Congress under the Sixteenth Amendment of the Constitution.  The Tax Court denied the taxpayer’s request for summary judgment and compelled them to respond to IRS discovery requests.  The taxpayer’s sought a writ of mandamus, seeking review of the Tax Court’s order compelling them to produce documents.  The Tenth Circuit determined that if the discovery request harmed them, the proper time to address that harm would be after the Tax Court case was fully resolved.  As a result, the taxpayer’s case proceeded to trial.

At trial, the taxpayer did not submit documentation to substantiate the cost of goods sold allowance or the ordinary and necessary business expenses.  Instead, an expert report was submitted to substantiate a cost of goods sold allowance in excess of what the IRS allowed during the examination.  The Tax Court ruled that the expert report was unreliable because it contained statements which failed to refer to underlying source information, failed to include underlying source information which the expert relied upon, and failed to include sufficient information and data to support the report’s conclusions.  As a result, the expert report was inadmissible.

Next, the court looked to evidence which would support a higher cost of goods sold allowance than the allowance determined in the IRS report.  Without documentation, the court concluded that the IRS determination of cost of goods sold would stand.  Further, because there was no substantiation of ordinary and necessary business expenses claimed under Section 162, the court determined that it did not need to address the application of Section 280E (the code section which disallows ordinary and necessary business deductions for businesses trafficking in controlled substances).

What is the lesson here?  This case provides no guidance on the limits that will be applied to cannabis companies in determining cost of goods sold.  Rather, this case tells us that a cannabis company should prepare for an IRS examination the same way any other taxpayer should, by maintaining documentation to support the deductions claimed on the return and by provided that documentation when the IRS requests it.  This is especially true in this case, where the court determined that “there was not enough evidence in the record to make a finding of fact that THC sold medical marijuana.”  Based on this statement, if the taxpayer would have substantiated its below-the-line expenses, they would not have been subject to Section 280E, which would have been a huge win for the taxpayer.

TIGTA recently released a report discusses their audit of the IRS’s estate and gift tax examination procedures.  TIGTA made eight recommendations of changes to the estate and gift tax examination process.  The bulk of TIGTA’s recommendations address the informal processes, lack of consistency, and unknown effectiveness of the estate and gift tax examination procedures.

One of the more significant findings of the report is that while the examination division proposed over $577 million of estate and gift tax deficiencies for FY 2016, only $98 million of those deficiencies were sustained after cases were considered by IRS Appeals.  The Examination division attributed this statistic to the fact that the Examination division proposes alternative deficiencies in order to prevent being whipsawed.  However, the Examination division could not separately identify the amount of deficiencies that were attributable to these alternative positions.  TIGTA highlighted that the Government could be subject to suits for attorneys’ fees pursuant to Section 7430 if the positions set forth in the notices of deficiency were not substantially justified.  TIGTA recommended that Examination division develop written guidance “on the circumstances in which it is advisable to propose and issue notices of deficiency in estate and gift tax examinations that contain alternative positions.”

Other highlights from the report include:

  • there is one gatekeeper who decides whether or not to route a case for examination and how to prioritize cases;
  • there is no quality review process;
  • unlike the process for selecting income tax returns for examination, the process of selecting estate and gift tax examinations for examination is based minimal written guidance and involves almost no objective procedures, but instead relies on human involvement and judgment; and
  • procedures for documenting case selection, examination documentation and managerial review either did not exist or if they did exist were not followed as closely as they should be.

TIGTA’s report can be accessed here.

The President has declared a major disaster in the State of Texas. The declaration permits the IRS to postpone certain deadlines for taxpayers who reside or have a business in the disaster area.

Individuals who reside or have a business in the following counties may qualify for tax relief: Aransas, Austin, Batrop, Bee, Brazoria, Calhoun, Chambers, Colorado, DeWitt, Fayette, Fort Bend, Galveston, Goliad, Gonzales, Hardin, Harris, Jackson, Jasper, Jefferson, Karnes, Kleberg, Lavaca, Lee, Liberty, Matagorda, Montgomery, Newton, Nueces, Orange, Polk, Refugio, Sabine, San Jacinto, San Patricio, Tyler, Victoria, Walker, Waller and Wharton.

