                           149 T.C. No. 7



                  UNITED STATES TAX COURT



BENYAMIN AVRAHAMI AND ORNA AVRAHAMI, Petitioners v.
   COMMISSIONER OF INTERNAL REVENUE, Respondent

    FEEDBACK INSURANCE COMPANY, LTD., Petitioner v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 17594-13, 18274-13.             Filed 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.
                                        -2-

         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


      *
         Matthew J. Howard as attorney for the Self-Insurance Institute of America,
Inc., filed a brief as amicus curiae.
                                       -3-

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.
                                         -4-

        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:




        1
        If a business meets the requirements of section 1361, it may elect to be
treated as an “S corporation” and pay no corporate tax. Secs. 1362(a), 1363(a).
An S corporation’s income and losses, like a partnership’s, flow through to its
shareholders, who then pay income tax. See sec. 1363(b). American Findings was
originally established as a C corporation, but elected to become an S corporation--
made an “S election”--effective for 2008. It is now wholly owned by the
Avrahamis. (All section references are to the Internal Revenue Code in effect for
the years at issue, and all Rule references are to the Tax Court Rules of Practice
and Procedure, unless otherwise indicated.)
                                       -5-

      •     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




      2
       BYS was incorporated in 1992 and made an S election effective that same
year. Mr. Avrahami owns 85% of BYS, and the remaining 15% is held equally
(5% each) by trusts for his three children.
      3
        Chandler One was formed as a limited liability company in 2003. It is
treated as a partnership for tax purposes and the Avrahamis are both general
partners, each with a 50% interest.
      4
       O&E was incorporated in 1991 and made an S election effective that same
year. Mr. Avrahami is the sole shareholder of O&E.
      5
        White Mountain was formed as a limited liability company in 1997 and is
treated as a partnership for tax purposes. The Avrahamis each own 39.5% of
White Mountain, and each of their three children own 7%.
                                        -6-

      •      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


      6
        White Knight was incorporated in 1993 and made an S election effective
that same year. Mr. Avrahami is the sole shareholder of White Knight.
                                         -7-

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

      7
          We will use “Clark” to refer both to Ms. Clark and her firm.
                                       -8-

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).
                                        -9-

      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 risk distribution programs. Specifically, Feedback issued

the following direct policies:8




      8
        The policy periods for all of Feedback’s direct policies during the years at
issue started December 15 of the stated year and ended one year later. (Except for
one--the 2010 Tax Indemnity Policy--that actually says December 15, 2010, to
December 15, 2010, but we assume that’s a typo.)
                                     - 10 -

                                                         2009 limit    2010 limit
                               2009         2010        (occurrence   (occurrence
 Insured     Coverage type   premium      premium        /aggregate   /aggregate)
American    Business
 Findings    income          $271,000     $213,000      $3M/$3M       $3M/$3M
            Employee
             fidelity          71,000          64,000   $2M/$2M       $2M/$2M
            Litigation
             expense           65,000         110,000   $1M/$1M       $1M/$1M
            Loss of key                                   $1.5M/
             employee          86,000          72,000     $1.5M       $1M/$1M
            Tax indemnity      75,000          75,000   $2M/$2M       $2M/$2M
 Total American Findings      568,000         534,000
Chandler    Administrative
 One         actions           30,000          33,000   $1M/$2M       $1M/$2M
            Business risk
             indemnity         61,000          97,000   $4M/$4M       $3M/$3M
 Total Chandler One            91,000         130,000
O&E         Administrative
             actions           33,000          33,000   $1M/$2M       $1M/$2M
            Business risk
             indemnity         38,000          39,000   $4M/$4M       $4M/$4M
 Total O&E                     71,000          72,000
White       Administrative
 Knight      actions           ---             34,000       ---       $1M/$2M
            Business risk
             indemnity         ---             40,000       ---       $4M/$4M
 Total White Knight            ---             74,000
                                       - 11 -

      Despite the formation of Feedback, each of the entities owned by the

Avrahamis continued to buy insurance from third-party commercial carriers and

made no change to its coverage under those policies after contracting with

Feedback. The following charts summarize each entity’s commercial coverage for

2009 and 2010:

                               American Findings
 Coverage                                                    Limit (occurrence/
   term          Insurer     Coverage type       Premium        aggregate)
 11/10/09- Jewelers        Business owners &                      Various/
 11/10/10   Mutual          jewelers block       $58,303         $2,000,000
 11/10/10- Jewelers        Business owners &                      Various/
 11/10/11   Mutual          jewelers block        61,352          2,000,000

                                  Chandler One
 Coverage                                                    Limit (occurrence/
   term          Insurer     Coverage type       Premium        aggregate)
 11/16/09- Travelers       Commercial                           $1,000,000/
 11/16/10                   general liability     $3,294         2,000,000
 11/16/09- Travelers       Umbrella                  815          2,000,000/
 11/16/10                                                         2,000,000
 11/16/10- Travelers       Commercial                             1,000,000/
 11/16/11                   general liability      3,451          2,000,000
 11/16/10- Travelers       Umbrella                  815          2,000,000/
 11/16/11                                                         2,000,000
                                       - 12 -

                                       O&E
 Coverage                                                     Limit (occurrence/
   term        Insurer        Coverage type      Premium         aggregate)
 05/01/09- Travelers       Commercial                            $1,000,000/
 05/01/10                   general liability     $7,477          2,000,000
 05/01/10- Allied          Business owners          7,014         1,000,000/
 05/01/11                                                         2,000,000
 05/01/10- AMCO            Umbrella                  500          2,000,000/
 05/01/11                                                         2,000,000

                                  White Knight
 Coverage                                                     Limit (occurrence/
   term        Insurer        Coverage type      Premium         aggregate)
 04/10/09- Travelers       Commercial                            $1,000,000/
 04/10/10                   general liability     $17,227         2,000,000
 04/10/09- AMCO            Umbrella                   900         2,000,000/
 04/10/10                                                         2,000,000
 04/10/10- Nationwide      Commercial                             1,000,000/
 04/10/11                   general liability        1,572        2,000,000
 04/10/10- Nationwide      Commercial
 04/10/11                   property/building       11,147        5,493,338
                           Commercial
                            property/business
                            income                                   800,001

      The Avrahami entities deducted a total of more than $1.1 million for 2009,

and more than $1.3 million for 2010, in insurance expenses. The IRS is not

challenging the validity of the Avrahami entities’ commercial policies or the
                                        - 13 -

deductibility of those premiums. The premiums paid to Feedback are another

matter. The IRS is taking the position that what Feedback sold was not insurance,

meaning the premiums are not deductible as ordinary and necessary business

expenses.

      3.     Insurance Policy Pricing

      As the Avrahami’s expert witness explained, underwriting “is the process of

determining the price, terms and conditions, [and] acceptability of a risk by an

insurance company.” In a competitive market, an insurer’s goal is to price policies

in such a way that the premiums brought in cover losses and the insurer’s business

expenses with enough profit left over to keep investors happy. To accomplish this

goal insurance companies typically use both actuaries and underwriters.

According to Feedback’s actuary, “the actuaries define the rating scheme and the

underwriters make * * * the individual selections and adjustments for the given

risks.” An actuary typically starts with published rates and large datasets for

particular risks and makes adjustments for policy limits, estimates of the frequency

and severity of loss, deductibles, the claims history of a particular customer, and

perhaps a dozen or so other factors that can be combined into equations that he

uses to set a premium for a particular policy. Actuaries are also supposed to

ensure their work is appropriate for its intended use, consider whether their work
                                        - 14 -

includes large enough risk classes “to allow credible statistical inferences

regarding expected outcomes,” and check the reasonableness of their results. See

Actuarial Standard of Practice No. 12: Risk Classification (for All Practice

Areas), sec. 3.3 (Actuarial Standards Bd. 2005).9 No one thinks this process lacks

all subjectivity, but the work of an actuary must be reproducible and explainable to

other actuaries. See Actuarial Standard of Practice No. 41: Actuarial

Communications, sec. 3.2 (Actuarial Standards Bd. 2010).

      The actuarial services that Feedback obtained were somewhat different.

      4.     Feedback Policy Pricing

      During 2009 and 2010 Clark hired Allen Rosenbach, an actuary, to price the

Feedback policies.10 Rosenbach first reviewed the work of Feedback’s previous

actuary and then began developing his own pricing model for the products

Feedback might wish to offer. To assist Rosenbach in his calculations, Clark

provided various documents--including Feedback’s business plan, which she


      9
        “The Actuarial Standards Board (ASB) is vested by the professional
actuarial societies with the responsibility for promulgating Actuarial Standards of
Practice (ASOPs) for actuaries providing professional services in the United
States. Actuaries are required to follow the ASOPs by their actuarial societies.”
Acuity, A Mut. Ins. Co., & Subs. v. Commissioner, T.C. Memo. 2013-209, at *13.
      10
        Rosenbach was something of a captive underwriter. He testified that in
2009 and 2010 he prepared premium estimates for more than 50 but fewer than 80
captives. Most, if not all, were Clark’s clients.
                                       - 15 -

drafted, and which detailed the types of coverage Feedback planned to issue, as

well as the insurance policy applications from the various Avrahami entities.11 At

a very high level, Rosenbach’s pricing process was to determine a base premium

for each policy and then to adjust that base by various factors.12 Because the

premium for each policy was determined using slightly different base rates and

factors, we will provide a more detailed explanation policy by policy.

             a.    Administrative Actions

      The Administrative Actions policies covered any legal expenses arising

from an administrative action or disciplinary proceeding instituted against the

policyholder--Chandler One, O&E, or White Knight. The parties agree that this is

an insurable risk and Rosenbach testified that this sort of coverage is available on

the commercial insurance market, though it is often part of another policy.

      Rosenbach analogized the coverage provided by the Administrative Actions

policies to commercial miscellaneous-professional-liability insurance. He



      11
         Rosenbach was also given “a summary of the terms and conditions of the
standard policies” to aid in his pricing calculations, but he never reviewed the
actual policies.
      12
         The simplified version of Rosenbach’s model that was admitted into
evidence in these cases did not identify any of the commercial filings that he relied
on in creating his premium determinations. Rosenbach testified that supplemental
documentation would have to be provided for another actuary to review the model.
                                           - 16 -

therefore started his premium calculations with information found in the public

filings of large insurance companies--specifically a January 2005 Chubb filing--

because Chubb is a very large commercial writer of insurance. The Chubb filing

indicates that the base rate should be calculated using the insured’s gross revenue

and its classification into one of four hazard groups according to the level of risk it

poses. For example, Rosenbach stated that Chandler One would be considered a

“property manager,” which according to a June 2005 Chubb filing falls under

hazard group 4.13 According to the January 2005 Chubb filing, the base rate for an

insured in hazard group 4 is a flat $10,400 for its first $250,000 of gross revenue

and then $6.70 per thousand of gross revenue for the next $250,000. Rosenbach

followed this methodology and calculated a base premium for Chandler One--

which for 2009 had expected gross revenue of $470,000--of $11,874.14

         Once the base premium for Chandler One was set, Rosenbach adjusted it by

five factors. The first was a claims-made factor of 1.3. Claims-made policies are

“[a]n agreement to indemnify against all claims made during a specified period,



         13
         The January 2005 Chubb filing--from which Rosenbach’s pricing model
got its base rate calculation and adjustment factors--actually classified “property
managers” into hazard group 2, not 4.
         14
              The $11,874 is calculated as $10,400 + (($470,000 – $250,000) / 1,000 x
6.70).
                                       - 17 -

regardless of when the incidents that gave rise to the claims occurred.” Black’s

Law Dictionary 821 (8th ed. 2004). However, a claims-made policy can also

include a retroactive date that limits how far back the incident could have

happened. Claims-made policies are often contrasted with occurrence policies,

which are “[a]n agreement to indemnify for any loss from an event that occurs

within the policy period, regardless of when the claim is made.” Black’s Law

Dictionary 822 (8th ed. 2004). Rosenbach used a claims-made factor of 1.3

because that was the factor designated in the Chubb filing for a claims-made

policy with retroactive coverage for five or more years. And in his view, all of the

Feedback policies were claims-made with no retroactive date, meaning the

incident or event that caused the insured loss could come from any point in time as

long as the claim was made during the policy period. The insuring agreement

states that Feedback “agrees to pay to the Insured any legal expense incurred by

the insured during the Policy Period, arising from or relating to the defense of any

Insured Event as defined hereunder, which Insured Event is instituted against the

Insured during the Policy Period.” The policy defines “Policy Period” as “[e]vents

occurring and reported from and after 12:01 a.m. December 15, 2009 and prior to

12:01 a.m. December 15, 2010.”
                                       - 18 -

      The second factor was a deductible factor of 2.3 and was meant to

compensate for the fact that the Feedback policy has a deductible15 different from

that of the base Chubb policy. For example, because the Chandler One policy had

a zero deductible, Rosenbach went to the “Deductible Factors” table in the Chubb

filing and looked up the factor for a hazard-group-4 insured with no deductible.

However, the lowest deductible on the Chubb table is $500 and carries a factor of

2.02, so Rosenbach extrapolated to reach the 2.3 factor he used in his model. The

third adjustment was the “increased limit factor” of 1.2, which like the deductible

factor accounts for differences between the policy issued by Feedback and the

Chubb policy. In this case, the Chubb policy was priced assuming both the

aggregate and occurrence limits were $1 million, but the Chandler One policy had

an occurrence limit of $1 million and an aggregate limit of $2 million. According

to the Chubb filing, this difference in aggregate limits adds 20% to the base

premium, thus the factor of 1.2.

      Rosenbach’s fourth adjustment was a 10% increase--a factor of 1.1--for

“endorsements”. As Rosenbach explained, the magnitude of the endorsement

factor was based solely on his professional judgment and accounts for “the breadth

      15
        In insurance, a deductible is “the portion of the loss to be borne by the
insured before the insurer becomes liable for payment.” Black’s Law Dictionary
444 (8th ed. 2004).
                                        - 19 -

of the coverage being broad.” And the final adjustment was a coverage factor of

0.65, which Rosenbach stated was actually made up of two parts--“30 percent of

the premium comes from the administrative actions coverage and another 30

percent comes from the coverage of fines and penalties.” In other words, this

factor adjusts the base premium because the Administrative Actions policy issued

by Feedback was both narrower, because it covered fewer events, and broader,

because it covered fines and penalties, than the miscellaneous-professional-

liability policy described in the Chubb filing.

      To reach the total premium for this type of policy, Rosenbach then

multiplied the base premium by the five factors. For example, for Chandler One’s

2009 policy Rosenbach calculated a premium of $30,000.16 The calculations for

the Administrative Actions policies purchased by Chandler One in 2010, O&E in

2009 and 2010, and White Knight in 2010 were performed in an identical manner.

Each used the exact same formula and factors--claims made of 1.3, deductible of

2.3, increased limit of 1.2, endorsement of 1.1, and coverage of 0.65--but started

with the various insured’s gross revenue when calculating the base premium.




      16
         The $30,000 is the rounded product of the base premium and the five
factors. In other words, $11,874 x 1.3 x 2.3 x 1.2 x 1.1 x 0.65 = $30,462, which
rounded to the nearest thousand is $30,000.
                                        - 20 -

             b.    Business Risk Indemnity

      The Business Risk Indemnity policies generally covered business liabilities

caused by “construction defects” or events excluded under the policyholder’s

commercial policies--for example, losses from asbestos, climate change, or fungi.

