Friday, October 28, 2011

The Economic Family Doctrine: Moline Properties and Risk Shifting and Risk Distribution

The economic family doctrine was the IRS' primary legal argument against captive insurance.  This theory was developed over a series of internal memorandums which I'll discuss in a later post.  But to understand the economy family doctrine -- and the primary arguments against it -- there are two legal concepts we need to explain.

The legally separate nature of corporations.  

While it seems common sense that a court would treat each corporation as a separate legal entity, this is a concept that had to be established in case law in Moline Properties.  The following is from my book:

In Moline, Uly Thompson organized Moline Properties as a Florida Corporation. Thompson transferred a mortgaged property to the corporation in 1928.  A trustee who represented Thompson’s creditors held the stock of the corporation as security for another of Thompson’s loans.  The corporation sold the property in 1933.  The corporation reported a loss in 1934 and a profit in 1935 and 1936.  Thompson “filed a claim for refund on petitioner’s behalf in 1934 and sought to report the 1935 gain as his individual return.”  Thompson also reported the 1936 gain on his individual return.  In other words, the primary shareholder attempted to report corporate income as individual income.  The question is whether the corporation or Thompson is responsible for the taxes from the sale of property.  The court ruled thusly:

The doctrine of corporate entity fills a useful purpose in business life.  Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity

In other words, the corporate form will be respected so long as it serves a legitimate business purpose. 

Central to the IRS' primary anti-captive argument is the concept of corporate family, meaning the service focuses on the tax implications of a corporate group rather then for an individual company.  In all the major economic family cases, the taxpayers would argue that the economic family theory violated the separate nature of corporate entities.

Risk Shifting and Risk Distribution

These are two concepts that are inherent in insurance.  Again from my book:

Helvering is a landmark decision in insurance law because it provides the basic legal definition of insurance: “Historically and commonly insurance involves risk shifting and risk distributing.”  All future captive cases will use this definition and expand on it. 

In Helvering,Helvering, an 80-year-old woman purchased an annuity and a life insurance contract. She paid $4,179 for the annuity and $22,946 for the life insurance policy making her total payment $27,125.  The annuity contract allowed her to receive $589.80 per year for life.The life insurance contract paid $25,000 on her death.  From an actuarial perspective, the purchaser would have to live to 84 in order for her total payout to exceed her amount paid (and that assumes the insurance company does not invest the money received).  She purchased these policies one month before her death.  The insurance company would not issue one policy without the other.  The proceeds of the life insurance policy went to her daughter who did not include the amount of the life insurance policy in the estate tax return.  The commissioner disallowed the exclusion, and included the total amount of the insurance policy in the decedent’s estate.

To determine if the commissioner made the correct determination, the court had to define “insurance.”  The court first looked through the various insurance statutes before arriving at this definition:  “We think the fair import of subsection [g] is that the amounts must be received as the result of a transaction which involved an actual ‘insurance risk’ at the time the transaction was executed.  Historically and commonly insurance involves risk shifting and risk distributing.”

Unfortunately, the court did not define either of these terms, leaving that task to later decisions, which have arrived at the following explanations.

Risk shifting is seen from the insureds perspective and is accomplished through a valid insurance contract.  Essentially, when X happens to the insured, Y pays.  For example, if I purchase home owners insurance that covers fire and my house burns down, then insurance company pays a claim and makes me whole.  Factually what matters here is that the insurance contract is valid.  This element is rarely challenged.

Risk distribution, however, is an entirely different matter.  This concept is seen from the insurance company's perspective.  First -- remember that the IRS' primary concern with captives was that the captive was in fact a reserve fund set up by the parent company.  Central to this concept is that the parent is only contributing its own money and not co-mingling it with other insureds.  In contrast, insurance companies take premiums from a larger number of insureds and pool them, which accomplishes two goals.  First, it pools risk, so that the possibility of a catastrophic loss forcing the insurance company into bankruptcy is minimized.  Secondly, it pools smaller premiums into a large pool of money (from an economic perspective, an insurance company is a financial intermediary like a bank or mutual fund).  Put another way, by insuring a larger number of insureds, an insurance company is distributing its risk.

Courts later defined this concept in several ways.  Some courts simply noted that a successful captive would include enough money from a non-parent so that a paid claim would include enough non-parent monies to make the insurance company valid. A second way of explaining this concept was that the captive had to comply with the law of large numbers:  
In probability theory, the law of large numbers (LLN) is a theorem that describes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.
Regardless of the definition used, an insurance company must have risk distribution in order to be legally recognized.  Central to the economic family argument is the idea that the captive has insufficient risk distribution to be considered a viable insurance company.

With these two concepts in mind, we'll next turn to the IRS' primary anti-captive argument the economic family doctrine as expressed over a series of internal memos.

