Saturday, November 26, 2011

The Economic Family Cases, Part I

When looking at the economic family cases, it's important to have some type of structure.  Therefore, I'll be using the fact patterns outlined in Revenue Ruling 77-316 and then looking at the cases which most resemble those fact patterns.  What follows is an excerpt from my book U.S. Captive Insurance Law.

The first fact pattern outlined in Revenue Ruling 77-316 is entirely insular:

During the taxable year domestic corporation X and its domestic subsidiaries entered into a contract for fire and other casualty insurance with S1, a newly organized wholly owned foreign “insurance” subsidiary of X.  S1 was organized to insure properties and other casualty risks of X and its domestic subsidiaries.  X and its domestic subsidiaries paid amounts as casualty insurance premiums directly to S1.  Such amounts reflect commercial rates for the insurance involved.  S1 has not accepted risks from parties other than X and its domestic subsidiaries.[1]

In other words, the captive only deals with other subs – it writes no policies outside the corporate family, nor does it obtain any reinsurance.  The captive is expected to stand on its own.  Several cases successfully prosecuted by the IRS illustrate how the service attacked this fact pattern.

The plaintiff in Stearns Rogers designed and manufactured “large mining, petroleum and power generation plants.”[2]  In order to bid on projects, the company had to obtain insurance for its own contractors as well as its clients.[3]  Starting in the early 1970s, the company “found it difficult or impossible to obtain from traditional companies the types and huge amounts of coverage needed.”[4]  Therefore the company formed a captive insurance company under the Colorado Captive Insurance Company Act.[5]  In order to gain approval from the Colorado Insurance Commissioner, Stearns Rogers had to demonstrate the company could not find other insurance.[6]  The plaintiff named the company Glendale Insurance Company, which only issued insurance policies for the plaintiff, the plaintiff’s subsidiaries and the plaintiff’s clients.[7]  Glendale did not use reinsurance.  The plaintiff agreed to indemnify the captive for up to three million dollars.  The plaintiff deducted payments it made to Glendale under the theory that the payments were insurance premiums.[8]  The service disallowed the deductions,[9] claiming the payments were in fact self-insurance or payments to a reserve which are not deductible.[10]

At trial, the service advanced its “economic family” argument,[11] while the plaintiff argued the payments were insurance premiums paid between two distinct corporate entities, thereby invoking Moline Properties.[12]  After an analysis that determined the captive was formed for a legitimate business purpose (and therefore not a sham for tax purposes), the court ruled Stearns-Rogers and Glendale Insurance were two distinct corporate entities which should be recognized.[13]  Next the court explained the “economic family” doctrine of Revenue Ruling 77-316, citing from Carnation v. Commissioner,[14] “The essence of that ruling [Carnation] is that there can be no deduction where, in actuality, there has been no shifting of risk outside the economic family.”[15]  To bolster its argument, the court distinguishes Stearns Rogers from Weber Paper Company, stating, 

“Its [Stearns Rogers] problem is that in contrast with the Weber Paper Company, it did not ally itself with others similarly situated so that the risk of any one member’s flood loss would be shifted to the “economic families” of the other insured members.[16] 

In effect, because Glendale did not insure any other company’s risks, there was no risk shifting.  There was no insurance, because “profits and losses stay within the Stearns Rogers “economic family.”  In substance the arrangement shifts no more risk from Stearns Rogers than if Stearns Rogers self-insured.”[17]

The appeals court affirmed the district court.[18]  They first noted that self-insurance plans do not constitute insurance.[19]  They next noted that risk did not leave the “parent company.”  The payments for coverage went from parent to subsidiary but the ultimate burden for losses was always on the parent.”[DL1] [20]  In effect, the court is arguing Stearns Rogers established a reserve fund without actually stating same.  In addition, the appeals court sidesteps the problems of not properly applying Moline Properties to the fact pattern by noting, 