      Rosenbach’s pricing model was slightly more complicated for these policies

because the premiums required three separate calculations. The first was for the

premium associated with coverage for events not covered by--the “major gaps”

in--a commercial policy. The second was for excess coverage, under which an

insurer agrees to indemnify an insured against a loss only if it exceeds the amount

covered by another policy. And the third was for the premium associated with

“construction defect” coverage.

      The gap-coverage portion of the calculation was similar to the

Administrative Actions model in that it started with the base premium from the

January 2005 Chubb filing for Miscellaneous Professional Liability coverage and

then adjusted for the same five factors. Rosenbach again used a claims-made

factor of 1.3 and a deductible factor of 2.3, but the increased limit, endorsement,

and coverage factors are slightly different. For example, for Chandler One’s 2009

policy, Rosenbach used an increased limit factor of 1.92 which is the amount

indicated in the Chubb filing for a policy with aggregate and occurrence limits of
                                        - 21 -

$4 million. He also used an endorsement factor of 1.25 to account for his belief

that the Business Risk Indemnity policy covered “much more” than the Chubb

base policy. Finally, Rosenbach used a coverage factor of 0.38, which he

explained at trial as:

             THE COURT: There is a coverage factor next, you had
      mentioned that before. This one is only .38, all right they don’t add
      up to one. What’s going on there? You have [a] coverage factor of
      0.38 and then [an] adjustment of 0.75?

             THE WITNESS: Yeah, the seven is built into the coverage
      factor, the .75 fee is a point, I take the product of a base adjustment
      and then I adjust it for the risk.

             THE COURT: Okay, I don’t understand that.

             THE WITNESS: Okay.

             THE COURT: What number do you start out with, the .75 or
      the .38?

             THE WITNESS: The .75 is --

             THE COURT: Okay, and what do you do with the .75?

             THE WITNESS: I actually multiply it by another factor that’s
      built into the coverage to come up with that --

             THE COURT: And what other factor are you multiplying that
      by?

             THE WITNESS: Well in this case it’s roughly .5, 50 percent.

             THE COURT: Why?
                                       - 22 -

             THE WITNESS: That, okay that’s what I’m saying, both the
      endorsement and the coverage puts together all of the risks that the
      insured is getting, the major ones. And it adjusts on a relative basis
      on what’s it’s worth, so it’s really a potpourri of a bunch of factors
      that come up with that .38.

              THE COURT: And again was this based on your experience or
      is this based on a commercially available filing like this Chubb one?

            THE WITNESS: It’s more experience.

With the base premium and five factors, Rosenbach reached a 2009 premium for

Chandler One for the gap-coverage portion of the Business Risk Indemnity policy

of $31,953.17

      But recall that this is only one part of the calculation. Rosenbach then

added $2,500 to account for the excess coverage--“the straight commercial

coverages going up in higher limits”--provided by the policy. And he added

another $26,438 for “construction defects” coverage because Chandler One’s

application indicated it was in the real-estate development and management

business and Rosenbach believed that “[a]nything that touches the real estate

[Chandler One] can get sued for it.” He arrived at the $26,438 by multiplying

Chandler One’s 2009 expected gross revenue of $470,000 by “certain rates that

      17
        The $31,953 is calculated as $11,874 x 1.3 x 2.3 x 1.92 x 1.25 x 0.375.
We note that for Rosenbach’s calculation to work out, the coverage factor must be
0.375 (0.75 x 0.5) and references to 0.38 are likely the rounded version of this
number.
                                        - 23 -

[he] use[s] for construction defect coverage because [he has] more data on that.”18

Putting all of this together, Rosenbach calculated a total premium for Chandler

One of $61,000.19 An identical calculation was done for the Business Risk

Indemnity policy purchased by O&E in 2009 except that Rosenbach started with

O&E’s gross revenue and added no additional premium for construction-defect

coverage.

      In 2010 the Business Risk Indemnity policies were calculated in a similar

manner, but again with a few adjustments. For example, the endorsement factor

was dropped to 1.0 and the coverage factor was increased to 0.5.20 And for

Chandler One’s 2010 policy, Rosenbach also dropped the occurrence and

aggregate policy limits to $3 million reducing the increased limit factor to 1.7,

lowered the charge for the excess coverage to $1,000, and increased the premium

for the construction defects coverage from $26,438 to $62,730. Rosenbach


      18
         Rosenbach’s construction defect rate appears to be around 5.625%
($470,000 x 5.625% = $26,438) of Chandler One’s gross revenue, yet he testified
that construction defect rates typically run “one to four percent of asset value.”
      19
        The $61,000 is the rounded sum of the three separate calculations. In
other words, $31,953 + $2,500 + $26,438 = $60,891, which rounded to the nearest
thousand is $61,000.
      20
        The reason for these changes is not clear from the record. When asked
whether his 2010 factors were determined in the same fashion as in prior years,
Rosenbach responded: “Yes, absolutely.”
                                         - 24 -

explained that this sharp increase in premiums related to construction defects was

due in part to 50% higher expected gross revenues and in part because “the

increased limit factor was applied to the base rate and the calculation, where in the

prior years it wasn’t. So it was a, it was a tweak in the model to incorporate some

more of a line risk.”

             c.     Business Income

      The Business Income policy covered any amount of business income

(limited to “overhead expenses”) that American Findings lost as the result of

reputational damage or new competition.

      To come up with the premiums for American Findings’s 2009 Business

Income policy Rosenbach started out with its gross revenue and multiplied it by

7.5%. As he explained, the 7.5% represents his assumption that “you might only

expect one policy limit loss every 20 years * * * [which] would turn into a five

percent expected loss, and that expected loss grossed up for expenses and risk will

give you a seven and a half percent rate.” Then Rosenbach adjusted this amount

by an increased limit factor and claims-made factor in the same manner as for the

other policies previously discussed. Finally, he multiplied by an “adjustment

factor” of 0.9 and an “other” factor of 0.165. Together, he said, these “judgmental

factors” accounted for financial stability, size, profitability, entry into the market,
                                        - 25 -

additional coverages, and a 10% surcharge for “competition and the reputational

damage.” Multiplying all of these parts together, Rosenbach calculated a premium

of $271,000.21

      American Findings’ 2010 policy was calculated in the same manner, but the

“adjustment factor” was decreased to 0.65 and the “other” factor was increased to

0.2325. The reason for these differences is not clear from the record, as

Rosenbach said that he used the same methodology for 2010 as he had for 2009.

             d.     Employee Fidelity

      The Employee Fidelity policy covered losses to American Findings caused

by fraudulent or dishonest acts committed by one of its employees acting alone or

in collusion with others. The parties agree this is an insurable risk.

      The 2009 Employee Fidelity policy was priced a little differently because it

represents coverage that exists in the commercial market and Rosenbach testified

that he was able to follow the rating methodology of a commercial carrier--

specifically a Chubb employee-fidelity crime-theft filing.22 For each factor,



      21
        The $271,000 is the rounded product of the gross revenue and the five
adjustments. In other words, $11,000,000 x 0.075 x 1.7 x 1.3 x 0.9 x 0.165 =
$270,753, which rounded to the nearest thousand is $271,000.
      22
         This Chubb filing was not offered into evidence by either party and is not
a part of the record.
                                        - 26 -

therefore, he used his judgment and what he knew about the American Findings

policy to select a factor from the defined range for that type of factor in the Chubb

filing. By multiplying all of the factors times the base premium--also derived from

the Chubb filing--Rosenbach reached a premium of $71,000.23 The calculation of

the 2010 premium was exactly the same, but it started with a different base

premium.

             e.    Litigation Expense

      The Litigation Expense policy covered any expenses American Findings

incurred in defending itself in a legal proceeding, in prosecuting a third party over

a matter pertaining to the business, or in obtaining “any legal consultation

pertaining to the business.”

      For the 2009 Litigation Expense policy Rosenbach started out with an

exposure base of $276,000, which he said was “basically a function of the

underlying expected losses of the given lines of business in the model with an

estimate for things outside of the model.” Or in other words “it’s an estimate from

      23
         The exact calculation of the $71,000 is not clear from the record.
Rosenbach’s model shows a base premium of $2,675 and then eight factors--2.0,
1.366, 1.3, 1.35, 2.0, 2.609, 1.265, and 0.9. The product of these nine numbers is
$76,194. However, in their reply brief the Avrahamis explained--albeit with a few
typos--that the correct math is (2.0 x 1.3 x 2.0 x 2.609 x 1.265 x 0.9) x (1.366 +
1.35 – 1.0) = (15.446 x 1.716) = 26.506. And 26.506 x $2,675 = $70,904, which
rounded to the nearest thousand is $71,000.
                                         - 27 -

all different sides of all different exposures that could impact the litigation. So,

what would feed into it would be parts of, part of the premium for administrative

action, part of the premium for crime, part of the premium for, for all different

other coverages.” Then Rosenbach multiplied by an “expected loss ratio” of 90%,

which accounts for his belief that Feedback would have to pay back 90% of the

premiums it collected in the form of reimbursements for losses covered by the

policy because “most of the captives have a ten percent expense ratio.” The next

adjustment was a 30% charge for “allocated loss adjustment expense.”

Rosenbach testified that this adjustment represents “[a]nything associated with

settling claims”--including legal fees--as a portion of the total loss. Then he

multiplied by another factor of 0.6 because “we’re only covering legal expense,

the loss is everything beforehand, is covering all the loss and loss adjustment

expense, we have to get just the, just the legal fee piece out of it.”

      Rosenbach’s model also reflects an expense ratio of 10%,24 an increased

limit factor of 1.0, and a claims-made factor of 1.3. He testified that to reach the

total premium of $65,000 calculated by his model “it should just be the product of

the factors. * * * Probably one minus the expense ratio, times the 0.6, times the


      24
       The expense ratio is the complement--a math term for the difference
between an amount and 100%--of the 90% expected loss ratio.
                                       - 28 -

1.3.”25 The 2010 Litigation Expense policy was calculated in the exact same

manner, but with a nearly 60% higher exposure base. Rosenbach explained this

increase:

            A: It’s an evaluation of all the other coverages that are part of
      the model and not part of the model and it was adjusted to reflect
      more exposure.

            Q: So it was a model adjustment?

             A: In the model, you can adjust for the different contributions
      to the lines. So it’s me applying the model in a little different light
      than they did in the past.[26]

            f.     Loss of Key Employee

      American Findings’ Loss of Key Employee policy covered lost business

income (limited to “overhead expenses”) resulting from the temporary or

permanent departure--including voluntary departure--of either Mr. or Mrs.



      25
        The exact calculation of the $65,000 is not clear from the record. The
product of all of the factors--but using one minus the expense ratio per
Rosenbach’s testimony--is $52,313 ($276,000 x 90% x 30% x (100% – 10%) x
60% x 1.0 x 1.3). However, in their reply brief the Avrahamis explained that what
Rosenbach meant was that he took the product of all of the factors except the
expense ratio and then divided by one minus the expense ratio. Essentially
($276,000 x 90% x 30% x 60% x 1.0 x 1.3) / (100% – 10%) = $64,584, which
rounded to the nearest thousand is $65,000.
      26
        We note that Rosenbach said “than they did in the past” even though 2009
was the first year that American Findings purchased a Litigation Expense policy
and he was the actuary that made the model.
                                          - 29 -

Avrahami. “Overhead expenses” is defined as American Findings’ “projected

ordinary operating expenses exclusive of distributions to shareholders or owners,

dividends, interest and principal payable to shareholders, owners, or affiliates,

income taxes, amortization and depreciation, for the period commencing on the

date of loss and ending at the termination of the Policy Coverage Period.” This

type of policy is not generally available in the commercial insurance market.

      To calculate the 2009 premium for the Loss of Key Employee policy,

Rosenbach started with projected gross income of $11 million and multiplied it by

an event rate of 5% and an “extra expense factor” of 1.15. The 5% is another

judgment call and is supposed to represent the expected losses under this type of

coverage. And the 1.15 “extra expense factor” accounts for “the cost of finding

replacements” in Rosenbach’s experience. He then multiplied by an adjustment

factor of 1.5 for “a disability add on” and another factor of 0.5 for the assumption

that “the duration of a claim won’t last a full year, it’ll only last half a year.”

Multiplying all of the factors together Rosenbach reached a preliminary premium

of $474,000.27 Next he apportioned this preliminary premium to the key

employees covered by the policy--the Avrahamis--whose salaries were 18.1% of

      27
        The $474,000 is the rounded product of the gross income and the four
adjustments. In other words, $11,000,000 x 0.05 x 1.15 x 1.5 x 0.5 = $474,375,
which rounded to the nearest thousand is $474,000.
                                         - 30 -

American Findings’ total payroll expense. This led to a final premium of

$86,000.28 The 2010 premium was calculated exactly the same way.

             g.     Tax Indemnity

      That brings us to perhaps the most peculiar policy of all--the Tax Indemnity

policy. This policy supposedly covered additional taxes, interest, and penalties

that American Findings might become obligated to pay as the result of an “adverse

resolution” of a position taken on its tax return--with exclusions for fraud,

criminal conduct, or a willful violation of the law. This type of policy is, as one

might expect, not generally available in the commercial insurance market.

      Here Rosenbach started with the $2 million policy limit and multiplied it by

an event rate of 7.5%. Rosenbach testified that he derived the 7.5% from an IRS

study on audit results. The origins of this number remain murky. We find it more

likely than not to be the ratio of deficiencies--including interest, penalties, and

additions to tax--to gross income reported on all returns aggregated for the country

as a whole, but adjusted for the size of the entity and the potential for a multiyear

audit. Next Rosenbach multiplied by an endorsement factor of 1.0 and an

“experience factor” of 0.5. The experience factor was a partially subjective

      28
        The $86,000 is the rounded product of the preliminary premium and the
percentage of payroll expense attributed to the Avrahamis. In other words,
$474,000 x 18.1% = $85,794, which rounded to the nearest thousand is $86,000.
                                       - 31 -

adjustment that accounted for American Findings’ ratio of deductions to total

revenue and the consistency of its tax returns from year to year. This led

Rosenbach to a total premium of $75,000 for 2009.29 The 2010 premium was

exactly the same.

      5.     The “Target”

      In total, the Avrahami entities paid Feedback premiums for their direct

policies of $730,000 in 2009 and $810,000 in 2010. Each year Clark told

Rosenbach that the Avrahamis had a “target premium” of $840,000 for their direct

policies and $1.2 million for total premiums--the direct policy premiums plus

$360,000 in premiums for terrorism insurance from Pan American. See infra p.

32. After completing his calculations, Rosenbach would send them back to Clark

for comments. While not related to the years at issue in these cases, Rosenbach

testified that an email chain between himself and Clark relating to the 2011 policy

premiums was representative of the sort of comments he received. Those emails

show that Rosenbach initially proposed total direct premiums for 2011 of

$899,000, but was then asked to add a “proration factor.” The email back from

Clark says: “It looks like we’re still pretty far even with 10 months prorated for


      29
        The $75,000 is the product of the limit and the three adjustments. In other
words, $2,000,000 x 0.075 x 1.0 x 0.5 = $75,000.
                                        - 32 -

the old policies. I think we should go back to full years for all the policies with

$840,000 as the target.” Rosenbach replied with new calculations when he had

“dropped the limits as suggested” and calculated total direct premiums of

$835,000. Once the premiums were finalized, Clark would go back and draft the

actual policies.

