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.

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