t c no 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 filed date ps claimed deductions under sec_162 on their and 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 sec_831 to be treated as a small insurance_company and under sec_953 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 sec_6662 held amounts paid to c and a are not insurance premiums for federal_income_tax purposes and are not deductible under sec_162 held further c’s sec_831 and sec_953 elections are invalid for and 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 sec_6662 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 they spent a little more than dollar_figure insuring them in this insurance bill soared to more than dollar_figure million and it flew even higher to more than dollar_figure million in 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 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 dollar_figure million by the end of dollar_figure 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 dollar_figure that the avrahamis’ jewelry stores sent down to a caribbean company for terrorism-risk insurance the full dollar_figure 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 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 the couple now live near phoenix arizona and have three adult children in mr avrahami decided to go into business with his brother so he created american findings corporation american findings 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 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 if a business meets the requirements of sec_1361 it may elect to be treated as an s_corporation and pay no corporate tax sec_1362 sec_1363 an s corporation’s income and losses like a partnership’s flow through to its shareholders who then pay income_tax see sec_1363 american findings was originally established as a c_corporation but elected to become an s corporation-- made an s election --effective for 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 bys company acc bys which owns and operates a retail shopping center in tempe arizona chandler one llc chandler one 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 which owns a shopping center in phoenix arizona white mountain equities l l c white mountain which owns land in show low arizona and bys was incorporated in and made an s election effective that same year mr avrahami own sec_85 of bys and the remaining is held equally each by trusts for his three children chandler one was formed as a limited_liability_company in it is treated as a partnership for tax purposes and the avrahamis are both general partners each with a interest o e was incorporated in and made an s election effective that same year mr avrahami is the sole shareholder of o e white mountain was formed as a limited_liability_company in and is treated as a partnership for tax purposes the avrahamis each own of white mountain and each of their three children own white knight investment a c c white knight 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 american findings chandler one o e and white knight collectively avrahami entities deducted a combined total of a little more than dollar_figure in insurance expenses b the advisers by 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 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 white knight was incorporated in and made an s election effective that same year mr avrahami is the sole shareholder of white knight 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 clark first got interested in captive insurance_companies in and her practice grew from there in she helped draft captive-insurance legislation for the dual-island caribbean nation of saint christopher and nevis st kitts clark had more than captive insurance clients in st kitts by and more than by 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 date 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 we will use clark to refer both to ms clark and her firm exchange for dollar_figure 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 date 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 feedback applied for and received authorization from st kitts to conduct small_group captive insurance_business under the st kitts captive insurance_companies act in it also made two elections the first--filed by clark on feedback’s behalf--was an election under sec_953 to be treated as a domestic_corporation for federal_income_tax purposes which was approved by the irs and the second--filed with its income_tax return--was an election to be taxed as a small insurance_company under sec_831 and in its first two years of operation--2007 and which are not before us in these cases--feedback sold property and casualty insurance policies to various entities owned by the avrahamis in these included american findings bys chandler one o e white mountain and white knight but in 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 and in 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 the policy periods for all of feedback’s direct policies during the years at issue started december of the stated year and ended one year later except for one--the tax indemnity policy--that actually says date to date but we assume that’s a typo premium premium limit occurrence aggregate limit occurrence aggregate dollar_figure dollar_figure dollar_figurem dollar_figurem dollar_figurem dollar_figurem big_number big_number dollar_figurem dollar_figurem dollar_figurem dollar_figurem big_number big_number big_number big_number big_number big_number big_number big_number dollar_figurem dollar_figurem dollar_figurem dollar_figurem dollar_figure 5m dollar_figure 5m dollar_figurem dollar_figurem dollar_figurem dollar_figurem dollar_figurem dollar_figurem big_number big_number dollar_figurem dollar_figurem dollar_figurem dollar_figurem big_number big_number big_number big_number dollar_figurem dollar_figurem dollar_figurem dollar_figurem big_number big_number dollar_figurem dollar_figurem dollar_figurem dollar_figurem big_number big_number big_number big_number dollar_figurem dollar_figurem dollar_figurem dollar_figurem --- --- --- big_number big_number big_number --- --- dollar_figurem dollar_figurem dollar_figurem dollar_figurem insured american findings coverage type business income employee fidelity litigation expense loss of key_employee tax indemnity total american findings administrative chandler actions one business risk indemnity total chandler one o e administrative actions business risk indemnity total o e white knight administrative actions business risk indemnity total white knight 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 and coverage term insurer jewelers mutual jewelers mutual coverage term insurer travelers travelers travelers travelers american findings coverage type premium business owners jewelers block business owners jewelers block dollar_figure big_number chandler one coverage type premium commercial general liability umbrella commercial general liability umbrella dollar_figure big_number limit occurrence aggregate various dollar_figure various big_number limit occurrence aggregate dollar_figure big_number big_number big_number big_number big_number big_number big_number coverage term coverage term o e coverage type premium insurer travelers allied commercial general liability business owners amco umbrella dollar_figure big_number white knight insurer travelers amco coverage type premium commercial general liability umbrella dollar_figure nationwide commercial general liability big_number limit occurrence aggregate dollar_figure big_number big_number big_number big_number big_number limit occurrence aggregate dollar_figure big_number big_number big_number big_number big_number nationwide commercial property building commercial property business income big_number big_number big_number the avrahami entities deducted a total of more than dollar_figure million for and more than dollar_figure million for in insurance expenses the irs is not challenging the validity of the avrahami entities’ commercial policies or the 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 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 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 risk classification for all practice areas sec_3_3 actuarial standards bd 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 actuarial communications sec_3_2 actuarial standards bd the actuarial services that feedback obtained were somewhat different feedback policy pricing during and clark hired allen rosenbach an actuary to price the feedback policiesdollar_figure 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 