D.    Pan American

      In addition to its direct policies, Feedback also participated in “risk

distribution” programs. In 2007 and 2008 the program was a cross-insurance

pool, which offered Clark’s clients the opportunity to purchase terrorism insurance

from other clients’ captive insurance companies. For example, in 2007 entities

owned by the Avrahamis paid $360,000 into the pool for terrorism coverage30 and

Feedback received $360,000 for insuring other members of the pool.

      In 2009 and 2010, however, Feedback started participating in a risk-

distribution program through Pan American Reinsurance Company, Ltd. (Pan

American). Pan American was incorporated in January 2009 in St. Kitts and

during the years at issue was an insurer licensed in and regulated by the Island of

Nevis. It had four shareholders--Diana Gentry (2.5%), Carl Gentry (2.5%),

      30
       Specifically, BYS paid $30,000; Chandler One paid $40,000; O&E paid
$30,000; White Mountain paid $20,000; White Knight paid $40,000; and
American Findings paid $200,000.
                                      - 33 -

Laurence Mohn (47.5%), and Sheila Trevors (47.5%). Diana and Carl are Clark’s

children, and neither ever communicated with Pan American’s management or the

other shareholders about business matters. Mohn was a “courtesy director” and

testified that “Nevis required someone with insurance experience that really was

my only, the only reason why I was involved.” He had no duties, no involvement

with Pan American’s day-to-day operations, and no regular communications with

anyone at Pan American. And Sheila Trevors is the wife of Robin Trevors--the

owner of Feedback’s management company, Heritor. Heritor’s sister company,

Heritage Services, Ltd. (Heritage), is the registered agent and insurance manager

of Pan American.

      1.    The Structure

      The aim of Pan American was simple--distribute risk. Clark told her clients:

      As you know, your captive insurance company is required to
      “distribute risk” in order to be treated as an insurance company for
      tax purposes. The IRS considers this requirement to be satisfied if a
      significant portion of the insured risk borne by your company is
      spread among one or more insureds that are unrelated to your
      company. Case law has established that 30% of the total premiums
      received by an insurance company represents a significant portion of
      its risk.

Pan American, therefore, was intended to connect Clark’s clients with other

businesses that operate small insurance companies so they could spread their risk
                                        - 34 -

to each other by buying and reinsuring terrorism insurance.31 Pan American would

sell policies to participating businesses and then reinsure--or “cede”--all of the risk

through the participating insurance companies pursuant to a Terrorism Risk Quota

Share Reinsurance Agreement. Each of the participating insurance companies

would pay premiums for terrorism coverage to Pan American, which would

deposit them in a trust account, and then return an amount almost equal to what it

had received to each of the reinsuring companies. For its services, Pan American

did not charge a ceding commission; rather it received a portion of the fixed “all-

inclusive” $5,000 fee that Clark charged each of her clients for participating in the

program.

      We’ll use real numbers to show how this worked. Feedback decided to

participate in Pan American’s program in 2009 “at $360,000, calculated at 30% of

[its] target premiums for 2009, which [was] $1.2 million.” Under the Terrorism

Risk Quota Share Reinsurance Agreement, it therefore agreed to a reinsurance


      31
         “Reinsurance is an agreement between an initial insurer (the ceding
company) and a second insurer (the reinsurer), under which the ceding company
passes to the reinsurer some or all of the risks that the ceding company assumes
through the direct underwriting of insurance policies. Generally, the ceding
company and the reinsurer share profits from the reinsured policies, and the
reinsurer agrees to reimburse the ceding company for some of the claims that the
ceding company pays on those policies.” Trans City Life Ins. Co. v.
Commissioner, 106 T.C. 274, 278 (1996).
                                      - 35 -

premium of $360,000 in exchange for accepting 1.797% of Pan American’s

“Ultimate Total Loss for terrorism coverage to the insureds.” In December 2009

American Findings paid Pan American $360,000--the same amount--for

“Terrorism Risk Insurance” with a policy limit of $5,525,000 and coverage

running from December 15, 2009, to December 15, 2010. Feedback, in turn,

received three payments from Pan American--slightly more than $180,000 (50% of

its reinsurance premium plus interest) in March 2010; slightly more than $171,000

(47.5% of its reinsurance premium plus interest) in June 2010; and slightly more

than $9,000 (2.5% of its reinsurance premium plus interest) in December 2010.

The same process repeated itself the next year--American Findings paid Pan

American $360,000--this time for up to $5,125,000 of coverage--and Pan

American paid Feedback $360,000 plus interest (50% in March 2011, 47.5% in

June, and 2.5% in December).

      In 2009 Pan American wrote policies for 103 insureds and then reinsured

the policies through 85 of Clark’s captive insurance companies; in 2010 it wrote

policies for 139 insureds and reinsured through 101 of those companies. Pan

American received more than $20 million in premiums in 2009 and almost $23

million in 2010. These amounts were then cycled back whence they came--50%

after 90 days and another 47.5% after 180 days. The last 2.5%--about $500,000 in
                                        - 36 -

2009 and $570,000 in 2010--was held back as a “loss reserve” until the policies

expired on December 15. Clark told her clients that the loss reserve was intended

to build a comfort level for the participants, but that “Nevis law requires loss

reserves to be maintained on net premiums only. In the situation outlined here,

Pan-American would not be retaining any risk or premiums, and so, technically,

would not be required to maintain any loss reserves.” Other than premiums

receivable, the only assets reported on Pan American’s tax returns for 2009 and

2010 were cash or cash equivalents of around $200,000 and $390,000,

respectively.

      2.        The Policy

      The Pan American risk-distribution program was built around its Terrorism

Risk Insurance Pool (TRIP). By its terms Pan American agreed to reimburse

policyholders for “losses of ‘property’ and ‘expenses’ resulting directly from an

‘act of terrorism’ occurring during the Indemnity Period.” It was designed to look

a bit like the terrorism coverage required to be offered with certain commercial

insurance products under the Terrorism Risk Insurance Act of 2002 (TRIA), Pub.

L. No. 107-297, sec. 103, 116 Stat. at 2327. During the years at issue here, both

TRIP and TRIA were triggered by an act of terrorism certified by the Secretary of

the Treasury with the concurrence of the Secretary of State and the Attorney
                                       - 37 -

General that resulted in more than $100 million in losses.32 As the parties note,

however, there are also several key differences. TRIP includes coverage for

damage caused by the dispersion of biological or chemical agents, which is

excluded under most--if not all--TRIA-backed policies. TRIP excludes acts of

terrorism “occurring in a city with more than 1.5 million residents,” though TRIP

policies notably leave the term “city” undefined. And TRIP is a stand-alone

terrorism insurance policy, meaning it is not tied to any provisions of another

policy.33

      3.     The Pricing

      Clark hired Rosenbach to perform a market survey of commercial terrorism

risk insurance to determine a price for the Pan American policies. In the survey

Rosenbach looked at several sources including government and industry reports as



      32
         TRIA was amended by the Terrorism Risk Insurance Extension Act of
2005, Pub. L. No. 109-144, sec. 6, 119 Stat. at 2662, which added the $100 million
loss requirement starting January 1, 2007. TRIA was also extended by the
Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA), Pub.
L. No. 110-160, sec. 3(c)(3), 121 Stat. at 1839, which extended the $100 million
loss requirement through 2014. We will refer to the 2002 act including its
amendments and extensions as TRIA.
      33
         The Avrahamis were apparently confused about the terms of this policy.
Mr. Avrahami was under the impression that Feedback was at risk only for the
amount of premiums put into Pan American--$360,000 each year--and testified
that it would “be weird” to lose money and if Feedback did he would “freak out”.
                                         - 38 -

well as the work of Feedback’s prior actuary. This helped him understand “what

was going on in the typical terrorism market” and “what competitors were doing

that offered similar coverage.” Combining this understanding with historical

information, catastrophe information, the differences between TRIP and other

terrorism policies, and his personal judgment, Rosenbach recommended a “rate on

line”--the premium divided by the occurrence limit--of 5% to 8% for 2009 and 5%

to 9% for 2010.34 Rosenbach testified that 80% to 90% of these rates are related to

the chemical and biological coverage and that the range is applicable to all of the

captives participating in the pool regardless of the type of business being insured

or its geographic location.

      Whether Rosenbach took other provisions of the Terrorism Risk Insurance

Insuring Agreement into account in his suggested range of rates is unclear from

the record. For example, the Commissioner’s expert witness pointed out that the

TRIP policy contains wording that makes it an excess policy,35 meaning that it


      34
        The rate on line eventually set for all TRIP policies was 6.5% in 2009 and
7% in 2010.
      35
         Section E.15 of the Terrorism Risk Insurance Insuring Agreement states:
“Except as otherwise stated in this paragraph, this policy does not apply to loss
recoverable or recovered under other insurance or indemnity. If the limit of the
other insurance or indemnity is insufficient to cover the entire amount of the loss,
this policy will apply to that part of the loss, other than that falling within any
                                                                           (continued...)
                                         - 39 -

would be triggered only if the loss was not covered, or not fully covered, by

another policy--e.g., the TRIA coverage included in American Findings’ policy

with Jewelers Mutual. The insuring agreement also allows Pan American--if it has

impaired solvency--to issue promissory notes to the insured payable over a

maximum of three years.36 And as Rosenbach noted, TRIP policies contain no

deductibles, don’t qualify for TRIA--i.e., government-backed--coverage, and to his

knowledge would not have been triggered by any event in history. Plus, each

reinsurer “is not liable for the subscription of any other participating [reinsurer]

who cannot or will not satisfy all or any part of their obligations.”

      In addition to its TRIP policy from Pan American, American Findings

continued to buy add-on terrorism coverage--backed by the federal government in

compliance with TRIA--from its commercial-insurance provider, Jewelers Mutual.

The record shows that American Findings paid around $1,500 in 2009 and $1,600

in 2010 for this additional coverage. The Jewelers Mutual policy had a $2 million




      35
       (...continued)
Deductible Amount, not recoverable or recovered under the other insurance or
indemnity.”
      36
         Rosenbach and the Commissioner’s expert witness both credibly testified
that they had never seen such a provision in an insurance policy before.
                                        - 40 -

aggregate limit and specifically excluded coverage for chemical and biological

hazards.

E.    The Flow of Funds

      To summarize a bit, in 2009 entities owned by the Avrahamis paid

Feedback $730,000 in premiums for direct coverage, American Findings paid Pan

American an additional $360,000 for terrorism insurance, and Pan American paid

Feedback $360,000 in reinsurance premiums. Likewise, in 2010 entities owned by

the Avrahamis paid Feedback $810,000 in premiums for direct coverage,

American Findings paid Pan American $360,000 for terrorism insurance, and Pan

American paid Feedback $360,000 in reinsurance premiums. This means the

Avrahami entities collectively deducted--as business expenses--insurance

premiums of $1,090,000 for 2009 and $1,170,000 for 2010. No claims were filed

against Feedback under any of its direct policies in either 2009 or 2010.37 And no

events took place triggering a claim under TRIP in either year. With significant

cash coming in the door and none going out to pay claims, Feedback quickly

accumulated a surplus. And it used this surplus to transfer funds to Mrs.

Avrahami and an entity named Belly Button Center, LLC (Belly Button).


      37
        Although outside the years at issue in these cases, we note that the first
claim against Feedback was filed in March 2013.
                                       - 41 -

       Belly Button was formed in 2007 and is treated as a partnership for tax

purposes. It is owned equally by the Avrahami’s three children, but all three

testified that they had no knowledge of Belly Button, that they owned Belly

Button, or what Belly Button did. We found out: Belly Button owns

approximately 27 acres of land in Snowflake, Arizona, which it purchased for

around $1,960,000 with about $1.2 million in cash from Mr. Avrahami and the rest

with a note payable to the sellers. The $1.2 million from Mr. Avrahami was

reported on Belly Button’s tax return as a liability “due to affiliates.” The aim was

not to make a gift to Belly Button. Mr. Avrahami--acting as the manager of Belly

Button--executed an unsecured promissory note for $1.2 million38 payable to

himself as an individual in or before April 2017. The note carried a 4% simple

interest rate.

       In March 2008--before the years at issue in these cases--Feedback

transferred $830,000 to Belly Button and reported the amount on its tax return

under “Mortgage and real estate loans.”39 The same day Mr. Avrahami--acting



       38
        Why the note payable was for only $1.2 million when the amount lent was
$1,201,000 is unclear from the record.
       39
        On its 2009 (and only on its 2009) tax return Belly Button shows this
$830,000 as “loans to shareholders.” We surmise this was just a scrivener’s error
(or perhaps a Freudian slip). This does not affect the outcome of these cases.
                                        - 42 -

again as manager of Belly Button--executed a $830,000 promissory note payable

to Feedback. The note required Belly Button to pay the principal and all accrued

interest--4.3% per year, compounded annually--in or before February 2018 and

was secured by “a Realty Mortgage on certain collateral.” The Realty Mortgage

described the land owned by Belly Button in Snowflake, Arizona. That same day

Mr. Avrahami also withdrew around $813,000 from Belly Button’s bank account

allegedly to pay off the note payable and accrued interest due to the original sellers

of the Snowflake land.

      Belly Button continued to benefit from its connection to Feedback. In

March 2010 Feedback transferred an additional $1.5 million to Belly Button and

again reported the amount on its tax return under “Mortgage and real estate loans.”

The next day Mr. Avrahami--again on behalf of Belly Button--executed a $1.5

million promissory note payable to Feedback. This note carried an interest rate of

4% per year--simple interest accruing “from time to time”--and was due in March

2020. The note also states that “[t]he Indebtedness is unsecured.” Two days after

this transfer of funds from Feedback to Belly Button--and the day after Mr.

Avrahami executed the $1.5 million promissory note--the Avrahamis (meaning

Mr. and Mrs. Avrahami, not their children, who were Belly Button’s putative
                                       - 43 -

owners) transferred $1.5 million from Belly Button’s bank account into their

personal one.

      Then it happened again. In December 2010, $200,000 went directly from

Feedback’s account to Mrs. Avrahami. Yet the transfer was papered just like the

transfers that had gone through Belly Button. There was a promissory note due on

demand, but no earlier than December 2012, that carried an interest rate of 3% per

year, was signed by Mr. Avrahami on behalf of Belly Button, and was reported on

Feedback’s 2010 tax return as a mortgage and real estate loan.40

      Insurance regulators often raise their bureaucratic eyebrows at related-party

dealings like this. But Feedback did not seek approval from its Kittian regulators

for any of these transfers to Belly Button or to Mrs. Avrahami before making

them.41 Clark disclosed the three transfers to Heritor in March 2014, after the


      40
         Although outside the years at issue in these cases, we note that in July
2012 the Avrahamis transferred nearly $207,000 from their bank account back into
Feedback’s. Feedback also transferred $1,739,000 to BYS in 2012. This transfer
was evidenced by a $1,775,000 promissory note with a 4% interest rate and a due
date of April 2022. The note was signed by Mr. Avrahami on behalf of BYS and
stated that it was “secured by the Deed of Trust.” However, such a Deed of
Trust--if it exists--is not part of the record in these cases.
      41
         And they should have. St. Kitts’s Captive Insurance Companies Act of
2006, c. 21.20, sec. 15.6, provides that “[a] captive insurance company may not
make a loan to or an investment in its parent company or affiliated persons without
prior written approval of the Registrar, and any such loan or investment shall be
                                                                      (continued...)
                                        - 44 -

Commissioner began his omphaloskeptical review. Heritor communicated the

information to the St. Kitts’s Registrar of Captive Insurance Companies in

September 2014.

