A husband and wife who paid $1.54 million in premiums to their captive insurance company and $720,000 in premiums to another insurer over two years, almost all of which ended up back in their bank accounts, have had their tax deductions for those payments disallowed in a lengthy opinion by the United States Tax Court.
The couple, Benyamin and Orna Avrahami, own a set of businesses and commercial properties in the Phoenix, Arizona area. In 2007, they set up a captive insurance company called Feedback, incorporated in St. Kitts and for which they elected treatment as a small insurance company under Internal Revenue Code section 831(b). While their total insurance expense in the year before they set up Feedback was $150,000, the Avrahamis’ businesses paid Feedback insurance premiums of $730,000 in 2009 and $810,00 in 2010. One of those businesses also paid Pan American Reinsurance Company $360,000 in both years for terrorism risk insurance, while Feedback participated in a “risk distribution program,” under which Pan American paid Feedback $360,000 in both years. The Avrahamis then deducted all of these premiums—$1.09 million in 2019 and $1.17 million in 2010—as business expenses.
The IRS began an audit of the Avrahamis in 2012, ultimately disallowing their deductions for insurance expenses paid to Feedback and Pan American. The IRS took the position that the payments to Feedback and Pan American were not actually insurance premiums, and the Tax Court agreed. The court found that Feedback did not meet the essential insurance characteristic of distributing risk because it only issued 7 policies insuring 3 stores, had 2 key employees, 35 other employees, and 3 commercial properties, all in the Phoenix area, in the relevant years. Feedback’s purported reinsurance relationship with Pan American did not help to distribute that risk, the court found, because Pan American was not a bona fide insurance company. The Court based this on its findings that: (1) the premiums Pan American charged were “grossly excessive” when compared with what was available on the market—particularly when the Avrahamis’ own witness could not identify a single event in history to which its terrorism insurance would provide coverage; (2) Pan American distributed virtually all of the premiums it received back to its policyholders or related entities; and (3) it was unlikely that it could actually pay claims if they arose. The court also found that Feedback did not operate like an insurance company—it issued policies with unclear and contradictory terms, paid no claims until the IRS began its audit, unreasonably invested the premiums in unsecured loans to related parties, and charged “utterly unreasonable” premiums—and thus the premiums paid to it were not actually for insurance.
As a result, the court sustained the IRS’s finding that the Avrahami’s could not deduct the premiums they paid to Feedback and Pan American. However, the court found that these disallowed deductions did not justify imposing penalties on the Avrahamis, despite the fact that much of the advice they received was from an attorney who qualified as a promoter of these transactions, because, in setting up Feedback and taking those deductions, they also reasonably relied on the advice of another attorney who was not a promoter. The court also found that, because it was not actually an insurer, Feedback did not qualify for treatment as a small insurer under section 831(b), but this also meant that, as a St. Kitts entity, it did not owe any U.S. taxes.