Taxpayers not in the covered disaster area, but whose records necessary to meet a deadline are in the disaster area are also entitled to relief. In addition, all relief workers affiliated with a recognized government or philanthropic organization assisting in the relief activities in the disaster area and any individual visiting the covered disaster area who was killed or injured as a result of the disaster are entitled to relief.

The IRS gives the affected taxpayers until January 30, 2018 to file most tax returns (including individual, corporate, and estate and trust income tax returns; partnership returns, S corporation returns, and trust returns; estate, gift, and generation-skipping transfer tax returns; and employment and certain excise tax returns), that have either an original or extended due date occurring on or after August 23, 2017, and before January 31, 2018. This includes taxpayers who had a valid extension to file their 2016 return that was due to run out on October 16, 2017. It also includes the quarterly estimated income tax payments originally due on September 15, 2017 and January 16, 2018, and the quarterly payroll and excise tax returns normally due on October 31, 2017. In addition, penalties on payroll and excise tax deposits due on or after August 23, 2017, and before September 7, 2017, will be abated as long as the deposits were made by September 7, 2017.

If an affected taxpayer receives a late filing or late payment penalty notice from the IRS that has an original or extended filing, payment or deposit due date that falls within the postponement period, the taxpayer should call the telephone number on the notice to have the IRS abate the penalty.

Casualty Losses

Affected taxpayers in a federally declared disaster area have the option of claiming disaster-related casualty losses on their federal income tax return for either the year in which the event occurred, or the prior year. Individuals may deduct personal property losses that are not covered by insurance or other reimbursements.

August brought three wins for taxpayers who donated conservation easements that were challenged by the IRS.  In all of the cases, terms of the conservation easement deed document carried the day. 

  • In BC Ranch II, L.P. v. Comm’r, No. 16-60068, 2017 BL 282040 (5th Cir. Aug. 11, 2017), the Fifth Circuit overturned a Tax Court decision finding that an easement deed allowing for small boundary adjustments violated the perpetuity requirement of Section 170(h)(2)(C).  The perpetuity requirement provides that, in order to qualify for a charitable contribution deduction for a conservation easement donation, a taxpayer must restrict, in perpetuity, the use which may be made of the real property.  The Fifth Circuit held that the Tax Court’s reliance in Belk  v. Comm’r, 140 T.C 1 (2013), aff’d 774 F.3d 2210 (4th Cir. 2014), to hold that the conservation easement restrictions violated the perpetuity requirement was misplaced because Belk involved a provision where the easement land could be substituted in its entirety for a new parcel of land.  The Fifth Circuit looked at similar cases where small adjustments to the easement were permitted to promote the underlying conservation purpose.  Because that was the case here, the court found that the perpetuity requirement was met.  Addressing the IRS alternative theory that the partners entered into disguised sales for partnership property, the court also determined that the portions of capital contributions made by partners, other than those attributable to the parcels that were distributed to them, were not disguised sales of partnership assets.  
  • Next, in 310 Retail, LLC, v. Comm’r, T.C. Memo 2017-164, and Big River Development, L.P. v. Comm’r, T.C. Memo 2017-166, the Tax Court held that the conservation easement deeds at issue met the contemporary written acknowledgement requirement set forth in Section 170(f)(8)(B).  The contemporary written acknowledgement provision requires that, in order to claim a charitable contribution deduction, the donor is required to obtain from the charity a written statement that describes the donation, states whether the charity provides goods and services in exchange for the donation, and, if goods and services were provided, the fair market value of those goods and service.  This documentation must be obtained before the earlier of the due date of the return or the date the return in filed.  In both cases, the donor did not obtain from the charity separate documentation that is traditionally sent to donees with this specific language.  However, because the conservation easement deeds contained language discussing the consideration given and stating that the deed was the complete agreement of the parties (known as a merger clause), the deed itself acknowledged that the charity did not provide goods and services to the donor and therefore satisfied the contemporaneous written acknowledgement requirements. 
  • In all three cases, while the taxpayers now presumably have established the right to claim the charitable contribution deduction, the next step of determining the value of the conservation easement will be a separate battle.