F.    The Returns and the Audit

      1.     Feedback’s Returns

      Feedback timely filed its 2009 and 2010 tax returns. On both returns

Feedback indicated that it had previously made an election under section 953(d) to

be treated as a domestic corporation for federal income tax purposes. And both

returns included current-year elections for Feedback to be treated and taxed as a

small insurance company under section 831(b). Feedback’s tax returns reported

total assets of almost $2.4 million at the end of 2009 and nearly $3.9 million at the

end of 2010, but because of the section 831(b) election it paid income tax only on

its investment income--i.e., interest, but not premiums.

      The IRS sent Feedback a notice of deficiency in May 2013 that questioned

whether Feedback was a valid insurance company and determined that “the

amounts characterized as insurance premiums” were income to Feedback under

section 61 since Feedback had not established that they were excludable under


      41
       (...continued)
evidenced by documentation approved by the Registrar.”
                                        - 45 -

another provision of the Code. Feedback timely petitioned this Court.42 The

parties stipulated before trial that the “‘Taxable Premiums Earned’ by [Feedback]

in the amounts of $1,090,000 and $1,170,000 for taxable years 2009 and 2010,

respectively, are not U.S. source fixed or determinable, annual or periodical

income under section 881, or income that is effectively connected with a U.S.

trade or business under section 882.”

      2.      The Avrahamis’ Returns

      The Avrahamis likewise filed 2009 and 2010 tax returns. Incorporated in

their returns was the income or loss--reflecting any insurance-expense deduction--

passed through to them from numerous partnerships and S corporations, including

the Avrahami entities. We summarize those insurance-expense deductions:

                        American         Chandler                        White
           Year         Findings           One            O&E            Knight
           2009         $975,650         $95,078         $78,477         $17,227
           2010         1,029,512        134,849          79,539          87,675




      42
        At the time it filed its petition, Feedback had no “principal place of
business or principal office or agency in any judicial circuit.” Therefore, absent an
agreement between the parties, Feedback’s case is appealable to the Tenth Circuit
because it filed its tax returns with the IRS Ogden, Utah, office. Sec.
7482(b)(1)(B).
                                        - 46 -

Nowhere on their 2009 or 2010 return did the Avrahamis report the amounts

transferred to them from Belly Button--$1.5 million--or from Feedback--$200,000,

because they assert that the cash that flowed from Belly Button went just to repay

loans. They admit that the $200,000 that went straight from Feedback to Mrs.

Avrahami cannot nestle in that nontaxable cubbyhole, but they instead assert that

it should have been reported and taxed for 2010 as a qualified dividend.

      3.     The Audit and the Claims

      The IRS began auditing the Avrahamis’ 2009 return in March 2012 and

later expanded the audit to include their 2010 return as well as the returns from

Feedback and the Avrahami entities. In January 2013 the IRS mailed the

Avrahamis documents explaining the examination changes for American Findings,

Chandler One, O&E, and White Knight. These documents noted that from

Feedback’s inception in 2007 to the end of 2010, Feedback had received

premiums totaling almost $3.9 million but had paid no claims. They also noted

that one of the nonexclusive factors for determining whether a captive insurance

company is a sham is “[w]hether any claims were filed with the captive; if claims

were filed – whether the validity of the claims was established before payments

were made on them.” This looks like it triggered something: By March 2013 the

claims started rolling in from entities owned by the Avrahamis:
                                       - 47 -

                      Date of
      Entity           claim         Policy/period       Nature of loss   Amount
 American           03/19/2013     Business income/
  Findings                           2011-2012            Ring dispute     $9,800
 American           03/19/2013    Litigation expense/     Ring dispute
  Findings                            2011-2012            litigation        2,816
 White Knight       04/05/2013       Business risk/
                                      2011-2012           Roof repairs     58,248
 Junction           04/05/2013       Business risk/         Building
  Development                         2011-2012              repairs         2,519
 American           09/06/2014       Business risk/
  Findings                            2013-2014          Water damage     Pending
 American           09/30/2014    Litigation expense/      Tax Court
  Findings                            2013-2014            litigation      48,965

      Feedback’s policy was to deal with claims on an “ad hoc basis.” For each

claim, Clark determined whether it appeared to be covered, drafted a claim

notification, requested a notification extension (if needed), prepared a sworn

statement in proof of loss, and sent everything to Heritor along with supporting

documents. Heritor then sent a letter back to Clark approving the claims. The

Commissioner does question whether several of the claims should have been

approved. The Business Risk policies under which the claims were made all

contain provisions requiring that Feedback receive the claim notification within
                                        - 48 -

the policy period. Yet Heritor granted notification extensions and approved

claims filed in April 2013 for policies that ended December 15, 2012.

      The Avrahamis weren’t alone in having returns audited because of their

interactions with a related microcaptive insurance company. The IRS has applied

increased scrutiny to these transactions, adding them to the “dirty dozen” list of

tax scams in 2015 and declaring them “transactions of interest” in 2016. See

Notice 2016-66, 2016-47 I.R.B. 745; I.R.S. News Release IR-2015-19 (Feb. 3,

2015). The Avrahamis’, however, is the first section 831(b) case to make it to

trial. The Commissioner determined deficiencies of nearly $380,000 for 2009 and

$990,000 for 2010, plus almost $275,000 in penalties. These deficiencies are the

result of three adjustments:

      •      an increase in the income passed through to the Avrahamis from
             American Findings, Chandler One, O&E, and White Knight of more
             than $1 million for both 2009 and 2010;43

      •      recharacterization of the $1.5 million transfer from Feedback to Belly
             Button and the $200,000 transfer from Feedback to Mrs. Avrahami as
             “other income” on the Avrahamis’ 2010 return; and

      •      a computational adjustment that decreased the amount of medical
             expense deductions allowed each year.


      43
          This increase in income was caused by the disallowance of the Avrahami
entities’ insurance expense deductions for the amounts they paid to Feedback and
Pan American.
                                       - 49 -

The Avrahamis were Arizona residents when they filed a timely petition with the

Court.44

                                     OPINION

I.    Taxation of Insurance

      Amounts paid for insurance are deductible under section 162(a) as ordinary

and necessary expenses paid or incurred in connection with a trade or business.

Sec. 1.162-1(a), Income Tax Regs. But amounts set aside in a loss reserve as a

form of self-insurance are not. See Harper Grp. v. Commissioner, 96 T.C. 45, 46

(1991), aff’d, 979 F.2d 1341 (9th Cir. 1992); see also Steere Tank Lines, Inc. v.

United States, 577 F.2d 279, 280 (5th Cir. 1978); Spring Canyon Coal Co. v.

Commissioner, 43 F.2d 78, 80 (10th Cir. 1930). However, neither the Code nor

the regulations define “insurance”. Securitas Holdings, Inc. v. Commissioner,

T.C. Memo. 2014-225, at *18. Instead we are guided by caselaw when

determining whether insurance exists for federal income tax purposes. The

Supreme Court has stated that insurance is a transaction that involves “an actual

‘insurance risk’” and that “[h]istorically and commonly insurance involves risk-

shifting and risk-distributing.” Helvering v. Le Gierse, 312 U.S. 531, 539 (1941).


      44
        Absent an agreement by the parties, the Avrahamis’ case is appealable to
the Ninth Circuit. See sec. 7482(b)(1)(A).
                                       - 50 -

      A.     Section 831

      While the Code permits the deduction of insurance premiums paid, it also

taxes insurance premiums received. Insurance companies--other than life-

insurance companies, see section 832--are generally taxed on their income in the

same manner as other corporations. See secs. 831(a), 11. Section 831(b),

however, provides an alternative taxing structure for certain small insurance

companies.

      Congress added this section to the Code as part of the Tax Reform Act of

1986 (TRA), Pub. L. No. 99-514, sec. 1024, 100 Stat. at 2405, but a tax break for

qualifying insurance companies is not a new idea. The Revenue Act of 1924, ch.

234, sec. 231(10), 43 Stat. at 283, exempted certain mutual-insurance companies45

from tax if 85% or more of their income was collected “for the sole purpose of

meeting losses and expense.” In 1942 the exemption provisions were revised,

making only small mutual insurers--those with interest, dividends, rents, and


      45
         Mutual-insurance companies--as opposed to stock-insurance companies--
generally have the following characteristics: “(1) Common equitable ownership of
assets by members; (2) the right of policyholders to be members to the exclusion
of others and to choose management; (3) a sole business purpose of supplying
insurance at cost; and (4) the right of members to the return of premiums which
are in excess of the amount needed to cover losses and expenses.” Okla. State
Union of the Farmers Educ. & Coop. Union of Am. v. Commissioner, 68 T.C. 651,
664 (1977); see also Rev. Rul. 74-196, 1974-1 C.B. 140.
                                        - 51 -

premiums not exceeding $75,000 for the taxable year--exempt from tax and

establishing an alternate taxing structure for insurers with income between

$75,000 and $125,000. See Revenue Act of 1942, ch. 619, sec. 165(a) and (b), 56

Stat. at 872; Tax Reform Proposals—XXII: Hearing Before the S. Comm. on

Finance, 99th Cong. 129 (1985) (Statement on Behalf of the National Association

of Mutual Insurance Companies (NAMIC)). The new limit aimed to favor small

and local mutual-insurance companies, practically all of which would fall under

the $75,000 threshold. See S. Rept. No. 77-1631 (1942), 1942-2 C.B. 504, 616.

In 1962 the threshold for complete tax exemption was raised to $150,000 and the

range for alternative taxation was changed to $150,000 to $500,000. See Revenue

Act of 1962, Pub. L. No. 87-834, sec. 8(a), 76 Stat. at 997; see also secs. 821(c),

501(c)(15) (1962). Nonlife mutual-insurance companies were sorted into three

categories: (1) those with gross receipts not exceeding $150,000, which were tax

exempt; (2) “small mutuals” with gross receipts between $150,000 and $500,000,

which were taxed only on their investment income; and (3) “ordinary mutuals”

with gross receipts over $500,000, which were taxed on both investment and

underwriting--i.e., premium--income. See Taxation of Property and Casualty

Insurance Companies: Hearing Before the S. Comm. on Finance, 98th Cong. 10

(1983) (Overview).
                                        - 52 -

      The next overhaul of these Code provisions occurred in 1986 when

Congress repealed and redesignated the Code sections governing the taxation of

mutual-insurance companies--sections 821 to 826, respectively--and instead

imposed a single taxing structure for all nonlife insurance companies--mutual and

stock--under section 831. TRA sec. 1024. This included the addition of section

831(b) to the Code, which provided alternative taxation to all small nonlife

insurance companies, but with a simplified structure and higher limits. See S.

Rept. No. 99-313, at 512 (1985), 1986-3 C.B. (Vol. 3) 1, 512 (explaining the

reason for the change in law was to simplify the taxation of small insurance

companies and remove the distinction between small stock and mutual insurers).

      This brings us up to the years at issue in these cases. For 2009 and 2010, if

a nonlife insurance company had gross receipts that did not exceed $600,000--or

$150,000 for mutual-insurance companies--and met certain premium percentage

requirements, then it was exempt from tax. Sec. 501(c)(15) (2010). Otherwise, if

it had net written premiums (or, if greater, direct written premiums) that did not

exceed $1.2 million for the year, then it could elect to be taxed under section
                                       - 53 -

831(b) and be subject to tax only on its taxable investment income. Sec. 831(b)(1)

and (2).46

      B.     Captive Insurance Companies

      Insurance taxation gets slightly more complicated when the insurer and the

insureds are related because the line between insurance and self-insurance begins

to blur. A pure captive insurance company is one that insures only the risks of

companies related to it by ownership. See Hosp. Corp. of Am. v. Commissioner,

T.C. Memo. 1997-482, 1997 WL 663283, at *2. The concept is often attributed to

Fred Reiss who, in the 1950s, in response to skyrocketing commercial-insurance

prices, figured out that Youngstown Sheet and Tube could set up its own

insurance company to insure its coke and iron mines. See Christopher L. Kramer,

“Ohio Agent Credited With Captives”, National Underwriter (Mar. 10, 2003),

https://www.captive.com/docs/default-source/default-document-library/ohio-

agent-credited-with-captive-movement.pdf. The concept spread, and the IRS

started challenging whether the payments between a company and its captive were

deductible insurance expenses. See, e.g., Rev. Rul. 77-316, 1977-2 C.B. 53.

      46
         The 2015 amendments to section 831(b) increased the premium ceiling to
$2.2 million--adjusted for inflation--and added new diversification requirements
that an insurance company must meet in order to receive the favorable tax
treatment of subsection (b). See Consolidated Appropriations Act, 2016, Pub. L.
No. 114-113, sec. 333, 129 Stat. at 3106.
                                          - 54 -

When the issue has come to us, we have applied and construed the Supreme

Court’s definition of insurance in Le Gierse and its four nonexclusive criteria. To

be considered insurance the arrangement must:

      •      involve risk-shifting;

      •      involve risk-distribution;

      •      involve insurance risk; and

      •      meet commonly accepted notions of insurance.

See Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1, 13 (2014); see also R.V.I.

Guar. Co. v. Commissioner, 145 T.C. 209, 225 (2015); Harper Grp., 96 T.C. at 58;

AMERCO & Subs. v. Commissioner, 96 T.C. 18, 38 (1991), aff’d, 979 F.2d 162

(9th Cir. 1992); Securitas, at *18.

      In AMERCO, 96 T.C. at 42, we found that transactions between

AMERCO--and its subsidiaries, which were in the business of renting U-Hauls--

and its indirectly wholly owned captive insurance company were for insurance for

federal tax purposes. In that case, the captive was regulated “under standard state

insurance laws” and issued a wide variety of insurance policies. Id. at 36-37.

Some of the policies were issued to AMERCO and its subsidiaries and covered

risks such as commercial perils, pollution, and worker’s compensation. Id. at 25-

26. But over 50% of the captive’s gross written premiums came from unrelated
                                        - 55 -

parties including some of AMERCO’s customers. Id. at 36-37. We held that on

the basis of the potential hazards faced by the insureds, insurance risk--not merely

investment risk--was present. Id. at 39. We also found that there was risk-

shifting--as opposed to merely the building of a reserve for losses--because the

captive wrote insurance contracts, collected premiums, paid losses, was regulated

by several states, and was “a separate, viable entity, financially capable of

meetings its obligations.” Id. at 40-41. We also found risk distribution because

the captive’s “insurance business was diverse, multifaceted, and * * * involved a

substantial amount of outside risks.” Id. at 41. Finally, we found on the basis of

all the facts and circumstances, including the captive’s licensing as an insurance

company in 45 states, that the transactions at issue in AMERCO involved

insurance in the commonly accepted sense. Id. at 37, 42.

