Doctor challenges Puerto Rico residency ruling and $5.8 million deficiency

Gary V. Karakashian v. Commissioner. United States Tax Court. No. 3119-26.

A dermatologist is asking the Tax Court to reverse a $5.77 million tax bill and a $4.29 million civil fraud penalty. The IRS claims he was not a true resident of Puerto Rico and wrongly left out Puerto Rico income from U.S. taxes.

What Happened

Dr. Gary Karakashian filed a petition in Tax Court to challenge an IRS Notice of Deficiency for 2021. The IRS claimed:

• $5,774,740 in additional income tax

• $4,293,843.75 in civil fraud penalties under §6663

The dispute centers on the main issue: whether Karakashian was a bona fide resident of Puerto Rico under §937(a). If so, he could exclude a large amount of Puerto Rico income from U.S. federal tax under §933.ed he failed:

• physical presence test

• tax home test

• closer connection test

The IRS also questioned a group of Puerto Rico entities, captive insurance deals, management companies, and investment structures connected to the taxpayer’s medical practice and investments.

Human civilization has now produced a world where dermatologists apparently maintain captive insurers, transfer pricing studies, Puerto Rico management entities, telehealth operations, reinsurance pools, and six-million-dollar intercompany loan chains. Accountants everywhere just nodded grimly and opened another spreadsheet.

Why It Matters

• Puerto Rico residency disputes remain a major IRS enforcement priority, especially where taxpayers exclude large amounts of capital gain or business income under §933.

• The case combines several areas currently receiving heightened scrutiny:

  • Puerto Rico Act 60 residency claims

  • captive insurance structures

  • Subpart F and GILTI issues

  • management company arrangements

  • economic substance penalties

• The IRS appears willing to assert both civil fraud penalties and alternative economic substance penalties in the same case when large Puerto Rico exclusion claims are involved.

• The petition highlights how residency determinations can affect downstream international tax treatment. If the taxpayer loses Puerto Rico residency status, multiple Puerto Rico entities could become controlled foreign corporations subject to Subpart F and GILTI inclusion rules.

Key Facts

Karakashian alleges that he became a permanent resident of Puerto Rico in 2018 and remained a bona fide resident through 2021.

He claims:

• 209 days of Puerto Rico presence during 2021

• a Puerto Rico tax home

• minimal U.S. personal connections

The taxpayer operated or owned several entities, including:

• Tripod Management Services, LLC

• Aqua Investments, LLC

• Zeus Protected Cell

• Gary V. Karakashian International Business Group, Inc.

• Gary V. Karakashian, M.D., P.A.

The petition states that Tripod provided physician, administrative, telehealth, pathology, billing, compliance, and management services from Puerto Rico to a New Jersey dermatology practice.

The IRS also challenged:

• more than $4 million of allegedly excluded capital gains

• deductions tied to captive insurance premiums

• depreciation and business expense deductions

• investment interest expense

• additional “other income” reconstructed using bank deposit methods

Statutory Framework

Section 937(a) defines a bona fide Puerto Rico resident using three principal tests:

• Physical presence test

• Tax home test

• Closer connection test

Section 933 generally excludes Puerto Rico source income from U.S. federal income tax for bona fide Puerto Rico residents.

Sections 951 and 951A govern Subpart F and GILTI inclusions for U.S. shareholders of controlled foreign corporations.

Section 6663 imposes a 75% civil fraud penalty on underpayments attributable to fraud.

Section 6662 includes accuracy-related penalties for:

• negligence

• substantial understatement

• non-economic substance transactions

• undisclosed foreign financial asset understatements

Taxpayer Argued

• He satisfied all Puerto Rico residency tests under §937(a).

• Puerto Rico source income was properly excluded under §933.

• Puerto Rico entities were not controlled foreign corporations because they were bona fide residents of Puerto Rico.

• Captive insurance arrangements constituted valid insurance transactions with economic substance.

• Premiums were actuarially determined and supported by risk distribution arrangements through a Puerto Rico reinsurance pool.

• Business deductions and depreciation were properly substantiated.

• He relied on qualified professional advisors and did not commit fraud.

Government Argued

According to the petition, the IRS concluded:

• the taxpayer failed Puerto Rico residency requirements

• Puerto Rico income exclusions were improper

• Puerto Rico entities constituted controlled foreign corporations

• certain income was subject to Subpart F and GILTI inclusion

• captive insurance arrangements failed federal tax requirements

• various deductions lacked substantiation or represented personal expenses

• fraud or alternative accuracy-related penalties applied

Court Process and Issues to Watch

The petition raises several issues that frequently appear in modern Puerto Rico enforcement cases.

Residency documentation

The taxpayer claims 209 qualifying Puerto Rico days, including days attributable to medical treatment exceptions. The IRS often scrutinizes:

• travel logs

• phone records

• flight data

• utility usage

• social connections

• business activity location

Captive insurance scrutiny

The petition describes a sophisticated captive insurance structure involving:

• protected cell arrangements

• actuarial studies

• reinsurance participation

• Puerto Rico insurance regulation

• risk distribution mechanisms

The IRS has aggressively challenged micro-captive and related insurance structures for years, especially where tax benefits substantially outweigh demonstrated insurance purpose.

Puerto Rico management company structures

The petition claims the taxpayer personally performed management and telehealth services from Puerto Rico through Tripod.

That issue matters because service income sourcing and operational substance remain central in Puerto Rico residency examinations.

Economic substance penalties

The IRS asserted fraud penalties and, alternatively, non-economic substance penalties.

That approach gives the government multiple fallback positions if fraud is difficult to prove. Tax litigation increasingly resembles a prosecutor carrying backup batteries because modern tax structures tend to fail in layers rather than all at once.

The Takeaway

This petition shows that Puerto Rico residency disputes often grow to include international tax, captive insurance, transfer pricing, and economic substance issues once the IRS questions residency.

For practitioners, the key point is both procedural and substantive: losing a Puerto Rico residency claim can cause a chain reaction across entity classification, Subpart F exposure, reporting, sourcing rules, and penalties. One residency decision can reopen an entire structure.

List of Citations

• §933: Exclusion of Puerto Rico source income for bona fide Puerto Rico residents.

• §937(a): Defines bona fide Puerto Rico residency tests.

• §951 and §951A: Subpart F and GILTI inclusion rules for controlled foreign corporations.

• §957(a) and §957(c)(1): Controlled foreign corporation definitions and Puerto Rico exceptions.

• §6663: Civil fraud penalty provisions.

• §6662(b)(6), §6662(i), §6662(j): Economic substance and foreign asset understatement penalties.

• Karakashian v. Commissioner: Tax Court petition challenging Puerto Rico residency determination and related penalties.