The separation [between the companies] is not ignored.  Instead the focus must be on the nature and consequences of the payments by the parent and the Supreme Court’s requirement that there must be a shift of risk to have insurance …  The comparison of the arrangement here made to self-insurance cannot be ignored.[21]

This is the exact same reasoning offered by the service regarding the possible problems of Moline Properties:

However, we are of the view that the concept of independent corporate identity is not being challenged by the rationale espoused.  We do not propose to ignore the taxpayer’s separate identity.  Rather, the proposed ruling examines the transaction for its economic reality.[22]

The service is making an anti-abuse argument by asking the court to look beyond legally and legitimately established corporate forms to see an “economic family.”  In effect, the service is advancing a new anti-avoidance theory.

In Beech Aircraft v. U.S., the plaintiff lost a jury verdict of $21,700,000 in 1971.[23]  The old insurance policy did not allow Beech to investigate claims against the company or participate meaningfully in their legal defense.[24]  As a result, Beech formed a captive insurance company in Bermuda on March 2, 1972 named Travel Air Insurance Company, Ltd.[25]  Travel Air was originally capitalized with $120,000.[26]  Beech paid a $1.5 million dollar premium to Travel Air for a $2 million dollar policy for the fiscal year September 1, 1971 to August 31, 1972.[27]  Beech made no assurances to Travel Air that Beech would “pay any losses which occurred greater than the excess insurance carried by Travel Air, nor did it agree to further enlarge the capital structure of Travel Air in any event.”[28]  Beech obtained an additional policy from Fairfax Underwriters for $10 million.[29]  While Travel Air sought outside business after 1973, that occurred after the period in question for this case.

The court’s reasoning was short.  First they noted that a transaction’s substance governs the tax consequences[30] – which is essentially an anti-avoidance argument.  The court’s primary ruling dealt with the corporate inter-relationship of Beech and Travel Air; because Beech owned a majority of Travel Air’s stock, a payment from Travel Air would lower Beech’s net worth: “Here the gain or loss enjoyed or suffered by Travel Air is reflected directly on the net worth of the parent Beech.[31] In addition, because Travel Air had a capitalization of $150,000, they would have to ask Beech for additional capital in the event of a payout larger than $150,000.[32]

Not stated, but certainly implied by the ruling, is the circular nature of the cash flows.  Beech paid a premium to Travel Air who would in turn pay Beech in the event of a claim against Beech.  In effect, Travel Air was a reserve fund for Beech that simply stored funds until requested by Beech.  Hence, the court’s quoting of the primary anti-avoidance concept of substance over form in conjunction with this concern: “It is conceivable, though unlikely, that if no losses were encountered, the deduction of purported insurance premiums could become a tax loophole for the parent company.”[33]

[1] Rev. Rul 77-316.
[2] Stearns-Rogers Corp., Inc. v. U.S., 577 F. Supp. 833, 834, (Colorado 1984).
[3] Id.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id at 834-835.
[9] Id at 835.
[10] Id .
[11] Id .
[12] Id at 835-836.
[13] Id at 836.
[14] Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Circuit 1981).
[15] Stearns-Rogers at 837.
[16] Id at 838.
[17] Id.
[18] Stearns Rogers Corp. v. U.S., 774 F.2d 414, (10th Circuit 1985).
[19] Id at 415.
[20] Id.
[21] Id at 416.
[22] Gen. Coun. Memo. 35349 (May 15, 1973).
[23] Beech Aircraft v. U.S., 1984 WL 988 at 1.
[24] Id .
[25] Id.
[26] Id.
[27] Id.
[28] Id at 2.
[29] Id.
[30] Gregory v. Helvering.
[31] Id at CONCLUSIONS OF LAW paragraph 4.
[32] Id at paragraph 5.

 [DL1]Where is the start of this quote?

Sunday, November 20, 2011

The Economic Family Doctrine; The IRS' Argument

The primary argument advanced by the IRS against captives was the economic family argument, which was formally announced in Revenue Ruling 77-316, but which was developed over a series of now published internal IRS Memorandums.