The Tax Court has issued its long-awaited decision addressing captive insurance arrangements. In Avrahami v. Commissioner, 149 T.C. No. 7 (2017), the Tax Court held that payments made from a number of businesses owned by the Avrahamis to a microcaptive insurance company that was wholly-owned by Mrs. Avrahami were not for “insurance,” and thus were not deductible as insurance premiums paid. Here is what you need to know.

Captive Insurance Generally

Amounts paid for insurance are deductible as ordinary and necessary business expenses. Insurance companies are generally taxed on the insurance premiums they receive. However, small insurance companies that satisfy certain requirements are eligible to make a section 831(b) election, in which case they are only taxed on their taxable investment income (which does not include premiums received). For 2009 and 2010, an insurance company other than a life insurance company that had written premiums that did not exceed $1.2 million could elect to be taxed under section 831(b) as long as they met all other requirements.

A pure captive insurance company is one that only insures the risks of companies related to it by ownership. A captive insurance company that is eligible to make a section 831(b) election (referred to as a “microcaptive”) does not pay tax on the premiums it receives. Thus, if a business owner creates a microcaptive that insures only the risks of the business owner’s business, the business is able to deduct up to $1.2 million for insurance premiums paid to the related microcaptive while the microcaptive does not pay tax on the premiums received. However, the premiums are only deductible if the payments are for “insurance,” which begs the question: what is “insurance”? This is the question Avrahami addressed in the context of payments made to microcaptives.

Case Background

The Avrahamis owned jewelry stores and commercial real estate companies (the “Avrahami Entities”). In November 2007, they created an insurance company (the “Captive”) to insure the risks of the Avrahami entities. The Captive was wholly-owned by Mrs. Avrahami. In 2009 and 2010 – the years at issue in this case – the Avrahami entities paid the Captive premiums for direct insurance policies of approximately $730,000 and $810,000, respectively, for policies covering seven types of risk including: administrative actions, business risk indemnity, business income protection, employee fidelity, litigation expense, loss of key employee, and tax indemnity. In addition to its direct policies, the Captive participated in a risk distribution program with other small captive insurance companies through Pan American. Through Pan American’s risk distribution program, the Avrahami Entities paid approximately $360,000 to Pan American for terrorism coverage only. Pan American then reinsured all of the risk it had assumed and would make sure that the Captive received reinsurance premiums equal to the amount paid by the Avrahami Entities to Pan American ($360,000), and in exchange the Captive would reinsure a small percentage of Pan American’s total losses. In total, the Avrahamis deducted approximately $1.1 million and $1.3 million in 2009 and 2010, respectively, for insurance premiums paid from the Avrahami Entities to the Captive or Pan American for both direct policies and for the terrorism coverage obtained through the risk distribution program. Only the Avrahami Entities were covered by the direct policies while over 100 insureds were included in the risk distribution program.

The IRS argued that neither the Captive nor Pan American sold “insurance”, meaning the premiums paid by the Avrahami Entities were not deductible as ordinary and necessary business expenses. The Tax Court agreed.

The Court’s Analysis

To be considered insurance, the arrangement must: (1) involve risk-shifting; (2) involve risk-distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance. The Tax Court analyzed only two of these elements: risk distribution and commonly accepted notions of insurance.

Risk distribution occurs when the insurer pools a large enough collection of unrelated risks. The Tax Court looked to the number of companies the Captive insured and the “number of independent risk exposures” (i.e., how many policies does the Captive issue and what do those policies cover). Ultimately, the Court determined that insuring 3 companies in 2009 and 4 in 2010, issuing 7 direct policies that covered 3 jewelry stores, 3 commercial real estate companies, 2 key employees, and 35 other employees did not cover a sufficient number of risk exposures to achieve risk distribution through the affiliated entities. The Court distinguished the facts present in this case from other cases where they have determined that insurers adequately distributed risk.