      Applying these criteria, we also found in favor of the taxpayer in Harper

Grp., 96 T.C. at 60. Harper was a holding company whose subsidiaries were in the

business of international shipping and which indirectly owned a captive insurance

company licensed in and regulated by Hong Kong. Id. at 47, 49. The captive was

created to provide marine legal-liability insurance to Harper’s subsidiaries, and

after its incorporation Harper terminated its substantially similar commercial-

carrier coverage. Id. at 49-50. The captive also derived approximately 30% of its
                                        - 56 -

premium revenue from a large number of unrelated parties--specifically the

customers of Harper’s subsidiaries--who purchased shipper’s-interest cargo

insurance. Id. at 50, 59-60. We found that the insureds faced substantial potential

liability in the shipping business--liability that had previously been covered by a

commercial policy--so this arrangement involved insurance risk. Id. at 58. We

found that risk-shifting occurred because the captive was not a sham, conducted a

bona fide insurance business, charged arm’s-length premiums, and was financially

capable of satisfying the claims made against it. Id. at 59. We also found the

policies that the captive offered were for insurance in its commonly accepted

sense. Id. at 60. But for risk distribution we focused on the number of unrelated

insureds covered by the captive and what proportion of the captive’s premium

income they represented. Id. at 59-60. We held that a “relatively large number of

unrelated insureds compris[ing] approximately 30 percent of [the captive’s]

business” amounted to “a sufficient pool of insureds to provide risk distribution.”

Id.

      More recently, we held that payments to a Bermudian captive from its

bother-sister companies--i.e., all owned by the same corporate parent--were

deductible insurance expenses. Rent-A-Center, 142 T.C. at 25. In Rent-A-Center

the captive provided workers’ compensation, automobile, and general-liability
                                       - 57 -

coverage only to its parent’s other subsidiaries. Id. at 5-6. We found that the

captive was not a sham because it was formed “to reduce [Rent-A-Center’s]

insurance costs, obtain otherwise unavailable insurance coverage, formalize and

more efficiently manage its insurance program, and provide accountability and

transparency relating to insurance costs.” Id. at 11. The Commissioner conceded

in that case that Rent-A-Center faced insurable risks. Id. at 12-13. We found that

there was risk-shifting--despite the captive’s parental guaranty and lack of

unrelated insureds--because a covered loss did not economically affect the

insureds. Id. at 21-22. We also explained that “[r]isk distribution occurs when an

insurer pools a large enough collection of unrelated risks.” Id. at 24. In Rent-A-

Center the captive had “a sufficient number of statistically independent risks”

because it provided workers’ compensation, automobile, and general liability

policies that covered more than 14,000 employees; 7,100 vehicles; and 2,600

stores. Id.

      C.      Microcaptives

      Combining these two concepts--captive insurance companies and the

section 831(b) tax advantages for small insurance companies--yields the

“microcaptive”. In theory, a microcaptive could be run in the manner of the

captives in Rent-A-Center or Harper Group, albeit on a much smaller scale. But it
                                        - 58 -

might also be run so that related parties pay the captive deductible insurance

premiums of just under $1.2 million a year. In turn the captive might pay out few

if any claims, might make a section 831(b) election so it pays tax only on its

investment income, and might quickly build up a large surplus. Then, if the

captive were to be licensed and regulated in a jurisdiction with extremely low

reserve requirements and loose rules on related-party transactions, it might lend its

surplus back to its affiliates. This might generate nearly $1.2 million in tax

deductions while arguably only moving money from one pocket to another. Or

perhaps the captive could be owned by a Roth IRA, which might mean it could

make large dividend payments to its stockholder, creating a form of deductible, yet

tax-free, retirement savings. Or perhaps the captive could be owned by its

business owner’s children or an irrevocable family trust, which might enable the

avoidance of future gift and estate taxes.

      There may be other variations on this theme; the Commissioner, however,

finds none of them pleasing.

II.   The Parties’ Arguments

      In these cases, the Commissioner’s position is that the amounts paid to

Feedback and Pan American are not deductible business expenses because the

arrangements lack all four criteria necessary to be considered “insurance” for
                                        - 59 -

federal tax purposes. He argues that several of Feedback’s policies included

uninsurable risks; that Feedback failed to distribute risk because it had an

insufficient pool of insureds; that risk was not shifted because neither Feedback

nor Pan American was financially capable of meeting its obligations; and that the

arrangements did not embody common notions of insurance because Feedback and

Pan American did not operate like insurance companies and their premiums were

not determined at arm’s length. In the Commissioner’s view this means that

Feedback was not an insurance company and that the funds transferred out of

Feedback that eventually ended up in the Avrahamis’ bank account--whether

directly or indirectly via Belly Button--must be ordinary income to them.

      The Avrahamis and Feedback, on the other hand, argue everything they did

complied with the Code and relevant caselaw. Their position is that Feedback is a

valid insurance company that qualified and properly elected to be taxed under

section 831(b); that all the policies covered insurable risks; that all premiums were

actuarially determined; and that Feedback distributed risk by ensuring at least 30%

of its premium income came from unrelated parties participating in the Pan

American program. They say this means the insurance-expense deductions

claimed by the various Avrahami entities were proper and that all the distributions

to Belly Button were valid, documented loans. (The amount distributed directly to
                                        - 60 -

Mrs. Avrahami, on the other hand, they concede should have been reported and

taxed--at qualified dividend rates, they argue--and would have been but for an

error by their CPA.)

III.   Were the Policies Contracts for “Insurance”?

       These cases turn on whether the transactions at issue involved “insurance”

for federal tax purposes. Precedent tells us to answer this question by considering

all the facts and circumstances and deciding whether the arrangement involves risk

shifting, risk distribution, and insurance risk, and meets commonly accepted

notions of insurance. See Rent-A-Center, 142 T.C. at 13-14; Securitas, at *18.

We will start with risk distribution.

       A.    Risk Distribution

       Risk distribution is one of the common characteristics of insurance

identified by the Supreme Court in Le Gierse, 312 U.S. at 539, and occurs when

the insurer pools a large enough collection of unrelated risks. Rent-A-Center, 142

T.C. at 24; Securitas, at *25. The idea is based on the law of large numbers--a

statistical concept that theorizes that the average of a large number of independent

losses will be close to the expected loss. See Securitas, at *25-*26; Malone &

Hyde, Inc. v. Commissioner, T.C. Memo. 1993-585, 1993 WL 516207, at *14

n.23, rev’d on other grounds, 62 F.3d 835 (6th Cir. 1995). As the Ninth Circuit
                                       - 61 -

explained in Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th

Cir. 1987), aff’g 84 T.C. 948 (1985), “[b]y assuming numerous relatively small,

independent risks that occur randomly over time, the insurer smoothes out losses

to match more closely its receipt of premiums.”

             1.    The Parties’ Arguments

      The Avrahamis and Feedback claim their arrangement distributed risk in

two independently sufficient ways. First, they rely on Securitas and the Sixth

Circuit’s opinion in Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989),

aff’g in part, rev’g in part 88 T.C. 197 (1987), to argue that Feedback created a

sufficient pool of risks merely by issuing seven types of direct policies--each

covering a variety of risks--to the Avrahami entities. Second, they argue that

Feedback adequately distributed risk through the Pan American program by

reinsuring over 100 geographically diverse third parties. They read Harper Group

to establish a rule that risk is distributed whenever premiums from unrelated

insureds constitute more than 29% of a captive’s premiums and point out that

Feedback received over 33% of its premiums in 2009 and almost 31% of its

premiums in 2010 from Pan American participants.

      The Commissioner doesn’t think it is quite that simple. He argues that

Feedback directly insured only three related entities in 2009 and four in 2010, too
                                          - 62 -

few compared with the numbers in our precedents where we found there to be

insurance and wholly insufficient to benefit from the law of large numbers. He

also claims that Feedback and the Avrahamis misread Harper Group by focusing

solely on the percentage of premiums that came from third parties when the

number of unrelated insureds--over 7,500--was equally important. Finally, the

Commissioner argues that the Pan American program doesn’t distribute risk

because the terrorism policies weren’t covering relatively small, independent risks.

             2.     Affiliated Entities

      We will look first at the argument that Feedback achieved sufficient risk

distribution by issuing policies to the Avrahami entities. It is certainly possible for

a captive to distribute risk by insuring only its brother-sister businesses. The Sixth

Circuit said as much in Humana, 881 F.2d at 257, and we subsequently agreed.

See Rent-A-Center, 142 T.C. at 24 (“A captive may achieve adequate risk

distribution by insuring only subsidiaries within its affiliated group.”); Securitas,

at *26-*27. But because the captive must still have a large enough pool of

unrelated risks, the question is, what is “large enough”?

      The experts in these cases would have us focus on the number of insureds.

David Babbel--the Commissioner’s expert witness with a background in insurance

and financial economics whom we find to be credible--testified at trial that
                                        - 63 -

“depending on the nature of the risk” a captive would likely need to insure a

minimum of 35 sibling entities to get good distribution of risk.47 In his opinion the

captive must insure this minimum number to start to benefit from the law of large

numbers and to get sufficient pooling of risk. The Avrahamis’ expert witnesses,

Daniel Spragg and Sheila Small, expressed a similar opinion--but with a lower

number--in their expert report. Citing Revenue Ruling 2002-90, 2002-2 C.B. 985,

they explained: “It is commonly cited that there must be at least 12 affiliated

corporate policyholders that pool their risk in a pure captive arrangement and in an

association captive arrangement, there must be at least seven policyholders.”48

Since Feedback was insuring only three affiliated entities in 2009 and four in

2010, we don’t need to decide which of these experts is correct. Instead we will




      47
         The Avrahamis objected to Babbel’s testimony on risk distribution,
asserting that he failed to form an opinion on risk distribution in his expert report
and citing Rule 143(g). We disagree--Babbel’s expert report did touch on risk
distribution in its discussion of the law of large numbers and the need for a
sufficiently large number of risk exposures.
      48
        We note that Rev. Rul. 2002-90, 2002-2 C.B. 985, discusses a situation in
which the IRS would consider amounts paid to a captive by its 12 sibling entities
to be deductible insurance premiums. Where Spragg and Small derive their
“seven policyholder” analysis is unclear from the record.
                                        - 64 -

simply agree that when analyzing the number of related insured companies,

Feedback failed to adequately distribute risk.49

      We also want to emphasize that it isn’t just the number of brother-sister

entities that one should look at in deciding whether an arrangement is distributing

risk. It’s even more important to figure out the number of independent risk

exposures. For example, in R.V.I. we found risk distribution not just because an

insurance company insured 714 different unrelated parties, but also because it

issued 951 policies covering more than 750,000 vehicles, 2,000 real estate

properties, and 1.3 million equipment assets in 7 different geographic regions.

R.V.I., 145 T.C. at 228-29. And in Rent-A-Center we found “a sufficient number

of statistically independent risks” when the captive provided workers’

compensation, automobile, and general liability policies that covered more than

14,000 employees, 7,100 vehicles, and 2,600 stores in all 50 states. 142 T.C. at

24. We also held that risk distribution was achieved when a captive provided

worker’s compensation coverage for more than 300,000 employees, automobile

coverage for more than 2,250 vehicles, and other coverages for more than 25

separate entities. See Securitas, at *26. Even in Humana, 881 F.2d at 257, where

      49
       Even the Avrahamis’ expert witnesses stated: “Since there were not
enough brother-sister companies to support that risk distribution structure
Feedback needed to find an alternative solution.”
                                         - 65 -

the Sixth Circuit held that risk distribution could occur when a captive “insures

several separate corporations within an affiliated group”, the captive insured more

than 20 corporations operating more than 60 hospitals with more than 8,500 beds.

See Humana Inc. v. Commissioner, 88 T.C. 197, 199-202 (1987).

      We find that Feedback’s risk exposures fall short of these situations. It

issued seven types of direct policies--five to American Findings and two each to

Chandler One, O&E, and White Knight. American Findings’ policies covered 3

jewelry stores, 2 key employees, and around 35 employees. The remaining

policies covered three commercial real estate properties, all in metropolitan

Phoenix. While we recognize that Feedback is a microcaptive and must operate

on a smaller scale than the insurance companies in R.V.I. or Rent-A-Center, we

can’t find that it covered a sufficient number of risk exposures to achieve risk

distribution merely through its affiliated entities.

             3.     Pan American

      Recall, however, that the Avrahamis also argue that Feedback distributed

risk by participating in the Pan American program and reinsuring third-party risk.

They stress that we found risk distribution in two prior cases by looking at the

percentage of the captive’s gross premium income received from unrelated

insureds. Specifically, in AMERCO, 96 T.C. at 36-37, “outside insurance
                                        - 66 -

constituted over 50 percent of [the captive’s] gross written premiums” and in

Harper Group, 96 T.C. at 52, at least 29% of the captive’s gross premium revenue

came from unrelated parties.50 The Avrahamis encourage us to use the same

reasoning here. We will decline to do so because we can’t read these cases--and

others like them--that narrowly.

      In cases where we have found there to be risk distribution because a captive

insured a sufficient number of unrelated parties, we also found the policies issued

to those unrelated parties covered insurable risks, successfully shifted the risks to

the captive, and satisfied all the commonly accepted notions of insurance. See,

e.g., Rent-A-Center, 142 T.C. at 21-25; Harper Grp., 96 T.C. at 58-60; AMERCO,

96 T.C. at 39-42; Securitas, at *7-*10. Therefore, before we can say whether

Feedback distributed risk through the Pan American program, we must decide if

      50
         In finding we did not err in Harper Grp. v. Commissioner, 96 T.C. 45
(1991), aff’d, 979 F.2d 1341 (9th Cir. 1992), the Ninth Circuit summarized
existing precedent: “Prior cases which have found true insurance have also
included higher percentages of unrelated business than those found here. See
Sears Roebuck & Co. v. Commissioner, 972 F.2d 858, 860 (7th Cir. 1992) (99.75
percent from others); Ocean Drilling & Exploration Co. v. United States, 24 Cl.
Ct. 714, 730 (1991) (44 percent to 66 percent from others). Cases which have
found no true insurance have found much lower percentages of unrelated business.
See, e.g., Beech Aircraft Corp. v. United States, 797 F.2d 920, 921-22 (10th Cir.
1986) (.5 percent from others); Gulf Oil Corp. v. Commissioner, 89 T.C. 1010,
1028 (1987) (2 percent from others), rev’d in part on other grounds, 914 F.2d 396
(3d Cir. 1990); Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1299
(9th Cir. 1987) (none from others).” Harper Grp., 979 F.2d at 1342.
                                       - 67 -

Pan American itself was a bona fide insurance company. See Rent-A-Center, 142

T.C. at 10. In determining whether an entity is a bona fide insurance company we

have looked at such factors as:

      •      whether it was created for legitimate nontax reasons;

      •      whether there was a circular flow of funds;

      •      whether the entity faced actual and insurable risk;

      •      whether the policies were arm’s-length contracts;

      •      whether the entity charged actuarially determined premiums;

      •      whether comparable coverage was more expensive or even available;

      •      whether it was subject to regulatory control and met minimum
             statutory requirements;

      •      whether it was adequately capitalized; and

      •      whether it paid claims from a separately maintained account.

