Avrahami v. Commissioner of Internal Revenue, 082117 FEDTAX, 17594-13

Docket Nº:17594-13, 18274-13
Opinion Judge:HOLMES, JUDGE:
Party Name:BENYAMIN AVRAHAMI AND ORNA AVRAHAMI, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent FEEDBACK INSURANCE COMPANY, LTD., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Tim A. Tarter and Kacie N.C. Dillon, for petitioners. Brandon A. Keim, Doreen M. Susi, Steven I. Josephy, and John W. Stevens, for respondent.
Case Date:August 21, 2017
Court:United States Tax Court
 
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149 T.C. No. 7

BENYAMIN AVRAHAMI AND ORNA AVRAHAMI, Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

FEEDBACK INSURANCE COMPANY, LTD., Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Nos. 17594-13, 18274-13

United States Tax Court

August 21, 2017

Ps claimed deductions under I.R.C. section 162 on their 2009 and 2010 tax returns for amounts paid by their passthrough entities to captive insurance company C wholly owned by PW and to off-shore company A which reinsured a portion of its risk with C. R denied the deductions and determined that C's elections under I.R.C. section 831(b) to be treated as a small insurance company and under I.R.C. section 953(d) to be taxed as a domestic corporation were invalid, as the amounts paid did not qualify as insurance premiums for federal income tax purposes. R also determined that amounts transferred out of C were distributions to Ps, not loans, and that Ps were liable for accuracy-related penalties under I.R.C. section 6662(a).

Held: Amounts paid to C and A are not insurance premiums for federal income tax purposes and are not deductible under I.R.C. section 162.

Held,

further, C's I.R.C. section 831(b) and section 953(d) elections are invalid for 2009 and 2010.

Held,

further, the amount transferred directly from C to PW is an ordinary dividend.

Held,

further, the amount transferred indirectly from C to Ps is not taxable to the extent it is a loan repayment, but the excess is either taxable interest or an ordinary dividend.

Held,

further, Ps are not liable for accuracy-related penalties under I.R.C. section 6662(a) except in relation to the amounts determined to be ordinary dividends or taxable interest.

Tim A. Tarter and Kacie N.C. Dillon, for petitioners. [*]

Brandon A. Keim, Doreen M. Susi, Steven I. Josephy, and John W. Stevens, for respondent.

HOLMES, JUDGE:

Benyamin and Orna Avrahami own three shopping centers and three thriving jewelry stores. In 2006 they spent a little more than $150, 000 insuring them. In 2009 this insurance bill soared to more than $1.1 million and it flew even higher, to more than $1.3 million, in 2010. The Avrahamis were paying the overwhelming share of these big bills to a new insurance company called Feedback that was wholly owned by Mrs. Avrahami. Yet there were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis' and their various entities' returns. With money flooding in and none going back out 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. 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.

FINDINGS OF FACT

A. The Avrahamis and Their Businesses

Benyamin Avrahami was born in Iran but was raised in Israel where his family fled religious persecution. He immigrated to the United States in 1974, went to college, and obtained degrees in both business administration and gemology as well as a real-estate license. He met and married Orna Avrahami, who was born and raised in Israel but moved to the United States in 1980. The couple now live near Phoenix, Arizona, and have three adult children.

In 1980 Mr. Avrahami decided to go into business with his brother, so he created American Findings Corporation (American Findings).1 As its name implies, American Findings started out as a supplier of findings--the components that go into finished pieces of jewelry including clasps, split-rings, solder, and settings for stones. A few years later, however, American Findings bought an existing but financially troubled jewelry store named London Gold and got out of the wholesale findings business. The Avrahamis are talented businesspeople. They turned London Gold around, and now American Findings (d.b.a. London Gold) operates--and operated during the years at issue in these cases--three successful retail jewelry stores that employ 35 people in the Phoenix metropolitan area.