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 tcmemo_2013_209 at rosenbach was something of a captive underwriter he testified that in and he prepared premium estimates for more than but fewer than captives most if not all were clark’s clients drafted and which detailed the types of coverage feedback planned to issue as well as the insurance_policy applications from the various avrahami entitiesdollar_figure 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 factorsdollar_figure 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 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 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 therefore started his premium calculations with information found in the public filings of large insurance companies--specifically a date 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 date chubb filing falls under hazard group dollar_figure according to the date chubb filing the base rate for an insured in hazard group is a flat dollar_figure for its first dollar_figure of gross revenue and then dollar_figure per thousand of gross revenue for the next dollar_figure rosenbach followed this methodology and calculated a base premium for chandler one-- which for had expected gross revenue of dollar_figure--of dollar_figure once the base premium for chandler one was set rosenbach adjusted it by five factors the first was a claims-made factor of claims-made policies are a n agreement to indemnify against all claims made during a specified period the date chubb filing--from which rosenbach’s pricing model got its base rate calculation and adjustment factors--actually classified property managers into hazard group not the dollar_figure is calculated as dollar_figure dollar_figure - dollar_figure big_number x regardless of when the incidents that gave rise to the claims occurred black’s law dictionary 8th ed 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 8th ed rosenbach used a claims-made factor of 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 a m date and prior to a m date the second factor was a deductible factor of 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 dollar_figure and carries a factor of so rosenbach extrapolated to reach the factor he used in his model the third adjustment was the increased limit factor of 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 dollar_figure million but the chandler one policy had an occurrence limit of dollar_figure million and an aggregate limit of dollar_figure million according to the chubb filing this difference in aggregate limits adds to the base premium thus the factor of rosenbach’s fourth adjustment was a increase--a factor of 1--for endorsements as rosenbach explained the magnitude of the endorsement factor was based solely on his professional judgment and accounts for the breadth 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 8th ed of the coverage being broad and the final adjustment was a coverage factor of which rosenbach stated was actually made up of two parts-- percent of the premium comes from the administrative actions coverage and another 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 policy rosenbach calculated a premium of dollar_figure the calculations for the administrative actions policies purchased by chandler one in o e in and and white knight in were performed in an identical manner each used the exact same formula and factors--claims made of deductible of increased limit of endorsement of and coverage of 65--but started with the various insured’s gross revenue when calculating the base premium the dollar_figure is the rounded product of the base premium and the five factors in other words dollar_figure x x x x x dollar_figure dollar_figure which rounded to the nearest thousand is dollar_figure 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 date chubb filing for miscellaneous professional liability coverage and then adjusted for the same five factors rosenbach again used a claims-made factor of and a deductible factor of but the increased limit endorsement and coverage factors are slightly different for example for chandler one’s policy rosenbach used an increased limit factor of dollar_figure which is the amount indicated in the chubb filing for a policy with aggregate and occurrence limits of dollar_figure million he also used an endorsement factor of dollar_figure 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 which he explained at trial as the court there is a coverage factor next you had mentioned that before this one is only all right they don’t add up to one what’s going on there you have a coverage factor of dollar_figure and then an adjustment of the witness yeah the seven is built into the coverage factor the dollar_figure 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 dollar_figure or the the witness the dollar_figure is -- the court okay and what do you do with the 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 percent the court why 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 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 premium for chandler one for the gap-coverage portion of the business risk indemnity policy of dollar_figure but recall that this is only one part of the calculation rosenbach then added dollar_figure to account for the excess coverage-- the straight commercial coverages going up in higher limits --provided by the policy and he added another dollar_figure 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 dollar_figure by multiplying chandler one’s expected gross revenue of dollar_figure by certain rates that the dollar_figure is calculated as dollar_figure x x x dollar_figure x dollar_figure x we note that for rosenbach’s calculation to work out the coverage factor must be dollar_figure x and references to dollar_figure are likely the rounded version of this number he use s for construction defect coverage because he has more data on that putting all of this together rosenbach calculated a total premium for chandler one of dollar_figure an identical calculation was done for the business risk indemnity policy purchased by o e in except that rosenbach started with o e’s gross revenue and added no additional premium for construction-defect coverage in 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 and the coverage factor was increased to dollar_figure and for chandler one’ sec_2010 policy rosenbach also dropped the occurrence and aggregate policy limits to dollar_figure million reducing the increased limit factor to lowered the charge for the excess coverage to dollar_figure and increased the premium for the construction defects coverage from dollar_figure to dollar_figure rosenbach rosenbach’s construction defect rate appears to be around dollar_figure x dollar_figure of chandler one’s gross revenue yet he testified that construction defect rates typically run one to four percent of asset value the dollar_figure is the rounded sum of the three separate calculations in other words dollar_figure dollar_figure dollar_figure dollar_figure which rounded to the nearest thousand is dollar_figure the reason for these changes is not clear from the record when asked whether hi sec_2010 factors were determined in the same fashion as in prior years rosenbach responded yes absolutely explained that this sharp increase in premiums related to construction defects was due in part to 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 business income policy rosenbach started out with its gross revenue and multiplied it by as he explained the represents his assumption that you might only expect one policy limit loss every 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 and an other factor of together he said these judgmental factors accounted for financial stability size profitability entry into the market additional coverages and a surcharge for competition and the reputational damage multiplying all of these parts together rosenbach calculated a premium of dollar_figure american findings’ policy was calculated in the same manner but the adjustment factor was decreased to dollar_figure and the other factor was increased to the reason for these differences is not clear from the record as rosenbach said that he used the same methodology for as he had for 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 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 filingdollar_figure for each factor the dollar_figure is the rounded product of the gross revenue and the five adjustments in other words dollar_figure x x x x x dollar_figure which rounded to the nearest thousand is dollar_figure this chubb filing was not