Saturday, October 22, 2011

The Flood Plane Cases, Part II

Last week, we looked at the first flood plane case Consumers Oil.  This week, we'll take a look at the second flood plane case -- U.S. v. Weber Paper Company.

To place this case in perspective, here is a bit of relevant history:
In mid-July 1951, heavy rains led to a great rise of water in the Kansas River and other surrounding areas. Flooding resulted in the Kansas, Neosho, Marais Des Cygnes, and Verdigris river basins. The damage in June and July 1951 exceeded $935 million dollars in an area covering eastern Kansas and Missouri, which, adjusting for inflation, is nearly $7 billion dollars in 2005.[1] The flood resulted in the loss of 17 lives and displaced 518,000 people.[2]
Like the taxpayer in Consumer Oil, the taxpayer in Weber couldn't find insurance due to the above mentioned flood.  To solve this problem, a group at the Kansas City Chamber of Commerce suggested that the parties form a reciprocal insurance exchange, which was organized under the insurance laws of Missouri, which -- along with the state of Kansas -- granted the exchange a license to conduct the business of insurance.  One participant went to far as to obtain a Private Letter Ruling stating the government would treat the deduction as allowable under 26 USC 162(a); another participant did not obtain a ruling, as it was then believed that the business deduction statute was sufficiently clear to allow the deduction.

The taxpayer made a $10,000 premium deposit for the first year's insurance policy, paying $1,000 with the application and tendering an additional $9,000 when the policy was issued.  The policy covered $100,000 of risk.  The policy issued was directly derived from policies then currently in force in New York, with changes made to comply with the laws of both Missouri and Kansas.

The policy contained the following clauses:
‘10. The credit balance in our Catastrophe Loss Account shall not be withdrawn by us except upon sixty (60) days prior written notice effective immediately after the end of our current policy year. In the event of withdrawal, our credit in this account will be adjusted to reflect the then average market value of investments owned by the exchange.

‘13. This agreement is strictly limited to the uses and purposes herein expressed and may be terminated at any time by the undersigned or by the Attorney, by either giving the other five days' notice in writing. Our liability created by virtue of this instrument shall begin and end simultaneously with liability of other subscribers to us and no liability shall accrue against us hereunder after termination.’
The policy itself contains a provision reading as follows:

‘Cancellation of policy. This policy shall be cancelled by the insured or by the Company by either giving the other five days' notice in writing.’

Remember the IRS' primary concern with captive insurance -- that the insured was not in fact buying insurance, but instead was creating a reserve fund which allowed the company to take a current year's deduction while at the same time timing the inclusion of income into a future year when taxable income was lower.  The above clause creates the impression that the insurance exchange was in fact a reserve which allowed the insured to manipulate his earnings.  However, the trial court noted that the taxpayer could not withdraw the money in the policy year, but instead had to wait until after the policy year to withdraw the funds.

Secondly, the IRS argued that because all the insureds were located in the same flood plane, they would all be impacted in the same manner, thereby preventing risk distribution from taking place.  This was the intellectual basis of Revenue Ruling 60-275, which outlined a fact pattern directly analogous to this case.  The service stated the following:
Since the eventual classification of the taxpayer with other member subscribers of the exchange will be limited to specific groups within the same flood district, each facing similar flood hazards, there is little likelihood that there could be a real sharing of the risks, because the occurrence of a major flood probably would affect all properties in a particular flood basin. Inasmuch as each subscriber to the instant exchange is substantially underinsured, any proceeds received by the taxpayer in the event of flood damage would, in effect, be a return of the taxpayer's own money.
The trial court simply noted the facts of the case were inconsistent with the Revenue Rulings, and left it at that.  In short, the trial and appellate court disagreed with the IRS' contention regarding the case.

As I note in my book, the IRS could have used this opportunity to develop a basic legal theory to deal with or explain captives.  However, instead they decided to issue Revenue Ruling 64-72, which states:
Although certiorari was not applied for in the Weber Paper Com pany case, the decision will not be followed as a precedent in the disposition of similar cases, and the position of the Service, as set forth in Revenue Ruling 60-275, C.B. 1960-2, 43, will be maintained pending further judicial tests.
This set-up the series of challenges based on the economic family doctrine, which I'll address next.

Thursday, October 13, 2011

The Flood Plane Cases, Part I

Although we think that the first important legal battle for captive insurance occurred during the economic substance cases that started in the 1970s, the reality is two cases from the 1950s (US. v. Weber and Consumers Oil Corp v. US) have all the hallmarks of modern-day captive insurance programs.  Most importantly, at their conclusion, these cases offered the IRS the opportunity to clearly outline specific rules and regulations related to captives.  However, the IRS declined to do so, instead issuing a Revenue Ruling stating they would not follow the conclusion of the cases and instead continue to litigate captive insurance cases.