The Avrahamis argued that they adequately distributed risk because, in addition to the Captive insuring the Avrahami Entities, the Captive participated in the Pan American risk distribution program and reinsured third-party risk. The Court determined that Pan American was not a bona fide insurance company in the first place, meaning the policies it issued were not “insurance” and the Captive could not have distributed risk by reinsuring policies that were not insurance to begin with. The Court looked to a number of factors to determine whether Pan American was a bona fide insurance company, ultimately concluding that it was not for the following reasons:

  • There was a circular flow of funds. Avrahami Entities paid Pan American, Pan American turned around and reinsured all of the risk it had assumed, making sure that the Captive received reinsurance premiums equal to those paid by the Avrahami Entities. Thus, money was effectively transferred from an entity owned by the Avrahamis (one of the Avrahami Entities) to an entity wholly-owned by Mrs. Avrahami (the Captive).
  • The premiums charged for terrorism coverage were “grossly excessive”. The only policy Pan American issued was for terrorism coverage, and the policy was worded in a way that it was highly unlikely that the triggering event would ever occur.
  • Pan American charged high premiums for an event that was unlikely to ever occur (and had never occurred in the past), and if the event did occur Pan American may have not been able to pay the claims.
  • Because the risk distribution program was not recognized by the Court, when the Court reviewed the direct policies it determined that on a stand-alone basis they also did not adequately distribute risk because the direct policies only covered the Avrahami Entities and the combination of risks and entities covered by the direct policies did not distribute risk among an adequate number of independent insurance risks.

For these reasons, the Court concluded that the Captive did not adequately distribute risk.

The Tax Court then analyzed whether the Captive met commonly accepted notions of insurance, which required the Court to work through a number of factors. The Court determined that the Captive was not selling insurance in the commonly accepted sense. The Court explained:

  • The Captive did not operate like an insurance company. No claims were filed until the IRS began its audit. The Captive only invested in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them.
  • The Captive returned substantial portions of its surpluses to the insureds and owners of the insured through various loans and distributions.
  • The Captive policies were questionable because they were unclear and contradictory.
  • The Captive charged unreasonable premiums even though an actuary priced the policies. The Court did not find the actuary’s pricing methodology at all persuasive, noting that the actuary consistently chose inputs that would generate higher premiums. The Court noted that before creating the Captive, the Avrahami Entities paid $150,000 for commercial insurance policies. After creating the Captive, the Avrahami Entities paid $1.1 million and $1.3 million in 2009 and 2010, and paid $90,000 for a commercial insurance policy.

As a result, the Court concluded that payments made from the Avrahami Entities to the Captive and Pan American were not for insurance, and thus were not deductible as ordinary and necessary business expenses.

It is worth noting that the Captive was incorporated under the laws of the Caribbean nation of Saint Christopher and Nevis (St. Kitts). The Captive made a section 953(d) election to be treated as a domestic corporation for federal income tax purposes, and also made an election to be taxed as a small insurance company under section 831(b). However, since the Captive’s policies were not for “insurance”, both elections were invalid, and it was thus treated as a foreign corporation for federal income tax purposes. The parties stipulated that the taxable premiums earned by the Captive were not subject to U.S. Federal income tax.

Impact on Continuing IRS Scrutiny of Captive Insurance Arrangements

For several years, the IRS has devoted significant resources to examinations of captive insurance arrangements and numerous cases are the subject of Tax Court petitions.  There are several cases pending in the Tax Court post-trial.  The IRS increased its scrutiny of microcaptives when it issued Notice 2016-66, requiring self-reporting by taxpayers engaging in captive insurance arrangements where there has been a low incidence of claims or where significant loans have been made to related parties. In light of the Avrahami decision, the IRS is likely to continue devoting resources to scrutinizing and challenging captive insurance arrangements it believes are abusive.