offered into evidence by either party and is not a part of the record 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 dollar_figure the calculation of the 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 litigation expense policy rosenbach started out with an exposure base of dollar_figure 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 the exact calculation of the dollar_figure is not clear from the record rosenbach’s model shows a base premium of dollar_figure and then eight factors--2 and the product of these nine numbers is dollar_figure however in their reply brief the avrahamis explained--albeit with a few typos--that the correct math is x x x x x x dollar_figure - x and x dollar_figure dollar_figure which rounded to the nearest thousand is dollar_figure 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 which accounts for his belief that feedback would have to pay back 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 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 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 an increased limit factor of and a claims-made factor of he testified that to reach the total premium of dollar_figure calculated by his model it should just be the product of the factors probably one minus the expense ratio times the times the the expense ratio is the complement--a math term for the difference between an amount and --of the expected loss ratio the litigation expense policy was calculated in the exact same manner but with a nearly 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 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 the exact calculation of the dollar_figure 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 dollar_figure dollar_figure x x x - x x x 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 dollar_figure x x x x x - dollar_figure which rounded to the nearest thousand is dollar_figure we note that rosenbach said than they did in the past even though was the first year that american findings purchased a litigation expense policy and he was the actuary that made the model 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 premium for the loss of key_employee policy rosenbach started with projected gross_income of dollar_figure million and multiplied it by an event rate of and an extra expense factor of the is another judgment call and is supposed to represent the expected losses under this type of coverage and the dollar_figure extra expense factor accounts for the cost of finding replacements in rosenbach’s experience he then multiplied by an adjustment factor of for a disability add on and another factor of 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 dollar_figure next he apportioned this preliminary premium to the key employees covered by the policy--the avrahamis--whose salaries were of the dollar_figure is the rounded product of the gross_income and the four adjustments in other words dollar_figure x dollar_figure x dollar_figure x x dollar_figure which rounded to the nearest thousand is dollar_figure american findings’ total payroll expense this led to a final premium of dollar_figure the 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 dollar_figure million policy limit and multiplied it by an event rate of rosenbach testified that he derived the 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 and an experience factor of the experience factor was a partially subjective the dollar_figure is the rounded product of the preliminary premium and the percentage of payroll expense attributed to the avrahamis in other words dollar_figure x dollar_figure which rounded to the nearest thousand is dollar_figure 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 dollar_figure for dollar_figure the premium was exactly the same the target in total the avrahami entities paid feedback premiums for their direct policies of dollar_figure in and dollar_figure in each year clark told rosenbach that the avrahamis had a target premium of dollar_figure for their direct policies and dollar_figure million for total premiums--the direct policy premiums plus dollar_figure in premiums for terrorism insurance from pan american see infra p 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 policy premiums was representative of the sort of comments he received those emails show that rosenbach initially proposed total direct premiums for of dollar_figure 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 months prorated for the dollar_figure is the product of the limit and the three adjustments in other words dollar_figure x x x dollar_figure the old policies i think we should go back to full years for all the policies with dollar_figure as the target rosenbach replied with new calculations when he had dropped the limits as suggested and calculated total direct premiums of dollar_figure 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 and 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 entities owned by the avrahamis paid dollar_figure into the pool for terrorism coverage30 and feedback received dollar_figure for insuring other members of the pool in and however feedback started participating in a risk- distribution program through pan american reinsurance company ltd pan american pan american was incorporated in date 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 carl gentry specifically bys paid dollar_figure chandler one paid dollar_figure o e paid dollar_figure white mountain paid dollar_figure white knight paid dollar_figure and american findings paid dollar_figure laurence mohn and sheila trevors 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 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 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 to each other by buying and reinsuring terrorism insurancedollar_figure 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 dollar_figure 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 at dollar_figure calculated pincite of its target premiums for which was dollar_figure million under the terrorism risk quota share reinsurance agreement it therefore agreed to a reinsurance 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 106_tc_274 premium of dollar_figure in exchange for accepting of pan american’s ultimate total loss for terrorism coverage to the insureds in date american findings paid pan american dollar_figure--the same amount--for terrorism risk insurance with a policy limit of dollar_figure and coverage running from date to date feedback in turn received three payments from pan american--slightly more than dollar_figure of its reinsurance_premium plus interest in date slightly more than dollar_figure of its reinsurance_premium plus interest in date and slightly more than dollar_figure of its reinsurance_premium plus interest in date the same process repeated itself the next year--american findings paid pan american dollar_figure--this time for up to dollar_figure of coverage--and pan american paid feedback dollar_figure plus interest in date in june and in december in pan american wrote policies for insureds and then reinsured the policies through of clark’s captive insurance_companies in it wrote policies for insureds and reinsured through of those companies pan american received more than dollar_figure million in premiums in and almost dollar_figure million in these amounts were then cycled back whence they came--50 after days and another after days the last --about dollar_figure in and dollar_figure in 2010--was held back as a loss reserve until the policies expired on december 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 and were cash or cash equivalents of around dollar_figure and dollar_figure respectively 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 tria pub_l_no sec_103 sec_116 stat pincite 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_general that resulted in more than dollar_figure million in lossesdollar_figure 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 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 policydollar_figure 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 a sec_32 tria was amended by the terrorism risk insurance extension act of pub_l_no sec stat pincite which added the dollar_figure million loss requirement starting date tria was also extended by the terrorism risk insurance program reauthorization act of tripra pub_l_no sec_3 stat pincite which extended the dollar_figure million loss requirement through we will refer to the act including its amendments and extensions as tria 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--dollar_figure each year--and testified that it