First, let's set the stage by explaining what caused the need to create one of these captives in the first place: the Trenton Flood of 1955
The worst natural catastrophe to befall Trenton was the flood of 1955.

City streets were turned into rivers and hundreds of families were evacuated as the normally  placid Delaware River surged over its banks.

Flood damage totaled $100 million in New Jersey, mostly in property damage, with $500,000  coming from the destruction of Mercer County roads.

In the weeks leading up to the flood, the area had been scorched with temperatures hitting  the 90s nearly every day in July and early August.

Worse yet, there had been little rain to ease the record-setting temperatures, as most towns  considered water rationing measures.

The earth became parched, reservoirs dried up, and sewers backed up due to a loss of water  pressure.

Area residents, especially Burlington County farmers who had suffered severe crop damage due to the heat, were probably praying for rain, ignoring the adage, "Be careful what you  wish for."

After the drought came the deluge, as Mother Nature flashed her fickle side.

The drought broke on Aug. 7, when 2.9 inches of rain fell on Trenton.
As a result, finding flood plane insurance in the NJ area in the years afterwords was nearly impossible.  To solve this problem, The Consumers Oil Company established its own trust fund.
The plaintiff, by a written agreement with three of its officers and directors, established a ‘trust fund’ which was to be administered by the latter and held by them as insurance against possible liability for property damage resulting from flood. The trust agreement was subject to automatic termination upon cessation of the plaintiff's business, and was unilaterally revocable by the plaintiff upon determination that continuance of the trust was no longer feasible ‘as a matter of business expediency and sound business operation.’ (Paragraphs 10 and 11 of the Agreement.) The balance in the fund was repayable to the plaintiff upon termination or revocation of the agreement. The agreement was executed on December 16, 1955, and was in effect during the years here in question.
The plaintiff made two payments into the trust fund, and attempted to deduct these amounts from its income tax -- a deduction which was disallowed by the service.  The court agreed, largely because this scenario looked remarkably similar to a reserve fund:
The fund thus created remained wholly within the control of the plaintiff and the balance remaining therein was subject to repayment upon either the cessation of its business or the unilateral revocation of the agreement. The payments entailed nothing more than a voluntary segregation of funds out of income as a reserve against a contingent liability and were, therefore, not allowable deductions
Central to the court's decision was the structure of the trust established by the company.  The trust was administered by directors of the company, making it look remarkably similar to a reserve fund.  In addition, the trust automatically terminated on the cessation of the company's business or if the company decided termination was warranted by business exigencies. This would allow the company to bring the earnings back on their income statement, which could allow them to manipulate their earnings -- a primary reason why the IRS fought against the establishment of reserves.

There are two important issues to mention regarding this case's facts.  First, the company did not set up an insurance company; instead, they set-up a trust.  There was no claims department, no formal insurance contract etc...  Under current law, this transaction would violate the third prong of the Harper Test (the arrangement would not be for insurance in its commonly accepted sense).  Secondly, there is no mention of any tax evasion concepts; that is, no one went to the company and said, "I've got a great way to lower your taxes."  What did happen is business exigencies (risk management) drove the transaction.  This is incredibly important, as we will see this as a fundamental part of the captive cases going forward.

Saturday, October 8, 2011

What Was The IRS' Beef With Captives?

Starting in the mid-1970s, and continuing through the UPS case, the IRS fought captives tooth and nail.  Over the course of these cases, they advanced three different legal arguments against captive insurance: the economic family argument, the nexus of contracts and the assignment of income doctrine. 

However, it's important to ask this question regarding the IRS' legal battle: "what was it about captives that the IRS didn't like?"  To answer that question, we need to go back to a series of cases from the early 20th century called the reserve cases.  In all of these cases, a taxpayer foresaw a particular adverse event and started to place money into a reserve fund in anticipation of future payment. In all of these cases, the taxpayer attempted to deduct the amount paid into the fund as a legitimate, section 162 deduction.  The Bureau of Tax Appeals (B.T.A.) heard all of these cases and struck down the deduction.  They advanced several reasons for these denials.
  1. The tax code allowed a deduction for business expenses, but not for amounts paid into an    internally held reserve.  This is supported by a strict reading of the statute.
  2. Moving funds internally – from cash to a reserve or from one corporate “pocket” to another – does not shift the risk as required by insurance. 
  3. Preventing the manipulation of gross income through the use of “reserves” and “contingency funds” as outlined in the case Spring Canyon Coal. 
  4. Both accrual and cash accounting methods require the taxpayer to deduct specific “realized” amounts.  A taxpayer cannot deduct a speculative amount. 
Point number one requires only a strict reading of the tax code. 26 U.S.C. 162 and the accompanying Treasury Regulations do not allow a deduction for payments into a reserve fund; the wording is simply not in the statute.  Point number 2 is basic accounting; paying into a reserve fund would debit cash and credit the reserve fund, but there would not be a net change on the balance sheet; the taxpayer is simply moving money internally (this concept would become part of the intellectual backbone of the economic family argument, the service's primary, anti-captive argument). 

