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 The credit balance in our Catastrophe Loss Account shall not be withdrawn by us except upon sixty (60) days prior written notice effective immediately after the end of our current policy year.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.

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