would be weird to lose money and if feedback did he would freak out 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 to for and to for dollar_figure rosenbach testified that to 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 meaning that it the rate on line eventually set for all trip policies was in and in section edollar_figure 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 would be triggered only if the loss was not covered or not fully covered by another policy--eg 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 yearsdollar_figure and as rosenbach noted trip policies contain no deductibles don’t qualify for tria--ie 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 dollar_figure in and dollar_figure in for this additional coverage the jewelers mutual policy had a dollar_figure million continued deductible amount not recoverable or recovered under the other insurance or indemnity rosenbach and the commissioner’s expert witness both credibly testified that they had never seen such a provision in an insurance_policy before aggregate limit and specifically excluded coverage for chemical and biological hazards e the flow of funds to summarize a bit in entities owned by the avrahamis paid feedback dollar_figure in premiums for direct coverage american findings paid pan american an additional dollar_figure for terrorism insurance and pan american paid feedback dollar_figure in reinsurance premiums likewise in entities owned by the avrahamis paid feedback dollar_figure in premiums for direct coverage american findings paid pan american dollar_figure for terrorism insurance and pan american paid feedback dollar_figure in reinsurance premiums this means the avrahami entities collectively deducted--as business expenses--insurance premiums of dollar_figure for and dollar_figure for no claims were filed against feedback under any of its direct policies in either or dollar_figure 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 although outside the years at issue in these cases we note that the first claim against feedback was filed in date belly button was formed in 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 acres of land in snowflake arizona which it purchased for around dollar_figure with about dollar_figure million in cash from mr avrahami and the rest with a note payable to the sellers the dollar_figure 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 dollar_figure million38 payable to himself as an individual in or before date the note carried a simple interest rate in date--before the years at issue in these cases--feedback transferred dollar_figure to belly button and reported the amount on its tax_return under mortgage and real_estate loans the same day mr avrahami--acting why the note payable was for only dollar_figure million when the amount lent was dollar_figure is unclear from the record on its and only on its tax_return belly button shows this dollar_figure 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 again as manager of belly button--executed a dollar_figure promissory note payable to feedback the note required belly button to pay the principal and all accrued interest--4 per year compounded annually--in or before date 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 dollar_figure 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 date feedback transferred an additional dollar_figure 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 dollar_figure million promissory note payable to feedback this note carried an interest rate of per year--simple interest accruing from time to time --and was due in march 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 dollar_figure million promissory note--the avrahamis meaning mr and mrs avrahami not their children who were belly button’s putative owners transferred dollar_figure million from belly button’s bank account into their personal one then it happened again in date dollar_figure 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 date that carried an interest rate of per year was signed by mr avrahami on behalf of belly button and was reported on feedback’ sec_2010 tax_return as a mortgage and real_estate loandollar_figure 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 themdollar_figure clark disclosed the three transfers to heritor in date after the although outside the years at issue in these cases we note that in date the avrahamis transferred nearly dollar_figure from their bank account back into feedback’s feedback also transferred dollar_figure to bys in this transfer was evidenced by a dollar_figure promissory note with a interest rate and a due_date of april 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 and they should have st kitts’s captive insurance_companies act of c sec_15 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 commissioner began his omphaloskeptical review heritor communicated the information to the st kitts’s registrar of captive insurance_companies in date f the returns and the audit feedback’s returns feedback timely filed its and tax returns on both returns feedback indicated that it had previously made an election under sec_953 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 sec_831 feedback’s tax returns reported total assets of almost dollar_figure million at the end of and nearly dollar_figure million at the end of but because of the sec_831 election it paid income_tax only on its investment income--ie interest but not premiums the irs sent feedback a notice_of_deficiency in date that questioned whether feedback was a valid insurance_company and determined that the amounts characterized as insurance premiums were income to feedback under sec_61 since feedback had not established that they were excludable under continued evidenced by documentation approved by the registrar another provision of the code feedback timely petitioned this courtdollar_figure the parties stipulated before trial that the ‘taxable premiums earned’ by feedback in the amounts of dollar_figure and dollar_figure for taxable years and respectively are not u s source fixed or determinable annual or periodical income under sec_881 or income that is effectively connected with a u s trade_or_business under sec_882 the avrahamis’ returns the avrahamis likewise filed and 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 year american findings dollar_figure big_number chandler one dollar_figure big_number o e dollar_figure big_number white knight dollar_figure big_number 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 nowhere on their or return did the avrahamis report the amounts transferred to them from belly button--dollar_figure million--or from feedback--dollar_figure because they assert that the cash that flowed from belly button went just to repay loans they admit that the dollar_figure 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 as a qualified_dividend the audit and the claims the irs began auditing the avrahamis’ return in date and later expanded the audit to include their return as well as the returns from feedback and the avrahami entities in date 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 to the end of feedback had received premiums totaling almost dollar_figure 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 date the claims started rolling in from entities owned by the avrahamis business income litigation expense date of claim entity american findings american findings white knight junction development american findings american findings policy period nature of loss amount business risk business risk business risk ring dispute ring dispute litigation dollar_figure big_number roof repairs big_number building repairs big_number water damage pending tax_court litigation big_number litigation expense 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 the policy period yet heritor granted notification extensions and approved claims filed in date for policies that ended date 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 and declaring them transactions of interest in see notice_2016_66 2016_47_irb_745 i r s news_release ir-2015-19 date the avrahamis’ however is the first sec_831 case to make it to trial the commissioner determined deficiencies of nearly dollar_figure for and dollar_figure for plus almost dollar_figure 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 dollar_figure million for both and recharacterization of the dollar_figure million transfer from feedback to belly button and the dollar_figure transfer from feedback to mrs avrahami as other income on the avrahamis’ return and a computational adjustment that decreased the amount of medical