Id. at 10-13. We will take a few of these in turn.

                   i.     Circular Flow of Funds

      Recall that Pan American was structured in such a way that a small business

would pay Pan American a premium for coverage up to a certain limit. Then Pan

American would turn around and reinsure all the risk it had assumed, making sure

that the captive related to the small business received reinsurance premiums equal
                                       - 68 -

to those paid by that small business. Under the 2009 program, for example,

American Findings paid Pan American $360,000 for up to $5,525,000 in terrorism

coverage and Pan American paid Feedback $360,000 for reinsuring 1.797% of Pan

American’s total losses. The same was true under the 2010 program--American

Findings paid Pan American $360,000 for up to $5,125,000 in terrorism coverage

and Pan American paid Feedback $360,000 for reinsuring 1.56% of Pan

American’s total losses. While not quite a complete loop, this arrangement looks

suspiciously like a circular flow of funds. The end result of two years in the Pan

American program was the transfer of $720,000 from an entity owned 100% by

the Avrahamis to one owned 100% by Mrs. Avrahami.

                   ii     Unreasonable Premiums

      Recall also that Pan American was structured around a single type of

insurance policy--terrorism coverage known as TRIP. While the parties agree that

terrorism is an insurable risk, their views on the reasonableness of the policy terms

and premiums charged are drastically different. The Avrahamis take the position

that the premium rate--6.5% of the loss limit in 2009 and 7% in 2010--was

reasonable because they fell within an actuarially determined range. Specifically,

they argue that Rosenbach--the actuary hired by Clark--performed a market study

and “based upon his experience and research” recommended a rate on line
                                       - 69 -

between 5% and 8% of the policy limit in 2009 and between 5% and 9% in 2010.

The Commissioner, however, has serious qualms about Rosenbach’s method. He

points out with considerable persuasiveness that Rosenbach’s study included no

rates from insurers that actually provided similar coverage. Rosenbach’s study did

not address, much less quantify, how the differences between Pan American’s

TRIP coverage and commercially available TRIA coverage might affect

premiums. And in the end he recommended a one-size-fits-all rate for all of

Clark’s scores of clients. There are some rather obvious questions here: For

example, Pan American charged the same rate to all of its participants regardless

of their geographic location, yet Rosenbach’s report cited an Insurance Services

Office source indicating the commercial market price for terrorism risk insurance

subject to TRIA can be up to 10 times more expensive for policyholders in large

cities like New York or Washington. Pan American participants also paid the

same rate even if they--like American Findings--had terrorism coverage under

another policy, even though the TRIP policy was written as an excess-coverage

policy, in which the risk assumed by Pan American was only the portion of a loss

not covered, or not fully covered, by another policy.

      In analyzing the reasonableness of Pan American’s premiums, Babbel’s

report compared Pan American’s terrorism risk rate to that of commercial carriers.
                                       - 70 -

While we recognize that Pan American was operating on a smaller scale than other

insurers providing stand-alone terrorism coverage and that the TRIP policies

contained some unique terms, we find Babbel’s insight instructive and a good

reasonableness check. For starters, American Findings paid Jewelers Mutual more

than $1,500 in 2009 and $1,600 in 2010 for add-on terrorism coverage with a

policy limit of $2 million and exclusions for chemical and biological hazards.

This amounts to a rate on line--the premium divided by the limit--of less than

0.081%. On the other hand, American Findings paid Pan American $360,000 in

both 2009 and 2010 for stand-alone terrorism coverage with policy limits of

around $5.5 million in 2009 and $5.2 million in 2010. This amounts to a rate on

line of between 6.5% and 7%--or approximately 80 times more than the rate under

the Jewelers Mutual policy. Some of this difference can be explained by TRIP’s

additional coverage of chemical and biological attacks--Rosenbach testified that

80% to 90% of the rate range he proposed was related to the chemical and

biological coverage. But this doesn’t account for TRIP’s policy terms that cut in

the other direction, such as the provision excluding coverage for any attack

occurring in any city with more than 1.5 million residents, the provision giving

TRIP excess status to any other policy, or the provision allowing for the payment

of claims with a promissory note payable over a maximum of three years.
                                        - 71 -

       Babbel also compared Pan American’s rates to the stand-alone terrorism

premium rates published in 2013 by Marsh Risk Management Research.51 As he

explained, Marsh “reported that median stand-alone terrorism insurance premium

rates for the real estate industry was $40 per million of TIV [total insurable value]

in 2010, while for the retail/wholesale sector, the median rate was $24 per million

of TIV in 2010.” Total insurable value (TIV) is the “full value of insured’s

covered property, business income values, and other covered property interests.”

Using the $8 million in total assets reported on American Findings’ 2010 tax

return as a proxy for its TIV, this means American Findings paid Pan American

$45,000 per million of TIV.52 Even if American Findings’ TIV was higher--

perhaps to account for TRIP’s inclusion of coverage for both the loss of property

and business income that resulted directly from a covered act of terrorism--the

premiums charged by Pan American are grossly excessive.

                   iii.   Arm’s-Length Contracts

      Babbel also questioned the contracts with Pan American and concluded that

“[u]nder this combination of conditions, no reasonable, profit-seeking business


      51
         Marsh is one of the world’s largest insurance brokers and has extensive
captive insurance experience.
      52
        American Findings’ 2010 premium payment to Pan American of $360,000
divided by 8 (number of millions of TIV) is $45,000.
                                        - 72 -

would enter into a contract with the terms of the Pan-American coverage with an

insurer absent certain beneficial tax considerations” (these conditions being that

Pan American was charging exorbitantly high premiums for coverage that had a

very low probability of being triggered and a questionable ability to pay claims).

For a claim to be covered under TRIP, the policyholder had to suffer a loss

resulting directly from an act of terrorism certified by the Secretary of the Treasury

with the concurrence of the Secretary of State and the Attorney General that

resulted in over $100 million in losses and that occurred within the United States

but not in a city with more than 1.5 million residents. The claim also had to not be

covered in full under another policy. Rosenbach testified that he did not know of

any event in history that would have met these requirements. And of course no

events took place that triggered a claim during the years at issue in these cases.

      It is also questionable whether a qualifying loss would have been paid. Pan

American received more than $20 million in premiums in 2009 and in turn agreed

to insure up to an aggregate of more than $308 million in losses. It ceded 100% of

this insurance risk to the participating captives and likewise passed on 100% of its

premiums--50% within 90 days, another 47.5% within 180 days, and the last 2.5%

when the policy expired on December 15. This means that by July 2010--more

than 180 days into the 2009 policy period--Pan American had only about $500,000
                                        - 73 -

of premium revenue on hand to pay claims. If a covered claim came in, Pan

American would have to go to each of the participating reinsurers to get the

necessary cash; and if a reinsurer wouldn’t or couldn’t pay, Pan American would

have to foot the bill itself--an event that would be more probable if, like Mr.

Avrahami, other captives owners would “freak out” if they lost money in the Pan

American program. We understand that Pan American was adequately capitalized

under Nevisian law, which required only $75,000 in capital because Pan American

ceded 100% of its risk. See Nevis International Insurance Ordinance 2009, c.

7.07(N), sec. 9(1)(b)(iii). But we need not pretend that a company as thinly

capitalized as Pan American, with directors and a management team substantially

weaker in numbers and ability than those of a normal reinsurer, would be hard

pressed to enforce the cession agreements against the scores of captive insurers it

might have to go after.

                    iv.   Bona Fide Insurance Company

      The Avrahamis nevertheless argue that Pan American was a fronting

company whose business purpose was to issue terrorism risk insurance and then

fully cede--or reinsure--that risk to other insurers. Both parties agree that fronting

companies are a real thing in the insurance industry. See, e.g., Hanover Ins. Co. v.

Urban Outfitters, Inc., 806 F.3d 761, 764 n.3 (3d Cir. 2015) (explaining that a
                                         - 74 -

fronting company issues fronting policies, which are “a risk management

technique in which an insurer underwrites a policy to cover a specific risk but then

cedes the risk to a reinsurer”); Wal-Mart Stores, Inc. v. Crist, 855 F.2d 1326, 1330

n.3 (8th Cir. 1988) (describing an entity as a “fronting company” when it

permitted the use of its insurance policy forms for a percentage fee). The

Commissioner, on the other hand, says Pan American wasn’t operated like a

fronting company and was formed merely as a mechanism for Clark’s clients to

meet their risk-distribution requirements. The Avrahamis’ expert witnesses

testified that fronting companies generally receive a fee of around 5% of

premiums as a “ceding commission” and noted that it is always a percentage rather

than a fixed fee. A fronting company, while not taking on any insurance risk, still

must be compensated for the services it provides, including the assumption of

credit risk--the risk that the reinsurers can’t or won’t pay their portion of an

insured loss, forcing the fronting company to come up with the money to settle a

claim. Pan American, however, did not charge a ceding commission. Instead,

100% of the premiums it received were passed through to the reinsurers and its

only compensation was an “insurance pool administration fee” paid by Clark of
                                         - 75 -

around $120,000 in 2009 and $410,000 in 2010.53 These amounts came out of the

$5,000 “all-inclusive” annual fee paid to Clark by each of the businesses

participating in the Pan American program.

      We won’t condemn Pan American solely for its atypical fee structure, but

that structure came combined with excessive premiums, an ultralow probability of

a claim ever being paid, and payments of a circular nature. We have to make a

finding of fact on this. Is such an entity engaged in insurance or is it just part of a

tax-reduction scheme papered to look like an entity engaged in insurance? The

answer is that more likely than not, Pan American is not a bona fide insurance

company. We know it was regulated under the laws of the Island of Nevis and

met that loosely regulated regime’s low capitalization requirements, but that is not

enough.

      Because we find that Pan American was not a bona fide insurance company,

we cannot find that the policies it was issuing were insurance, which in turn means

Feedback’s reinsurance of those same policies did not distribute risk. Therefore,

neither through its affiliated entities nor through Pan American did Feedback




      53
        Pan American ceded more than $20 million of premiums in 2009 and
almost $23 million in 2010. Therefore, the fixed fees Pan American received were
equivalent to approximately 0.6% of premiums in 2009 and 1.8% in 2010.
                                        - 76 -

accomplish sufficient risk distribution for its arrangements to be considered

“insurance” for federal income tax purposes.

      B.     Insurance in the Commonly Accepted Sense

      The absence of risk distribution by itself is enough to sink Feedback. See

AMERCO, 96 T.C. at 40 (holding that risk-shifting and risk-distributing “are

necessary to the existence of insurance” (emphasis added) (citing Gulf Oil Corp.

v. Commissioner, 89 T.C. 1010, 1023 (1987)); see also Humana, 881 F.2d at 257

(“Risk transfer and risk distribution are two separate and distinct prongs of the test

and both must be met to create an insurance contract.”). But the cases tell us that

in deciding whether an arrangement is insurance we can also look at whether it

looks like insurance in the commonly accepted sense. This is an alternative

ground. To analyze it, we look at numerous factors, including whether the

company was organized, operated, and regulated as an insurance company;

whether the insurer was adequately capitalized; whether the policies were valid

and binding; whether the premiums were reasonable and the result of an arm’s-

length transaction; and whether claims were paid. See R.V.I., 145 T.C. at 231;

Rent-A-Center, 142 T.C. at 24-25; Harper Grp., 96 T.C. at 60; Securitas, at *27.

We have also looked at whether the policies covered typical insurance risks and
                                        - 77 -

whether there was a legitimate business reason for acquiring insurance from the

captive. See Hosp. Corp., 1997 WL 663283, at *26.

             1.    The Parties’ Arguments

      The Avrahamis and Feedback argue that their arrangements clearly satisfied

these requirements. They assert that Feedback was organized, operated, and

regulated as an insurance company under the laws of St. Kitts. Likewise, they

claim Feedback was adequately capitalized because it met or exceeded the

minimum capitalization requirements established by St. Kitts. Their position is

that all the policies were valid and binding because they contained customary

insurance terms and conditions, the premiums were reasonable and determined by

an actuary, and all approved losses were paid.

      The Commissioner disagrees. He argues that Feedback was organized

solely for tax purposes, didn’t operate as an insurance company, lacked arm’s-

length premium determinations, failed to get timely approval for transfers to

related parties in violation of Kittian regulations, didn’t satisfy Arizona insurance

regulations, and issued policies with contradictory provisions.

             2.    Organization, Operation, and Regulation

      We will start with organization, operation, and regulation as an insurance

company. The parties agree that Feedback was incorporated and regulated as a
                                        - 78 -

captive insurance company in St. Kitts. The Commissioner, however, argues that

Feedback was also subject to, but in violation of, Arizona insurance regulations.

Whether the Commissioner is correct will not change the outcome of these cases,

so we’ll leave this question for another day--or perhaps leave it to the Arizona

Department of Insurance. The more interesting question is whether Feedback was

operated as an insurance company and in making this determination we “must

look beyond the formalities and consider the realities of the purported insurance

transactions.” Id. at *24 (citing Malone & Hyde, Inc. v. Commissioner, 62 F.3d

835, 842-43 (6th Cir. 1995), rev’g T.C. Memo. 1989-604).

      We have to find that Feedback’s operations left something to be desired. It

dealt with claims “on an ad hoc basis.” It invested only in illiquid, long-term

loans to related parties and failed to get regulatory approval before transferring

funds to them. And we will not overlook the fact that the Avrahami entities made

no claims whatsoever against Feedback from its inception in 2007 until March

2013--two months after the IRS sent the Avrahamis documents about the audits of

the returns of American Findings, Chandler One, O&E, and White Knight that

suggested Feedback was a sham. And even the claims Feedback did receive it

dealt with in questionable ways. Most of the claims were approved despite being

filed late--the policies required that Feedback be notified within 30 days of the
                                       - 79 -

loss “as a condition precedent to payment of any benefit hereunder.” And Heritor

approved White Knight’s claim for a new roof despite a lack of evidence about the

cause of the damage. If the damage was caused by a fortuitous event--i.e., hail

damage--then Heritor should have considered whether White Knight’s commercial

policies with Allied Insurance would have covered the loss since White Knight’s

Business Risk Indemnity policy from Feedback offered only excess coverage.

And if the damage was caused by normal wear and tear--i.e., not a fortuitous

event--then Feedback probably shouldn’t be covering the loss because it is a

normal business expense and not an insurance risk. See Commissioner v.

Treganowen, 183 F.2d 288, 290 (2d Cir. 1950), rev’g 13 T.C. 159 (1949).

      Feedback also made investment choices only an unthinking insurance

company would make. For example, in 2010 Feedback reported two types of

assets on its tax return--more than $1.35 million in cash and $2.53 million in

“mortgage and real estate loans.” The $2.53 million comprised an $830,000

secured promissory note from Belly Button with no payments due until February

2018, a $1.5 million unsecured promissory note from Belly Button due in March

2020, and a $200,000 unsecured note from Belly Button--even though the funds

went directly to Mrs. Avrahami--due no earlier than December 2012. This meant

that by the end of 2010 more than 65% of Feedback’s assets were tied up in long-
                                        - 80 -

term, illiquid, and partially unsecured loans to related parties. And, despite Kittian

regulations requiring advance approval for any loan to a parent or affiliated

person, see Captive Insurance Companies Act of 2006, ch. 21.20 sec. 15.6 (2006),

Heritor didn’t disclose these loans to St. Kitts’ Registrar until September 2014. If

something catastrophic happened to Belly Button, its ability to repay the loans

would be impaired and make Feedback’s ability to pay on any claims doubtful.

Even if Feedback was organized and regulated as an insurance company, we find

it was not operated like one.

