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.