expense deductions allowed each year 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 the avrahamis were arizona residents when they filed a timely petition with the courtdollar_figure i taxation of insurance opinion amounts paid for insurance are deductible under sec_162 as ordinary and necessary expenses paid_or_incurred in connection with a trade_or_business sec_1_162-1 income_tax regs but amounts set_aside in a loss reserve as a form of self-insurance are not see 96_tc_45 aff’d 979_f2d_1341 9th cir see also 577_f2d_279 5th cir 43_f2d_78 10th cir however neither the code nor the regulations define insurance securitas holdings inc v commissioner tcmemo_2014_225 at 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 312_us_531 absent an agreement by the parties the avrahamis’ case is appealable to the ninth circuit see sec_7482 a sec_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 sec_831 sec_11 sec_831 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 sec_1024 stat pincite but a tax break for qualifying insurance_companies is not a new idea the revenue act of ch sec stat pincite exempted certain mutual-insurance companie sec_45 from tax if or more of their income was collected for the sole purpose of meeting losses and expense in the exemption provisions were revised making only small_mutual insurers--those with interest dividends rents and mutual-insurance companies--as opposed to stock-insurance companies-- generally have the following characteristics common equitable ownership of assets by members the right of policyholders to be members to the exclusion of others and to choose management a sole business_purpose of supplying insurance at cost and the right of members to the return of premiums which are in excess of the amount needed to cover losses_and_expenses 68_tc_651 see also revrul_74_196 1974_1_cb_140 premiums not exceeding dollar_figure for the taxable year--exempt from tax and establishing an alternate taxing structure for insurers with income between dollar_figure and dollar_figure see revenue act of ch sec_165 and b stat pincite tax reform proposals-xxii hearing before the s comm on finance 99th cong 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 dollar_figure threshold see s rept no 1942_2_cb_504 in the threshold for complete tax exemption was raised to dollar_figure and the range for alternative taxation was changed to dollar_figure to dollar_figure see revenue act of pub_l_no sec a stat pincite see also secs c c nonlife mutual-insurance companies were sorted into three categories those with gross_receipts not exceeding dollar_figure which were tax exempt small mutuals with gross_receipts between dollar_figure and dollar_figure which were taxed only on their investment_income and ordinary_mutuals with gross_receipts over dollar_figure which were taxed on both investment and underwriting--ie premium--income see taxation of property and casualty insurance_companies hearing before the s comm on finance 98th cong overview the next overhaul of these code provisions occurred in when congress repealed and redesignated the code sections governing the taxation of mutual-insurance companies--sections to respectively--and instead imposed a single taxing structure for all nonlife insurance companies--mutual and stock--under sec_831 tra sec_1024 this included the addition of sec_831 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 pincite 1986_3_cb_1 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 and if a nonlife insurance_company had gross_receipts that did not exceed dollar_figure--or dollar_figure for mutual-insurance companies--and met certain premium percentage requirements then it was exempt from tax sec_501 otherwise if it had net written premiums or if greater direct written premiums that did not exceed dollar_figure million for the year then it could elect to be taxed under sec_831 and be subject_to tax only on its taxable_investment_income sec_831 and dollar_figure 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 tcmemo_1997_482 wl at 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 date 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 eg revrul_77_316 1977_2_cb_53 the amendments to sec_831 increased the premium ceiling to dollar_figure 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 pub_l_no sec_333 sec_129 stat pincite 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 142_tc_1 see also r v i guar co v commissioner 145_tc_209 harper grp t c pincite 96_tc_18 aff’d 979_f2d_162 9th cir securitas at in amerco t c pincite 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 pincite some of the policies were issued to amerco and its subsidiaries and covered risks such as commercial perils pollution and worker’s compensation id pincite- but over of the captive’s gross written premiums came from unrelated parties including some of amerco’s customers id pincite we held that on the basis of the potential hazards faced by the insureds insurance risk--not merely investment risk--was present id pincite 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 pincite we also found risk_distribution because the captive’s insurance_business was diverse multifaceted and involved a substantial amount of outside risks id pincite finally we found on the basis of all the facts and circumstances including the captive’s licensing as an insurance_company in states that the transactions at issue in amerco involved insurance in the commonly accepted sense id pincite applying these criteria we also found in favor of the taxpayer in harper grp t c pincite 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 pincite 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 pincite the captive also derived approximately of its premium revenue from a large number of unrelated parties--specifically the customers of harper’s subsidiaries--who purchased shipper’s-interest cargo insurance id pincite 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 pincite 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 pincite we also found the policies that the captive offered were for insurance in its commonly accepted sense id pincite 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 pincite we held that a relatively large number of unrelated insureds compris ing approximately 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--ie all owned by the same corporate parent--were deductible insurance expenses rent-a-center t c pincite in rent-a-center the captive provided workers’ compensation automobile and general-liability coverage only to its parent’s other subsidiaries id pincite 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 pincite the commissioner conceded in that case that rent-a-center faced insurable risks id pincite 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 pincite we also explained that r isk distribution occurs when an insurer pools a large enough collection of unrelated risks id pincite 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 big_number employees big_number vehicles and big_number stores id c microcaptives combining these two concepts--captive insurance_companies and the sec_831 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 might also be run so that related parties pay the captive deductible insurance premiums of just under dollar_figure million a year in turn the captive might pay out few if any claims might make a sec_831 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 dollar_figure 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 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 sec_831 that all the policies covered insurable risks that all premiums were actuarially determined and that feedback distributed risk by ensuring at least 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 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 t c pincite securitas at 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 u s pincite and occurs when the insurer pools a large enough collection of unrelated risks rent-a-center t c pincite securitas at 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 malone hyde inc v commissioner tcmemo_1993_585 wl at n rev’d on other grounds 62_f3d_835 6th cir as the ninth circuit explained in 811_f2d_1297 9th cir aff’g 84_tc_948 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 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 881_f2d_247 6th cir aff’g in part rev’g in part 88_tc_197 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 geographically diverse third parties they read harper group to establish a rule that risk is distributed whenever premiums from unrelated insureds constitute more than of