Point number three is, I believe, the most pointed argument.   A good example of this situation occurred in 2006 when Exxon earned a record amount of revenue.  At the time, there were calls for a windfall profits tax on the company.  If Exxon could set aside money in a reserve for this contingency and then deduct the payment to the fund Exxon could manipulate its earnings.  In the year of the deduction, it could lower its taxable income be claiming there was a possible contingency, and then when its taxable income was low, it could argue the contingency no longer existed (and it would not, as there would be no windfall profits) and then bring the reserve back onto its income  statement.  In short, the company would be able to time it's earnings to, from the court's perspective, an uncomfortable degree.

Point number four is a bit weak, as the courts focused on the amounts paid from the contingency fund rather than the amounts deducted.  However, the point, I believe, is that in all these situations, the taxpayers underlying analysis of the payment from the company's perspective was a bit weak.  Instead of looking at the risk from an actuarial perspective, all the company's simply eyeballed the amounts and started making payments.       

While not stated in the any of the reserve cases, central to all of these arguments is this point: the company is engaging in accounting maneuvers rather than insuring risk.  In addition, the taxpayer is attempting to obtain a tax benefit (in the form of lower taxable income) because of these maneuvers.   These two, inter-twinging issues, need to be continually on the minds of planners, even today.     

Saturday, October 1, 2011

The Proper Role of Life Insurance And Captives

The topic of life insurance and captive insurance companies is fairly controversial.  Some practitioners have no problem recommending that a captive invest in life insurance as part of their investment portfolio, while others recommend against it.  I fall into the latter camp for the following reasons:

1.)  The vast majority of time when a captive invests its investment assets into life insurance products, it does so because that has been the strategy since the beginning of the sales process.  That is, a salesperson went to a prospect and said, "I've got a great idea; we can form a captive insurance company and have the company invest in life insurance as part of their investment portfolio."  The problem with this approach is it runs against the basic legal function of a captive insurance company -- to underwrite risk.  If the sales process completely avoids this central tenant -- or, if underwriting risk is not the primary reason for forming the captive -- the transaction runs counter to the primary legally defensible reason for forming a captive.

The entire history of anti-avoidance law is filled with cases where the sales literature, methodology, and presentations used demonstrated an intent counter to a standard business transaction.   For further reading on the topic, I would recommend the entire series of equipment leasing cases from the 1980s, the COLI cases from the 2000s or the new codification of the economic substance doctrine by the IRS.

2.) The 831(b) captive is already a tax-advantaged vehicle; it is taxed on its investment portfolio rather than its gross earnings.  Why would a company that has a tax advantage invest in a tax advantaged product?  It's a situation directly analagous a person with $30,000 in annual income investing in a municipal bond; it's a complete mismatch between the investor's investment profile and the investment.

3.) Before I was a lawyer, I was a bond broker.  Insurance companies made up about half of my clients.  In all the time I dealt with the investment side of insurance companies I never once saw them invest in life insurance.  Why?  Because the actuarial department of insurance companies spend a fair amount of time aligning the duration of the expected liabilities and the duration of the investment portfolio (for more on this idea -- at least from the fixed income side -- read Frank Fabozzi's Fixed Income Mathematics).  Life insurance just doesn't serve in this capacity.  But another way, the duration of the average life insurance policy is far longer than the average expected P and C claim.

Why is this important?  Because the third prong of the three prong Harper test states the court will recognize a captive so long as the transaction "was for “insurance” in its commonly accepted sense."  I call this test the "duck test;" the captive must walk and talk like an insurance company.  Because other insurance companies don't invest in life insurance, captives shouldn't either.

All that being said, there are two places where life insurance can play a part in the captive process.

1.) Buy-sell agreements: these are especially appropriate when the captive is inter-twined with an estate plan.  The parents and the children create and sign a buy-sell agreement funded with life insurance at some point in the captive's life cycle.  This strategy can also be employed when the captive has multiple owners.  Buy-sell agreements are standard business plans that will not draw any unwarranted scrutiny.

2.) A highly liquid loan to an ILIT: once a captive has been in existence for a number of years it will have the ability to make loans thanks to excess cash.  One of these loans could be a callable loan to an irrevocable life insurance trust that is part of an overall estate plan.  The loan must conform to transfer pricing rules and regulations.