             3.    Capitalization

      Next we look at capitalization. The parties agree that Feedback met the

minimum capitalization requirements of St. Kitts. But the question is whether

meeting Kittian minimums is the same as being adequately capitalized. Our

caselaw implies that the answer is yes. See R.V.I., 145 T.C. at 231 (holding that

insurers who met the minimum capital requirements of their regulators were

adequately capitalized); Rent-A-Center, 142 T.C. at 13, 23-24 (finding that a

captive was adequately capitalized when it met Bermuda’s minimum statutory

requirements after consideration of a parental guaranty); Harper Grp., 96 T.C. at

50, 60 (holding a captive that was in compliance with Hong Kong’s minimum

capital law was adequately capitalized); Securitas, at *23 (finding a reinsurer was
                                        - 81 -

adequately capitalized when it met Vermont’s minimum premium-to-surplus

ratio); Malone, 1993 WL 516207, at *15. We won’t upset that consensus here.

             4.    Valid and Binding Policies

      Caselaw is slightly less vague on what makes a policy “valid and binding.”

Our Opinion in R.V.I. suggests policies are valid and binding if the insureds filed

claims for all covered losses and the captive paid them. See R.V.I., 145 T.C. at

231. And in Securitas we found valid and binding policies when “[e]ach insurance

policy identified the insured, contained an effective period for the policy, specified

what was covered by the policy, stated the premium amount, and was signed by an

authorized representative of the company.” Securitas, at *28. Here the policies

issued by Feedback and Pan American identified the insured, stated the premium

amount, and were signed by Heritor or Heritage as the authorized insurance

manager. But some of the policies were less than a model of clarity. The

Avrahamis assert that all the policies issued by Feedback were claims-made

policies, yet the policies say otherwise. For example, Chandler One’s 2009

Administrative Action policy states that Feedback “agrees to pay to the Insured

any legal expense incurred by the insured during the Policy Period, arising from or

relating to the defense of any Insured Event as defined hereunder, which Insured

Event is instituted against the Insured during the Policy Period.” The policy then
                                       - 82 -

defines “Policy Period” as “[e]vents occurring and reported from and after 12:01

a.m. December 15, 2009 and prior to 12:01 a.m. December 15, 2010.” By its plain

terms the policy limits coverage to legal expenses incurred and reported between

December 2009 and December 2010, terms indicative of both a claims-made

policy--the claim must be reported during the policy period--and of an occurrence

policy--the claim must occur during the policy period.

             5.    Reasonableness of Premiums

      The next question is whether Feedback’s and Pan American’s premiums

were reasonable and the result of an arm’s-length transaction. Clark did hire

Rosenbach to help price the policies, and he testified extensively about his

process; but because he priced captives only for Clark and his explanations were

often incomprehensible, we don’t find them persuasive. We find instead that the

premiums were utterly unreasonable. In 2006--before Feedback was formed--the

Avrahami entities spent about $150,000 on insurance. With Feedback in the

picture, their insurance bills soared to more than $1.1 million in 2009 and more

than $1.3 million in 2010. While the Avrahami entities were paying Feedback and

Pan American just shy of $1.2 million a year, they were also maintaining their

commercial coverage for less than $90,000 a year.
                                           - 83 -

         Starting with Feedback’s direct policies, recall that Rosenbach’s process

was to determine a base premium for each policy and then to adjust that base by

various factors. While he derived parts of his calculations from a standard Chubb

filing, he consistently chose inputs that generated higher premiums. For example,

Rosenbach used the hazard-group classifications from a June 2005 Chubb filing,

which placed “property managers” like Chandler One, O&E, and White Knight

into a riskier--and therefore more expensive--group, even though the January 2005

Chubb filing from which he pulled other adjustment factors put them in a less

risky group. This decision alone has a ripple effect. All else being equal, if

Rosenbach had used hazard group 2 instead of 4 when he determined the premium

for Chandler One’s 2009 Administrative Action policy, he would have calculated

a base rate of $4,99154 instead of $11,874, which would reduce the total premium

by more than half. He likewise chose a claims-made factor of 1.3--the highest in

the Chubb filing and representing retroactive coverage for five or more years--on

the assumption that all of the Feedback policies were claims-made with no

retroactive date. But as we have already found several of the policies had terms

limiting coverage to events occurring during the policy period. And the Chubb


         54
              The $4,991 is calculated as $4,375 + (($470,000 – $250,000) / 1,000 x
2.80).
                                        - 84 -

filing states that if there is no retroactive coverage the claims-made factor should

be 1.0--a 30% reduction from what Rosenbach used.

      Apart from the factors suggested in the Chubb filing, Rosenbach also made

adjustments based on his professional judgment--most without a coherent

explanation. For example, he increased Chandler One’s 2009 Business Risk

Indemnity premium by $2,500--$1,000 in 2010--for providing excess general-

liability coverage but offered no rationale for the amount chosen. In the same

calculation, Rosenbach also increased the premium by more than $26,000--and

more than $62,000 in 2010--for “construction defects” coverage. But Chandler

One wasn’t constructing anything; it just owned and leased commercial real estate.

Rosenbach also struggled to explain the premium calculation for the Litigation

Expense policy, which included a subjective “base exposure” and several

subjective factors that Rosenbach testified were multiplied together to reach the

premium amount. As the Avrahamis had to explain in their reply brief, however,

to reach the premium that Rosenbach calculated the base exposure has to be

multiplied by all of the factors except the expense ratio and then divided by one

minus the expense ratio. In 2010 Rosenbach came up with a nearly 60% higher

premium for the Litigation Expense policy because he “appl[ied] the model in a

little different light.” Similarly, Rosenbach was unable to explain the 7.5% event
                                        - 85 -

rate used in the Tax Indemnity calculation or even what it represented. Without a

comprehensible explanation we can’t find these premium amounts justified.

      We also note that Rosenbach performed his premium calculations using

applications, financial statements, tax returns, and a “business plan” that Clark

provided and that summarized the key terms of the policies. The business plan

indicated that the Loss of Key Employee policy insured American Findings

against “a reduction of its business income resulting from the voluntary departure

of any of its key employees, not including shareholders.” Yet the $86,000

premium calculated by Rosenbach for 2009 is based on the assumption that Mr.

and Mrs. Avrahami--American Findings’ shareholders--would be the only covered

key employees. We find from all this that Rosenbach’s calculations aimed not at

actuarially sound decision-making but at justifying total premiums as close as

possible to $1.2 million--the target--without going over. To do so he would add in

a proration factor or drop the policy limits until he reached his goal.

             6.     Payment of Claims

      Finally, we will look at whether Feedback paid its claims. The simple

answer is yes. Once the Avrahamis knew the IRS was looking, they began to file

claims against Feedback--six in total. Five have been paid and one was still

pending at the time of trial.
                                        - 86 -

      Does this add up to “insurance in the commonly accepted sense?” We find

that the answer is “no”. Although Feedback was organized and regulated as an

insurance company, paid the claims filed against it, and met the minimal

capitalization requirements of St. Kitts, these insurance-like traits cannot

overcome its other failings. It was not operated like an insurance company, it

issued policies with unclear and contradictory terms, and it charged wholly

unreasonable premiums.

      C.     Not Insurance

      Because we find that Feedback failed to distribute risk and was not selling

insurance in the commonly accepted sense, we need not decide whether its

transactions involved insurance risk or risk shifting. See, e.g., Clougherty, 811

F.2d at 1300 n.5 (“While the Supreme Court in Le Gierse expressly stated that

insurance must exhibit both the shifting and the distributing of risk, the resolution

of that case depended only on the absence of risk shifting. Here, too, we need not

consider whether Clougherty’s captive insurer arrangement exhibited risk

distribution because we conclude that Clougherty did not shift its risk.”). Even if

they did, our decision would remain the same. Despite the attempts of Feedback

to make its transactions look like traditional insurance and take advantage of the

apparent loophole at the intersection of section 831 and captive insurance caselaw,
                                        - 87 -

the premiums paid to Feedback and deducted by the Avrahami entities are not

“insurance” for federal tax purposes. Because we find that Pan American was not

a bona fide insurance company, the premiums paid to it and deducted by American

Findings are also not for “insurance” for federal tax purposes. See Rent-A-Center,

142 T.C. at 10. In light of our holding we need not address the Commissioner’s

other arguments--i.e., that the amounts deducted as insurance expenses should be

disallowed under the economic-substance, substance-over-form, and step-

transaction doctrines.

IV.   Effect on Feedback

      Our holding has two major consequences. The first is on Feedback’s

elections. Recall that Feedback elected to be treated as a domestic corporation for

federal income tax purposes under section 953(d) and elected to be taxed as a

small insurance company under section 831(b). To qualify under section 831(b) a

company must first be an “insurance company,” which the Code defines as “any

company more than half of the business of which during the taxable year is the

issuing of insurance or annuity contracts or the reinsuring of risks underwritten by

insurance companies.” Secs. 816(a), 831(c). Since Feedback’s policies were not

contracts for insurance, it does not fall within this definition because less than half

of its business--in fact none of its business--was the issuance of insurance
                                         - 88 -

contracts. Its section 831(b) election is therefore invalid for the years at issue in

these cases--2009 and 2010.55 Likewise, to make a valid section 953(d) election, a

controlled foreign corporation--as defined in section 957(a)--must qualify under

part I (life insurance companies) or II (other insurance companies) of subchapter

L. Sec. 953(d)(1)(B). To qualify for either part a company must meet the section

816(a) definition of “insurance company,” which Feedback did not. See secs.

816(a), 831(c). Feedback’s section 953(d) election is therefore likewise invalid

for 2009 and 2010.

      Although we find that Feedback’s elections are invalid and it is therefore a

foreign corporation for federal income tax purposes, we still have to figure out

what this means for the taxation of the amounts Feedback received. It appears,

however, the parties have resolved this issue themselves by stipulating that the

“‘Taxable Premiums Earned’ by [Feedback] in the amounts of $1,090,000 and

$1,170,000 for taxable years 2009 and 2010, respectively, are not U.S. source

fixed or determinable, annual or periodical income under section 881, or income

that is effectively connected with a U.S. trade or business under section 882.”




      55
        We do not have jurisdiction over Feedback’s elections for years other than
2009 and 2010 since they were not part of the notice of deficiency and are not
before us. See Rule 13.
                                       - 89 -

This means Feedback isn’t subject to tax under those two sections, which govern

the taxation of foreign corporations. See secs. 881(a)(1), 882(a)(1).

V.    Effect on the Avrahamis

       The second major consequence is that if the payments aren’t for insurance,

then they are not ordinary and necessary business expenses and may not be

deducted under section 162(a) by American Findings, Chandler One, O&E, and

White Knight. See sec. 1.162-1(a), Income Tax Regs. We therefore sustain the

Commissioner’s determination to adjust the Avrahamis’ income from Schedule E,

Supplemental Income and Loss, by disallowing these deductions.

      A.     Ordinary Dividend

      We also must decide the tax effect of the transfers from Feedback to Belly

Button and Mrs. Avrahami. Recall that during the years at issue in these cases

Feedback transferred $200,000 directly to Mrs. Avrahami. While the Avrahamis

and Feedback originally claimed this $200,000 was a loan and was backed by a

demand promissory note, they now concede that it was a dividend and was

mistakenly left out of their taxable income for 2010. They do argue that it should

be taxed as a qualified rather than ordinary dividend. Section 1(h)(11) provides

preferential tax rates for “qualified dividend income” if the dividend is received

from a domestic corporation or a qualified foreign corporation. Since we found
                                       - 90 -

that Feedback’s section 953(d) election was invalid, it is not a domestic

corporation. It is also not a qualified foreign corporation because it was not

incorporated in a possession of the United States or eligible for benefits under an

income tax treaty. See sec. 1(h)(11)(C). We therefore hold that the $200,000

transferred to Mrs. Avrahami should be taxed at ordinary income rates.

      B.     Bona Fide Loans

      In 2010 Feedback also transferred $1.5 million to Belly Button in exchange

for an unsecured promissory note with an interest rate of 4% per year--simple

interest accruing “from time to time.” Two days later the Avrahamis

transferred$1.5 million from Belly Button’s bank account into their personal one.

The Avrahamis argue that these are two separate nontaxable transactions. They

assert that the first was a bona fide loan between Feedback and Belly Button and

the second was the repayment of the $1.2 million loan--used by Belly Button to

purchase land in May 2007--between Belly Button and Mr. Avrahami. The

Commissioner counters that together the two transactions were really just a

taxable distribution from Feedback to the Avrahamis.

      This is a common chew toy in tax litigation. How do we distinguish bona

fide loans from distributions? A loan is “an agreement, either express or implied,

whereby one person advances money to the other and the other agrees to repay it
                                        - 91 -

upon such terms as to time and rate of interest, or without interest, as the parties

may agree.” Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000)

(quoting Commissioner v. Valley Morris Plan, 305 F.2d 610, 618 (9th Cir. 1962)),

aff’g T.C. Memo. 1998-121. We therefore ask whether both parties had an actual

intent to establish a debtor-creditor relationship at the time the funds were

advanced. Talmage v. Commissioner, T.C. Memo. 2008-34, 2008 WL 440831, at

*24 (citing Estate of Chism v. Commissioner, 322 F.2d 956, 960 (9th Cir. 1963),

aff’g Chism Ice Cream Co. v. Commissioner, T.C. Memo. 1962-6), aff’d, 391 F.

App’x 660 (9th Cir. 2010); see also Kaider v. Commissioner, T.C. Memo. 2011-

174, 2011 WL 2976203, at *5. We also ask whether the debtor intended to repay

the loan and whether the creditor intended to enforce its repayment. See Kaider,

2011 WL 2976203, at *5; see also Beaver v. Commissioner, 55 T.C. 85, 91

(1970); Fisher v. Commissioner, 54 T.C. 905, 909-10 (1970). Precedent gives us

lots of factors to look at to answer these questions:

      •      the ability of the borrower to repay;

      •      the existence or nonexistence of a debt instrument;

      •      security, interest, a fixed repayment date, and a repayment schedule;

      •      how the parties’ records and conduct reflect the transaction;

      •      whether the borrower had made repayments; and
                                        - 92 -

      •      whether the lender had demanded repayment.

Kaider, 2011 WL 2976203, at *5-*6 (citing Welch, 204 F.3d at 1230-31; Frierdich

v. Commissioner, 925 F.2d 180, 182-85 (7th Cir. 1991), aff’g T.C. Memo. 1989-

393; Mann Constr. Co. v. Commissioner, T.C. Memo. 1999-183); see also Stanley

v. Commissioner, T.C. Memo. 2016-196, at *8.

             1.    Ability To Repay and Debt Instruments

      Whether a borrower has the ability to repay is determined by whether there

was “a reasonable expectation of repayment in light of the economic realities of

the situation.” Fisher, 54 T.C. at 910. The borrower’s inability to repay at the

time it received the funds suggests the parties did not intend for the transaction to

be a bona fide loan. Kaider, 2011 WL 2976203, at *6. In 2007 after Belly Button

borrowed the $1.2 million from Mr. Avrahami, it had assets of around $1,980,000

and outstanding loans of the same amount. By 2010 its liabilities exceed its assets

by more than $50,000.56 But assuming the land appreciated--which Mr. Avrahami

believed at the time that it would since it was across the street from a lot owned by




      56
          We note that Belly Button’s 2010 tax return reports only $2,031,000 of
liabilities--$1.5 million in notes payable and $531,000 “due to related party.” Yet
by the end of 2010 it had outstanding promissory notes payable to Feedback of
$2,330,000--$830,000 from 2007 and another $1.5 million from 2010.
                                        - 93 -

Walmart--there was a reasonable expectation that Belly Button could satisfy its

debts and accrued interest by selling the land. This makes them look like loans.