a captive’s premiums and point out that feedback received over of its premiums in and almost of its premiums in 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 and four in too 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 big_number -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 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 f 2d pincite and we subsequently agreed see rent-a-center t c pincite a captive may achieve adequate risk_distribution by insuring only subsidiaries within its affiliated_group securitas at 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 depending on the nature of the risk a captive would likely need to insure a minimum of sibling entities to get good distribution of riskdollar_figure 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 revrul_2002_90 2002_2_cb_985 they explained it is commonly cited that there must be at least 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 since feedback was insuring only three affiliated entities in and four in we don’t need to decide which of these experts is correct instead we will 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 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 we note that revrul_2002_90 2002_2_cb_985 discusses a situation in which the irs would consider amounts paid to a captive by it sec_12 sibling entities to be deductible insurance premiums where spragg and small derive their seven policyholder analysis is unclear from the record simply agree that when analyzing the number of related insured companies feedback failed to adequately distribute riskdollar_figure 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 different unrelated parties but also because it issued policies covering more than big_number vehicles big_number real_estate properties and million equipment assets in different geographic regions r v i t c pincite 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 big_number employees big_number vehicles and big_number stores in all states t c pincite we also held that risk_distribution was achieved when a captive provided worker’s compensation coverage for more than big_number employees automobile coverage for more than big_number vehicles and other coverages for more than separate entities see securitas at even in humana f 2d pincite where 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 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 corporations operating more than hospitals with more than big_number beds see 88_tc_197 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 jewelry stores key employees and around 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 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 t c pincite outside insurance constituted over percent of the captive’s gross written premiums and in harper group t c pincite at least of the captive’s gross premium revenue came from unrelated partiesdollar_figure 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 eg rent-a-center t c pincite harper grp t c pincite amerco t c pincite securitas at therefore before we can say whether feedback distributed risk through the pan american program we must decide if in finding we did not err in 96_tc_45 aff’d 979_f2d_1341 9th cir 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 972_f2d_858 7th cir dollar_figure percent from others ocean drilling exploration co v united_states cl_ct percent to percent from others cases which have found no true insurance have found much lower percentages of unrelated business see eg 797_f2d_920 10th cir percent from others 89_tc_1010 percent from others rev’d in part on other grounds 914_f2d_396 3d cir 811_f2d_1297 9th cir none from others harper grp f 2d pincite pan american itself was a bona_fide insurance_company see rent-a-center t c pincite 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 pincite 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 to those paid_by that small_business under the program for example american findings paid pan american dollar_figure for up to dollar_figure in terrorism coverage and pan american paid feedback dollar_figure for reinsuring of pan american’s total losses the same was true under the program--american findings paid pan american dollar_figure for up to dollar_figure in terrorism coverage and pan american paid feedback dollar_figure for reinsuring 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 dollar_figure from an entity owned by the avrahamis to one owned 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 of the loss limit in and 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 between and of the policy limit in and between and in 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 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 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 dollar_figure in and dollar_figure in for add-on terrorism coverage with a policy limit of dollar_figure million and exclusions for chemical and biological hazards this amounts to a rate on line--the premium divided by the limit--of less than on the other hand american findings paid pan american dollar_figure in both and for stand-alone terrorism coverage with policy limits of around dollar_figure million in and dollar_figure million in this amounts to a rate on line of between and --or approximately 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 to 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 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 babbel also compared pan american’s rates to the stand-alone terrorism premium rates published in by marsh risk management researchdollar_figure as he explained marsh reported that median stand-alone terrorism insurance premium rates for the real_estate industry was dollar_figure per million of tiv total insurable value in while for the retail wholesale sector the median rate was dollar_figure per million of tiv in total insurable value tiv is the full value of insured’s covered property business income values and other covered property interests using the dollar_figure million in total assets reported on american findings’ tax_return as a proxy for its tiv this means american findings paid pan american dollar_figure per million of tivdollar_figure 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 busine sec_51 marsh is one of the world’s largest insurance brokers and has extensive captive insurance experience american findings’ premium payment to pan american of dollar_figure divided by number of millions of tiv is dollar_figure 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 dollar_figure million in losses and that occurred within the united_states but not in a city with more than 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 dollar_figure million in premiums in and in turn agreed to insure up to an aggregate of more than dollar_figure million in losses it ceded of this insurance risk to the participating captives and likewise passed on of its premiums--50 within days another within days and the last when the policy expired on december this means that by date--more than days into the policy period--pan american had only about dollar_figure 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 dollar_figure in capital because pan american ceded of its risk see nevis international insurance ordinance c n sec 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 eg 806_f3d_761 n 3d cir explaining that a 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 855_f2d_1326 n 8th cir 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 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 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 around dollar_figure in and dollar_figure in dollar_figure these amounts came out of the dollar_figure 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 pan american ceded more than dollar_figure million of premiums in and almost dollar_figure million in therefore the fixed fees pan american received were equivalent to approximately of premiums in and in 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 t c pincite holding that risk-shifting and risk-distributing are necessary to the existence of insurance emphasis added citing 89_tc_1010 see also humana f 2d pincite 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 t c pincite rent-a-center t c pincite harper grp t c pincite securitas at we have also looked at whether the policies covered typical insurance risks and whether there was a legitimate business reason for acquiring insurance from the captive see hosp corp wl at 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 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 