In 77-316, the IRS outlines three common captive insurance scenarios:
Situation 1
During the taxable year domestic corporation X and its domestic sub­sidiaries entered into a contract for fire and other casualty insurance with S1 , a newly organized wholly owned foreign "insurance" subsidiary of X. S1 was organized to insure properties and other casualty risks of X and its domestic subsidiaries. X and its do­mestic subsidiaries paid amounts as casualty insurance premiums directly to S1 . Such amounts reflect commer­cial rates for the insurance involved. S1 has not accepted risks from parties other than X and its domestic subsidi­aries.
Situation 2
The facts are the same as set forth in Situation 1 except that domestic corporation Y and its domestic subsidi­aries paid amounts as casualty insur­ance premiums to M, an unrelated domestic insurance company. This in­surance was placed with M under a contractual arrangement that pro­vided that M would immediately transfer 95 percent of the risks under reinsurance agreements to S2 , the wholly owned foreign "insurance" sub­sidiary of Y. However, the contractual arrangement for reinsurance did not relieve M of its liability as the primary insurer of Y and its domestic subsidi­aries; nor was there any collateral agreement between M and Y, or any of Y's subsidiaries, to reimburse M in the event that S2 could not meet its reinsurance obligations.
Situation 3
The facts are the same as set forth in Situation 1 except that domestic corporation Z and its domestic sub­sidiaries paid amounts as casualty in­surance premiums directly to Z's wholly-owned foreign "insurance" sub­sidiary, S3 . Contemporaneous with the acceptance of this insurance risk, and pursuant to a contractual obli­gation to Z and its domestic subsidi­aries, S3 transferred 90 percent of the risk through reinsurance agreements to an unrelated insurance company, W.

Situation 1 is a standard captive arrangement; the parent forms a captive and then insures various risks through the captive.  Situation 2 involves a standard reinsurance arrangement, where the parent insures risks through an insurance company who then reinsures a percentage of the risk with the parent's captive.  This is usually done to obtain access to the credit rating of the third party insurer and is referred to as a fronting arrangement.  In situation 3, the parent's captive transfers a certain percentage of the risk outside the captive to a third party.  

The service explained its reasoning thusly:
Under the three situations described, there is no economic shifting or distributing of risks of loss with respect to the risks carried or retained by the wholly owned foreign subsidi­aries, S1 , S2 , and S3, respectively. In each situation described, the insuring parent corporation and its domestic subsidiaries, and the wholly owned "insurance" subsidiary, though sepa­rate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss. To the extent that the risks of loss are not retained in their entirety by (as in Situation 2) or reinsured with (as in Situation 3) insurance companies that are unre­lated to the economic family of in­sureds, there is no risk-shifting or risk­distributing, and no insurance, the premiums for which are deductible under section 162 of the Code.
Notice the lack of solid legal analysis explaining the service's reasoning; they simply state the corporate group is an economic family and essentially leave it at that.  There are no cases cited, no doctrines quoted, no theories proffered.   They simply put forward an idea.

The internal memorandums which develop this legal theory offer no substantive guidance.  General Council Memorandum 35340 develops the legal reasoning for the first fact situation.  Regarding the fact situation, it concludes:
Inasmuch as S does not underwrite any substantial risks from outside the affiliated group, the requisite shifting and distribution of insurance risk is absent. Accordingly, the amounts paid by P and its affiliates to S do not constitute premiums for insurance deductible under Int. Rev. Code of 1954, § 162 [hereinafter cited as Code].
The service bases their arguments on two points.  First,
In Rev. Rul. 60-275, 1960-2 C.B. 43, taxpayer, a common carrier, leased facilities bounded by a river which exposed the property to potential flood damages. The taxpayer entered into a reciprocal flood insurance exchange agreement with other subscribers wherein each paid an annual premium deposit. The funds were paid into reserves for the payment of losses.