In addition to their jewelry stores, the Avrahamis own several commercial real-estate companies. There are six involved in these cases: • BYS Company, ACC (BYS), 2 which owns and operates a retail shopping center in Tempe, Arizona;

• Chandler One, LLC (Chandler One), [3] which owns a commercial building in Chandler, Arizona, and leases the space to three tenants--one of the jewelry stores owned by American Findings, a vitamin store, and a wireless carrier;

• Junction Development, LLC (Junction Development), which is in Scottsdale, Arizona, and leases space to another of the jewelry stores owned by American Findings;

• O & E Corporation (O&E), [4] which owns a shopping center in Phoenix, Arizona;

• White Mountain Equities, L.L.C. (White Mountain), 5 which owns land in Show Low, Arizona; and

• White Knight Investment, A.C.C. (White Knight), 6 which owns a large commercial strip mall in Tempe, Arizona, and leases the space to several tenants including a charter school.

While the Avrahamis are consulted on major decisions like new tenants and costly repairs, they hire out the responsibility for the day-to-day operations of Chandler One, O&E, and White Knight to a management company. In 2006 American Findings, Chandler One, O&E, and White Knight (collectively, Avrahami entities) deducted a combined total of a little more than $150, 000 in insurance expenses.

B. The Advisers

By 2007 the Avrahami entities were flourishing and the Avrahamis were in need of some advice. They turned to Craig McEntee, who had been their trusted CPA for about 25 years. Upon McEntee's recommendation, the Avrahamis retained Neil Hiller for some estate-planning services. Hiller is a Phoenix-based lawyer who practices in estate planning, employee benefits, and tax.

Around the same time, McEntee also suggested that a captive insurance company might be a good fit for the Avrahamis and recommended that they consult Celia Clark. Clark, who graduated from a well-regarded law school in the Midwest, but who has lived and worked in New York for many years, focuses her practice on tax, trusts, and estate planning. She is the founding partner of Clark & Gentry, PLLC, which was formerly known as the Law Offices of Celia R. Clark, PLLC.7 Clark first got interested in captive insurance companies in 2002, and her practice grew from there. In 2006 she helped draft captive-insurance legislation for the dual-island Caribbean nation of Saint Christopher and Nevis (St. Kitts). Clark had more than 50 captive insurance clients in St. Kitts by 2007 and more than 75 by 2008. Today a large part of Clark's practice is the formation and maintenance of such insurance companies.

Before moving forward with Clark, the Avrahamis told Hiller they were considering forming a captive insurance company and asked for his advice. Hiller discussed the idea with the Avrahamis and recommended that they hire Clark, whom he had previously worked with on another captive insurance company matter. The Avrahamis therefore gave the green light for Clark to start reviewing information about their various businesses--to be provided by Hiller and McEntee--and to determine what sort of captive insurance company might work for them. Then, in November 2007, the Avrahamis signed a retainer agreement with Clark in which they agreed that Clark and Hiller would act as co-counsel and provide all legal services relating to the start-up of a captive insurance company in exchange for $75, 000. This agreement eventually led to the formation of the Avrahamis' captive insurance company--Feedback Insurance Company, Ltd. (Feedback).

C. Feedback

Feedback was incorporated in St. Kitts in November 2007. Mrs. Avrahami was its sole shareholder as well as its treasurer and bookkeeper, though both Avrahamis had signature authority over Feedback's bank account. Feedback also hired a St. Kitts company called Heritor Management, Ltd. (Heritor), to assist with general management, monitor compliance with Kittian regulations, apply for licenses, and process claims. Heritor is owned by Robin Trevors. Before the end of 2007, Feedback applied for and received authorization from St. Kitts to "conduct small group captive insurance business" under the St. Kitts 2006 Captive Insurance Companies Act. In 2008 it also made two elections. The first--filed by Clark on Feedback's behalf--was an election under section 953(d) to be treated as a domestic corporation for federal income tax purposes, which was approved by the IRS. And the second--filed with its 2007 income tax return--was an election to be taxed as a small insurance company under section 831(b).

1. 2007 and 2008

In its first two years of operation--2007 and 2008, which are not before us in these cases--Feedback sold property and casualty insurance policies to various entities owned by the Avrahamis. In 2007 these included American Findings, BYS, Chandler One, O&E, White Mountain, and White Knight, but in 2008 only Chandler One, O&E, and White Knight. Feedback also entered into a cross-insurance program to reinsure terrorism insurance for other small captive insurers through a risk-distribution pool set up by Clark exclusively for clients of her firm.

2. 2009 and 2010

In 2009 and 2010--the years at issue in these cases--Feedback continued to sell policies to entities owned by the Avrahamis and to reinsure terrorism polices through one of Clark's...

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