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 citing 62_f3d_835 6th cir rev’g t c memo 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 until date--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 days of the 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--ie 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--ie 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 183_f2d_288 2d cir rev’g 13_tc_159 feedback also made investment choices only an unthinking insurance_company would make for example in feedback reported two types of assets on its tax return--more than dollar_figure million in cash and dollar_figure million in mortgage and real_estate loans the dollar_figure million comprised an dollar_figure secured promissory note from belly button with no payments due until date a dollar_figure million unsecured promissory note from belly button due in march and a dollar_figure unsecured note from belly button--even though the funds went directly to mrs avrahami--due no earlier than date this meant that by the end of more than of feedback’s assets were tied up in long- 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 ch dollar_figure sec_15 heritor didn’t disclose these loans to st kitts’ registrar until date 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 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 t c pincite holding that insurers who met the minimum capital requirements of their regulators were adequately capitalized rent-a-center t c pincite finding that a captive was adequately capitalized when it met bermuda’s minimum statutory requirements after consideration of a parental guaranty harper grp t c pincite holding a captive that was in compliance with hong kong’s minimum capital law was adequately capitalized securitas at finding a reinsurer was adequately capitalized when it met vermont’s minimum premium-to-surplus ratio malone wl at we won’t upset that consensus here 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 t c pincite 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 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 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 defines policy period as e vents occurring and reported from and after a m date and prior to a m date by its plain terms the policy limits coverage to legal expenses_incurred and reported between date and date 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 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 dollar_figure on insurance with feedback in the picture their insurance bills soared to more than dollar_figure million in and more than dollar_figure million in while the avrahami entities were paying feedback and pan american just shy of dollar_figure million a year they were also maintaining their commercial coverage for less than dollar_figure a year 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 date 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 date 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 instead of when he determined the premium for chandler one’s administrative action policy he would have calculated a base rate of dollar_figure instead of dollar_figure which would reduce the total premium by more than half he likewise chose a claims-made factor of 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 the dollar_figure is calculated as dollar_figure dollar_figure - dollar_figure big_number x filing states that if there is no retroactive coverage the claims-made factor should be 0--a 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 business risk indemnity premium by dollar_figure--dollar_figure 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 dollar_figure--and more than dollar_figure 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 rosenbach came up with a nearly 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 event 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 dollar_figure premium calculated by rosenbach for 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 dollar_figure 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 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 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 eg clougherty f 2d pincite n 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 sec_831 and captive insurance caselaw 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 t c pincite in light of our holding we need not address the commissioner’s other arguments--ie 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 sec_953 and elected to be taxed as a small insurance_company under sec_831 to qualify under sec_831 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 sec_816 sec_831 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 contracts its sec_831 election is therefore invalid for the years at issue in these cases--2009 and dollar_figure likewise to make a valid sec_953 election a controlled foreign corporation--as defined in sec_957 a --must qualify under part i life_insurance_companies or ii other insurance_companies of subchapter_l sec_953 to qualify for either part a company must meet the sec_816 definition of insurance_company which feedback did not see sec_816 sec_831 feedback’s sec_953 election is therefore likewise invalid for and 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 dollar_figure and dollar_figure for taxable years and respectively are not u s source fixed or determinable annual or periodical income under sec_881 or income that is effectively connected with a u s trade_or_business under sec_882 we do not have jurisdiction over feedback’s elections for years other than and since they were not part of the notice_of_deficiency and are not before us see rule this means feedback isn’t subject_to tax under those two sections which govern the taxation of foreign_corporations see sec_881 sec_882 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 sec_162 by american findings chandler one o e and white knight see sec_1_162-1 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 dollar_figure directly to mrs avrahami while the avrahamis and feedback originally claimed this dollar_figure 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 they do argue that it should be taxed as a qualified rather than ordinary dividend sec_1 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 that feedback’s sec_953 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 we therefore hold that the dollar_figure transferred to mrs avrahami should be taxed at ordinary_income rates b bona_fide loans in feedback also transferred dollar_figure million to belly button in exchange for an unsecured promissory note with an interest rate of per year--simple interest accruing from time to time two days later the avrahamis transferreddollar_figure 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 dollar_figure million loan--used by belly button to purchase land in date--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 upon such terms as to time and rate of interest or without interest as the parties may agree 204_f3d_1228 9th cir quoting 305_f2d_610 9th cir aff’g tcmemo_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 tcmemo_2008_34 wl at citing 322_f2d_956 9th cir aff’g chism ice cream co v commissioner t c memo aff’d 391_fedappx_660 9th cir see also kaider v commissioner tcmemo_2011_ wl at we also ask whether the debtor intended to repay the loan and whether the creditor intended to enforce its repayment see kaider wl at see also 55_tc_85 54_tc_905 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 whether the lender had demanded repayment kaider wl at citing welch f 3d pincite 925_f2d_180 7th cir aff’g tcmemo_1989_ mann constr co v commissioner t c memo see also stanley v commissioner tcmemo_2016_196 at 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 t c pincite 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 wl at in after belly button borrowed the dollar_figure million from mr avrahami it had assets of around dollar_figure and outstanding loans of the same amount by its liabilities exceed its assets by more than dollar_figure 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 we note that belly button’ sec_2010 tax_return reports only dollar_figure of liabilities--dollar_figure million in notes payable and dollar_figure due to related_party yet by the end of it had outstanding promissory notes payable to feedback of dollar_figure--dollar_figure from and another dollar_figure million from 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 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 dollar_figure million principal plus accrued interest--simple