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.