A recent decision by the Tax Court Avrahami v IRS and Feedback Insurance Co V IRS highlighted that the IRS is now looking more closely at captive insurance companies being used for tax avoidance.
The Avrahamis own 3 jewelry stores and 3 shopping malls in the Phoenix area. Their CPA McEntee recommended that they set up a captive insurance company to reduce their taxes. Based on that recommendation the Avrahami’s retained Attorney Hiller for estate planning services and Attorney Clark of Clark & Gentry PLLC who specialized in setting up and maintaining captive insurance companies.
In 2007 Feedback Insurance was set up by Clark with Mrs. Avrahami as the sole shareholder, treasurer and bookkeeper. Once Feedback was set up and running, the Avrahamis continued the same business insurance coverage with the same 3rd party insurance companies that they had prior to Feedback being setup. The cost for their business insurance coverage through the 3rd party insurance companies continued to be around $70,000 a year.
With Feedback Insurance in operation they took out addition insurance coverage that cost the Abrahamis over $800,000 annually and deducted it as an business expense. Because Feedback had no claims or real exposure most of this money ended up in Feedback’s surplus. The Abrahamis regularly loaned themselves money from the surplus of Feedback.
The Tax Court concluded that the captive insurance companies did not provide legitimate insurance and ruled the company owed more than $1 million in back taxes and penalties. It also stated that it did not find a prior similar ruling. Likely the Tax Court will review these captive insurance relationships on a case by case basis in the future.
For attorneys and CPA’s that helped prepare captive insurance companies, a case by case decision means that all are subject to IRS review and potential seven figure liability tax bills. It is likely that these clients will seek damages from the attorneys and CPS’s that helped set up and maintain these companies.