interest pincite per year-- on march the note from belly button to mr avrahami required repayment of the dollar_figure million principal plus accrued interest--simple interest pincite per year--on date the avrahamis insist that the dollar_figure 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 dollar_figure million note contains an identical statement although the dollar_figure million note called for interest when it was allegedly paid in neither the avrahamis nor belly button reported any interest_paid while the absence of security weighs against 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 parties’ conduct the next factor is how the parties’ records and conduct reflect the transactions in when the dollar_figure million note was executed belly button recorded it on its tax_return as dollar_figure due to affiliates the dollar_figure was the full amount belly button received from mr avrahami yet the note evidences a dollar_figure lower amount for no clear reason then in belly button transferred dollar_figure million from its bank account into the avrahamis’ bank account claiming this was a repayment of the dollar_figure million loandollar_figure yet belly button’ sec_2010 tax_return shows only a dollar_figure reduction in the amount owed to mr avrahami and no indication that any interest had been paiddollar_figure the recording of the dollar_figure million we note that this repayment was made less than three years after the execution of the dollar_figure million promissory note so even with simple interest accrued pincite per year on the unpaid principal the repayment shouldn’t have exceeded dollar_figure the rest of the dollar_figure million transfer appears to be reflected on belly button’ sec_2011 tax_return where it reported a further dollar_figure reduction in the amount due to related parties and a new dollar_figure asset under loans to partners or persons related to partners but still no indication of any interest payment dollar_figure dollar_figure dollar_figure dollar_figure million note has similar problems while the full dollar_figure million was reported on feedback’ sec_2010 tax_return under mortgage and real_estate loans belly button reported only a dollar_figure increase to its note-payable account in dollar_figure our great pause grows into skepticism 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 eg welch f 3d pincite here the dollar_figure 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 dollar_figure million note on the other hand calls for payment of the principal and all accrued interest 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 eg kaider wl at 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 belly button seems to have recorded the rest in when it reported an additional increase to its notes payable of dollar_figure 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 dollar_figure million in date the problem here is that mr avrahami himself was on all sides of both transactions he was--as an individual--the lender on the dollar_figure million note and--as a manager of feedback--the lender on the dollar_figure 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 tcmemo_2015_131 at the ultimate question which is a factual one is whether the parties intended a loan when the funds were advanced see also 56_tc_556 aff’d 474_f2d_1338 3d cir this question becomes even more important when the commissioner has proposed an alternative characterization see holden at n see eg 135_tc_26 stock sale proceeds aff’d 691_f3d_1315 11th cir teymourian v commissioner tcmemo_2005_232 constructive dividends here the commissioner argues that belly button was a mere conduit for the transfer of a dollar_figure 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 dollar_figure million from mr avrahami it had the ability to repay 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 dollar_figure 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 dollar_figure million of the dollar_figure million transfer from belly button to the avrahamis is a nontaxable loan repayment and should not be included in their gross_income the extra dollar_figure from mr avrahami to belly button will be treated as a nontaxable capital_contribution see sec_1_118-1 income_tax regs the dollar_figure difference will be split between interest to the avrahamis calculated according to the dollar_figure 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 reciteddollar_figure vi penalties out last issue is whether any of this triggers an accuracy-related_penalty under sec_6662 this section imposes a penalty on the portion of the no one questioned whether feedback had sufficient earnings_and_profits for this distribution to be a dividend see sec_316 underpayment_of_tax attributable to any substantial_understatement_of_income_tax or negligence or disregard of rules or regulations sec_6662 and b and 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 the commissioner has the initial burden of production to show that the understatement of income_tax was substantial sec_7491 this is a math question an understatement of income_tax is substantial if it exceeds the greater of dollar_figure or percent of the tax required to be shown on the return sec_6662 here the avrahamis’ corrected tax_liability for is more than dollar_figure but they originally reported a tax_liability of just shy of dollar_figure likewise for their corrected tax_liability reflects adjustments to income of over dollar_figure million but they originally reported a tax_liability of less than dollar_figure these understatements are well over dollar_figure and greater than 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 sec_6662 sec_6664 sec_1_6664-4 income_tax 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 and c income_tax regs see also 469_us_241 115_tc_43 aff’d 299_f3d_221 3d cir 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 t c pincite 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 years of experience hiller is a reputable phoenix-based estate_planning attorney with more than years of experience and clark is a new york lawyer with more than 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 of tax the parties dispute however whether the avrahamis actually relied in good_faith on the advice of mcentee hiller and clark 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 136_tc_67 aff’d 684_f3d_84 d c cir neonatology assocs t c pincite 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 ltd t c pincite citing tigers eye trading llc v commissioner t c memo 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 of her clients she also profited a great deal from the transaction receiving a portion of both an initial dollar_figure engagement fee and the annual flat fees the avrahamis could not reasonably rely on her 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 dollar_figure start-up fee and assisted the avrahamis in documenting the 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 132_tc_347 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 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 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 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 sec_162 sec_831 and sec_953 and we have previously declined to impose accuracy-related_penalties when there is no clear authority to guide taxpayers see petersen v commissioner t c ___ ___ slip op pincite date 123_tc_144 103_tc_711 see also 756_f2d_1430 9th cir aff’g in part vacating in part 80_tc_34 we accordingly find the avrahamis acted reasonably and in good_faith when relying on hiller’s professional advice and we will not impose sec_6662 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 dollar_figure million loan from mr avrahami to belly button and the dollar_figure million loan from feedback to belly button were bona_fide therefore the sec_6662 penalties should not be imposed to the extent they are related to repayment of the dollar_figure million loan but there is no reasonable explanation for why any underpayment flowing from the failure to report dollar_figure in interest and dividends for the overrepayment of that loan with the dollar_figure 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 dollar_figure 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 and c they controlled feedback’s bank account and they caused the dollar_figure 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 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 dollar_figure we will sustain the commissioner’s imposition of a sec_6662 penalty to the extent it relates to the dollar_figure distribution decisions will be entered under rule