Navel Gazing Micro Captive Insurance Company Denied Deductions

Yesterday the Tax Court issued a long-anticipated opinion on a fully-litigated micro-captive insurance company. Micro-captive insurance companies have long been a popular means of self-insuring for closely-held businesses but recently have come under additional scrutiny by the IRS. This case long preceded the IRS’s formal announcement focusing on micro-captive companies and was supported on brief by the Self-Insurance Institute of America, Inc.

Photo by Gregg Taveres

Micro-captive insurance companies are specifically provided for under IRC Section 831(b) but, as demonstrated by the Court’s opinion, they must meet certain factual criteria to maintain that preferred tax status. In a detailed and precedential division opinion authored by Judge Holmes, the Tax Court found that the insurance company formed by business owners Benyamin and Orna Avrahami was not operated like an insurance company, issued policies with unclear and contradictory terms, and charged wholly unreasonable premiums. Because the company was not an insurance company as required by section 831(b), its election to be treated as a micro-captive insurance company was invalid. As such, the premiums paid to the company by the Avrahamis were not deductible business expenses.

The Avrahamis also owned an entity called Belly Button Center which received funds from their insurance company and made loans to them personally. After its “omphaloskeptical review” the IRS challenged the validity of the loans alleging that they were a sham. The Court declined to reach that conclusion but did treat a little less than $300,000 of the $1.5 million transferred between the related parties as taxable dividends.

Finally, the Court considered whether negligence penalties applied to the Avrahamis. Based in part on the fact that this was a case of first impression with regard to micro-captive insurance, the Court found that the taxpayers had reasonable cause for the position taken on the returns and thus avoided penalties on the disallowed insurance premiums. The Court did, however, impose penalties on the portion of the loan treated as a dividend and another dividend of $200,000 that the taxpayers failed to report on their return.

Read the entire opinion here: Avrahami.

Tax Court: Business Expense Deductions Still Require…a Business

bowling-w-fred-flintstoneIn a case that would have Fred Flintstone rolling over in his grave, the Tax Court reminded us that expenses incurred while pursuing a hobby cannot be claimed as deductions – no matter how you see it.

Bruce Phillips was a career postal worker. He was also a self-taught bowler. Until 2004, he worked the night shift and spent a far amount of time at the bowling alley.

2000 was a very good year for Mr. Phillips. He won over $50,000 in bowling tournaments. It seemed his pastime might be lucrative enough to become a business. He invested heavily in the bowling venture – to the tune of $30,000 per year. He was not an overnight sensation though. He only won more than $10,000 in a year once more. He nonetheless continued to view bowling as his business.

That brings us to 2008. In 2008, Mr. Philips was working days for the post office and apparently found less time to bowl. Even though he had not won a tournament in three years, he continued to devote substantial resources to his bowling endeavors – or at least he claimed that he did on his 2008 tax return. Mr. Phillips claimed earnings of $67,171 from the postal service and deductions for business expenses of $28,243 related to his bowling endeavors in 2008. (Credit Mr. Phillips’ accountant who refused to sign the return.)

The IRS denied Mr. Phillips’ business expenses and he challenged the Commissioner’s determinations by filing a pro se petition in Tax Court. The Tax Court walked through the nine factors in Treas. Reg. §1.183-2(b), which defines activities not engaged in for profit, concluding that Mr. Phillips satisfied none of them. The Court’s conclusion probably had as much to do with Mr. Phillips’ failure to produce evidence that he even participated a bowling tournament in 2008 as it did with his failure to show that he carried out his bowling venture in any kind of business-like manner. It seems from the evidence and testimony recounted in the opinion that he did neither.

Mr. Phillips’ business expense deductions were denied in full and he found himself subject to an accuracy-related penalty of 20%. Gutter ball.

Read the entire opinion here:
Phillips v. Commissioner, TC Memo. 2013-215