      The second factor does too: Both of the transactions at issue here--the

transfer from Feedback to Belly Button and from Mr. Avrahami to Belly Button--

were papered properly by promissory notes signed by Mr. Avrahami.

             2.    Security, Interest, and Repayment Schedules

      The third factor is slightly more complicated. While both promissory notes

indicated the interest rate to be charged and the date for repayment, neither was

secured. The promissory note from Belly Button to Feedback required repayment

of the $1.5 million principal plus accrued interest--simple interest at 4% per year--

on March 17, 2020. The note from Belly Button to Mr. Avrahami required

repayment of the $1.2 million principal plus accrued interest--simple interest at

4% per year--on April 30, 2017. The Avrahamis insist that the $1.5 million note

from Belly Button to Feedback was secured by a mortgage on Belly Button’s land,

but the plain terms of the promissory note indicate otherwise. It specifically

states: “No Security. The Indebtedness is unsecured.” The $1.2 million note

contains an identical statement. Although the $1.2 million note called for 4%

interest, when it was allegedly paid in 2010 neither the Avrahamis nor Belly

Button reported any interest paid. While the absence of security weighs against
                                       - 94 -

finding a loan, the overall factor is more neutral because defined interest and

repayment schedules were included in both notes. But the casual attitude toward

the payment and reporting of interest gives us great pause.

             3.    Parties’ Conduct

      The next factor is how the parties’ records and conduct reflect the

transactions. In 2007 when the $1.2 million note was executed, Belly Button

recorded it on its tax return as $1,201,000 “due to affiliates.” The $1,201,000 was

the full amount Belly Button received from Mr. Avrahami, yet the note evidences

a $1,000 lower amount for no clear reason. Then in 2010 Belly Button transferred

$1.5 million from its bank account into the Avrahamis’ bank account, claiming

this was a repayment of the $1.2 million loan.57 Yet Belly Button’s 2010 tax

return shows only a $670,000 reduction in the amount owed to Mr. Avrahami and

no indication that any interest had been paid.58 The recording of the $1.5 million



      57
        We note that this “repayment” was made less than three years after the
execution of the $1.2 million promissory note, so even with simple interest
accrued at 4% per year on the unpaid principal the repayment shouldn’t have
exceeded $1,344,000.
      58
         The rest of the $1.5 million transfer appears to be reflected on Belly
Button’s 2011 tax return where it reported a further $531,000 reduction in the
amount due to related parties and a new $299,000 asset under “loans to partners
(or persons related to partners)” but still no indication of any interest payment.
($670,000 + $531,000 + $299,000 = $1.5 million.)
                                        - 95 -

note has similar problems. While the full $1.5 million was reported on Feedback’s

2010 tax return under “mortgage and real estate loans,” Belly Button reported

only a $670,000 increase to its note-payable account in 2010.59 Our great pause

grows into skepticism.

             4.     Repayments and Demands

      We will look at the fifth and sixth factors together. Both repayments and

demands for repayment are evidence that the parties intended a bona fide loan.

See, e.g., Welch, 204 F.3d at 1230-31. Here, the $1.2 million note was removed

from Belly Button’s books--which suggests it was repaid, but without the payment

of accrued interest or any demand for it. The $1.5 million note, on the other hand,

calls for payment of the principal and all accrued interest 10 years after the date of

the note. Although no repayments or demands for repayment had been made by

the time of trial in these cases, none were due. These factors therefore neither help

nor hurt the Avrahamis. See, e.g., Kaider, 2011 WL 2976203, at *9.

      We also consider the testimony of the borrower and lender--here, Mr.

Avrahami. He did indeed insist that the transactions were intended to be loans.

      59
         Belly Button seems to have recorded the rest in 2011, when it reported an
additional increase to its notes payable of $830,000. We are not sure why it did
this--Belly Button is a cash-basis taxpayer, and the record contains the bank
statement that plainly states that Belly Button received $1.5 million in March
2010.
                                       - 96 -

The problem here is that Mr. Avrahami himself was on all sides of both

transactions. He was--as an individual--the lender on the $1.2 million note and--as

a manager of Feedback--the lender on the $1.5 million note. He was also the

signer on behalf of the borrower--Belly Button--for both notes.

      Our skeptical view turns into a jaundiced eye here. As we said in Holden v.

Commissioner, T.C. Memo. 2015-131, at *27: “The ultimate question, which is a

factual one, is whether the parties intended a loan when the funds were advanced.”

See also Miele v. Commissioner, 56 T.C. 556, 567 (1971), aff’d, 474 F.2d 1338

(3d Cir. 1973). This question becomes even more important when the

Commissioner has proposed an alternative characterization. See Holden, at *27

n.11; see, e.g., Calloway v. Commissioner, 135 T.C. 26, 27 (2010) (stock sale

proceeds), aff’d, 691 F.3d 1315 (11th Cir. 2012); Teymourian v. Commissioner,

T.C. Memo. 2005-232 (constructive dividends). Here, the Commissioner argues

that Belly Button was a mere conduit for the transfer of a $1.5 million distribution

from Feedback to the Avrahamis. He encourages us to apply the substance-over-

form and step-transaction doctrines to construe the transfer as a constructive

dividend to Mrs. Avrahami. We will nevertheless decline to do so.

      It’s a fairly close question, but the economic reality is that when Belly

Button accepted the $1.2 million from Mr. Avrahami, it had the ability to repay,
                                       - 97 -

reasonably expected its land would appreciate, and evidenced its obligation to

repay with a debt instrument that specified the applicable interest rate and

repayment schedule. The same facts lead us to conclude that there really was a

$1.5 million loan from Feedback to Belly Button as well. But we also find that the

difference between these amounts ended up in the Avrahamis’ account. We’ll

hold everyone to the terms of these facially valid notes and the bank records we

have: $1.2 million of the $1.5 million transfer from Belly Button to the

Avrahamis is a nontaxable loan repayment and should not be included in their

gross income. The extra $1,000 from Mr. Avrahami to Belly Button will be

treated as a nontaxable capital contribution. See sec. 1.118-1, Income Tax Regs.

The $300,000 difference will be split between interest to the Avrahamis calculated

according to the $1.2 million note’s terms (we’ll leave the math for the parties to

do); and a taxable distribution to Mrs. Avrahami--taxable as an ordinary dividend

for the reasons we’ve already recited.60

VI.   Penalties

      Out last issue is whether any of this triggers an accuracy-related penalty

under section 6662(a). This section imposes a 20% penalty on the portion of the


      60
          No one questioned whether Feedback had sufficient earnings and profits
for this distribution to be a dividend. See sec. 316.
                                        - 98 -

underpayment of tax attributable to any substantial understatement of income tax

or negligence or disregard of rules or regulations. Sec. 6662(a) and (b)(1) and (2).

Negligence includes any failure to make a reasonable attempt to comply with the

provisions of the Code; and disregard includes any careless, reckless, or

intentional disregard. Sec. 6662(c). The Commissioner has the initial burden of

production to show that the understatement of income tax was substantial. Sec.

7491(c). This is a math question: An understatement of income tax is substantial

if it exceeds the greater of $5,000 or “10 percent of the tax required to be shown

on the return.” Sec. 6662(d)(1)(A). Here, the Avrahamis’ corrected tax liability

for 2009 is more than $475,000, but they originally reported a tax liability of just

shy of $100,000. Likewise, for 2010 their corrected tax liability reflects

adjustments to income of over $1.6 million, but they originally reported a tax

liability of less than $30,000. These understatements are well over $5,000 and

greater than 10% of the tax required to be shown on the return, so the

Commissioner has met his burden.

      A.     The Insurance Deductions

      The Avrahamis can avoid accuracy-related penalties by showing either that

they had “substantial authority” or that they acted with reasonable cause and in

good faith. See secs. 6662(d)(2)(B)(i), 6664(c)(1); sec. 1.6664-4(a), Income Tax
                                        - 99 -

Regs. They try both, but we begin with reasonable cause and good faith. In

determining whether this exception applies we examine all the relevant facts and

circumstances, including whether they relied in good faith on professional advice

and whether their reliance was reasonable. See sec. 1.6664-4(b) and (c), Income

Tax Regs.; see also United States v. Boyle, 469 U.S. 241, 250-251; Neonatology

Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d

Cir. 2002). Reliance on an adviser is reasonable if:

      •      the adviser was a competent professional who had sufficient expertise
             to justify reliance;

      •      the taxpayer provided necessary and accurate information to the
             adviser; and

      •      the taxpayer actually relied in good faith on the adviser’s judgment.

Neonatology Assocs., 115 T.C. at 99. The Avrahamis argue that they relied in

good faith on the professional advice of McEntee, Hiller, and Clark. We have no

doubt that all three were competent professionals with sufficient expertise--

McEntee is a CPA with more than 25 years of experience, Hiller is a reputable

Phoenix-based estate planning attorney with more than 30 years of experience, and

Clark is a New York lawyer with more than 35 years of experience who focuses

her practice on small insurance companies. We also find that the Avrahamis

provided their advisers with all the relevant data needed to assess the correct level
                                         - 100 -

of tax. The parties dispute, however, whether the Avrahamis actually relied in

good faith on the advice of McEntee, Hiller, and Clark.

             1.     Promoters

      We have already held that a taxpayer cannot reasonably rely in good faith

on an adviser who is a “promoter” of the disputed transaction. See 106 Ltd. v.

Commissioner, 136 T.C. 67, 79-80 (2011), aff’d, 684 F.3d 84 (D.C. Cir. 2012);

Neonatology Assocs., 115 T.C. at 98. A promoter is “an adviser who participated

in structuring the transaction or is otherwise related to, has an interest in, or profits

from the transaction.” 106 Ltd., 136 T.C. at 79 (citing Tigers Eye Trading, LLC v.

Commissioner, T.C. Memo. 2009-121) (adopting the definition of promoter from

Tigers Eye for cases involving an adviser offering the same tax shelter to

numerous parties). We find that the Avrahamis cannot reasonably rely on Clark

because she is a promoter of the microcaptive transaction. She structured the

captive-insurance-company transaction, drafted the purported insurance policies,

and designed and set up the failed risk-distribution programs, which she sold to

more than 100 of her clients. She also profited a great deal from the transaction,

receiving a portion of both an initial $75,000 engagement fee and the annual flat

fees. The Avrahamis could not reasonably rely on her.
                                       - 101 -

       Hiller is a closer call. He recommended Clark to the Avrahamis, acted as

co-counsel during Feedback’s start-up phase, received a portion of the $75,000

start-up fee, and assisted the Avrahamis in documenting the 2008 loan from

Feedback to Belly Button. But that appears to be the extent of his involvement.

Hiller testified that he did not provide advice on the capitalization of Feedback;

had no involvement in selecting an actuary to determine premiums and underwrite

the polices; and played no role--not even as a reviewer--in the formation or

documentation of the transactions with Pan American. He also had a prior

relationship with the Avrahamis, did not give unsolicited advice, and--aside from

the start-up fee--billed the Avrahamis on an hourly basis. These are all signs that a

tax adviser is not a promoter, see Countryside Ltd. P’ship v. Commissioner, 132

T.C. 347, 352-53 (2009), and we find that he was not a promoter. The same goes

for McEntee--he recommended Clark and prepared the tax returns for the

Avrahamis and all of their entities, but we find that he was not a promoter because

he did not structure the captive-insurance-company transaction or otherwise have

an interest in it.

              2.     Reasonable Reliance

       Our analysis does not end here. Our finding that the advice from Hiller and

McEntee is not disqualified as advice from a promoter doesn’t necessarily mean
                                       - 102 -

that it was reasonable to rely on their advice or that the Avrahamis did in fact

reasonably rely on their advice in good faith. The majority of the accuracy-related

penalties imposed on the Avrahamis is related to the improper deduction of

purported insurance premiums by the Avrahami entities, which calls into question

all of the advice they received about captive-insurance-company transactions. At

trial the Avrahamis admitted that all of the advice “during the formation of

Feedback” came from Clark and Hiller, and McEntee himself testified that the

extent of his involvement with Feedback was to provide bookkeeping services and

sign tax returns. McEntee’s advice is therefore not a good defense because we

find that the Avrahamis did not rely on it when they decided to set up and use

Feedback.

      Hiller is another matter. Although he did not specifically advise the

Avrahamis about brother-sister or parental captive arrangements, Hiller credibly

testified that he advised them on how captives worked, the structure of Feedback,

and what kind of investments their captive could make. Mr. Avrahami also

credibly testified that he decided to move forward with Clark because Hiller “gave

his blessing.” Therefore, we find that the Avrahamis did rely--and reasonably

relied--on Hiller’s professional advice.
                                       - 103 -

             3.      Good Faith

      But was that reliance on Hiller in good faith? Here we are sympathetic to

the Avrahamis’ position. This is a case of first impression--we have discovered no

other case addressing microcaptives and the interplay among sections 162, 831(b),

and 953(d). And we have previously declined to impose accuracy-related

penalties when there is no clear authority to guide taxpayers. See Petersen v.

Commissioner, 148 T.C. ___, ___ (slip op. at 29) (June 13, 2017); Williams v.

Commissioner, 123 T.C. 144, 153 (2004); Hitchins v. Commissioner, 103 T.C.

711, 719-720 (1994); see also Foster v. Commissioner, 756 F.2d 1430, 1439 (9th

Cir. 1985), aff’g in part, vacating in part 80 T.C. 34 (1983). We accordingly find

the Avrahamis acted reasonably and in good faith when relying on Hiller’s

professional advice, and we will not impose section 6662(a) penalties to the extent

the underpayments are attributable to the nondeductibility of the premiums paid to

Feedback.

      B.     Loans

      The rest of the accuracy-related penalties imposed on the Avrahamis are

related to the Commissioner’s reclassification of loans as taxable distributions

from Feedback. We have held that both the $1.2 million loan from Mr. Avrahami

to Belly Button and the $1.5 million loan from Feedback to Belly Button were
                                        - 104 -

bona fide. Therefore, the section 6662(a) penalties should not be imposed to the

extent they are related to repayment of the $1.2 million loan. But there is no

reasonable explanation for why any underpayment flowing from the failure to

report $300,000 in interest and dividends for the overrepayment of that loan with

the $1.5 million from Feedback should not be penalized. The Avrahamis don’t

even make such an argument, so the Commissioner wins on this one.

      C.     Ordinary Dividend

      We also have the penalty related to the $200,000 distribution directly from

Feedback to Mrs. Avrahami, which we held should have been reported as an

ordinary dividend. The Avrahamis argue that this was an inadvertent omission

caused by their accountant’s error. The Avrahamis, however, are sophisticated

and successful business owners, and we find they acted at least in careless

disregard of the Code in their treatment of this item. See sec. 6662(b)(2) and (c).

They controlled Feedback’s bank account, and they caused the $200,000 to be

transferred directly from Feedback to Mrs. Avrahami. They knew or should have

known that the transfer should not have been reported--as they originally

claimed--as an additional loan from Feedback to Belly Button. See sec. 1.6664-

4(b), Income Tax Regs. We are therefore not persuaded that they acted with

reasonable cause and in good faith in failing to report their receipt of the
                                        - 105 -

$200,000. We will sustain the Commissioner’s imposition of a section 6662(a)

penalty to the extent it relates to the $200,000 distribution.


                                               Decisions will be entered under

                                        Rule 155.