The agreement provided that each subscriber's risks would be divided into classes according to the nature of its business, flood hazard, location, and flood district. The ruling stated that inasmuch as the classification of taxpayer with other subscribers will be limited to specific groups within the same flood district each facing the same flood hazards that there is no real staring and distribution of insurance risks. In the event of flood damage to any of the subscribers in that group, there is a strong likelihood that all subscribers would be similarly affected. Therefore, any proceeds would merely be a return of subscriber's premium deposit. The ruling thus concluded that in the absence of the essential risk-sharing element, the premium deposits were not deductible as insurance premiums in accordance with Code § 162(a).2
Remember -- this is the legal basis for the service's objection to the insurance arrangement in the flood plane cases -- an analysis already rejected by at least one court.  However, the above fact pattern quoted is situation 1 is different from at least one of the flood plane cases which insured risks of a group of insureds rather than the risk of a single insured (see here and here for further discussion).  But the memo does not make a distinction between single parent and group; instead it attempts to apply itself to all captive insurance situation, making it that much less potent.

The service's second argument borders on anti-avoidance:
Although we agree with the rationale and the conclusion of the proposed revenue ruling, we recognize that the road to favorable judicial resolution is pervaded by the concept of separate corporate identity. Only in exceptional circumstances are the courts willing to disregard the corporate entity. New Colonial Company v. Helvering, 292 U.S. 435, 442 (1934). To successfully defeat corporate identity, it must be shown that the corporation was formed solely for tax purposes and has no substantive business activity, Moline Properties v. Commissioner, 319 U.S. 436 (1943), or that it is a mere skeleton, Perry R. Bass, 50 T.C. 595, 600 (1968). When the corporation is sufficiently capitalized and maintains the indicia of business operations, its corporate identity is rarely denied. Compare, Lloyd F. Noonan, 52 T.C. 907 (1969), aff'd per curiam 28 A.F.T.R.2d ¶71-6042 (9th Cir. 1971) with Perry R. Bass, 50 T.C. 595 (1968). In the instant case, to consider the affiliated group in the aggregate for the purpose of determining the lack of a substantial shift of risk, it may be argued that the separate corporate identity of each member of the group is improperly ignored.4
However, we are of the view that the concept of independent corporate identity is not being challenged by the rationale here espoused. We do not propose to ignore any taxpayer's separate identity . Rather, the proposed ruling examines the transaction for its economic reality. The payments here are simply not being made for insurance. The arrangement is basically designed to obtain a deduction by indirect means which would be denied if sought directly.
 When a tax lawyer sees the phrase "economic reality" we immediately think, "substance over form" or "anti-avoidance."  This is a judicial doctrine which allows the courts to recast a transaction if its form diverges from its substance.  By this time in the development of anti-avoidance law, the doctrine had morphed into the sham transaction doctrine, which was the predecessor to the now codified economic family doctrine.  Regardless of the terms used, the memorandum offers no further analysis; it simply uses the key phrase and stops  This greatly weakens the IRS argument in this practitioner's opinion.

GCM 35629 developed the services reasoning for situation 2 from 77-316.   However, the reasoning is just as weak.  The service states:
Under the facts of the instant case, *** sought to authenticate its so-called insurance premium payment by introducing an independent insurer between it and its subsidiaries and *** The substance of the transaction, however, was that *** insured only *** percent of the risk involved and was contemporaneously guaranteed reinsurance at specified rates with *** The whole transaction then was carefully orchestrated to produce a single result-eventual placement of the insurance with *** The economic reality in this case is no different from that found to exist in *** there is no economic shift or distribution of *** percent of the risk ‘insured’.
Note that the IRS is making sweeping legal conclusions regarding the transaction.  It's highly likely that this is a fronting arrangement -- a common occurrence in the insurance world as explained above.  Yet the service is assuming a fraudulent intent without any analysis or presentation of the facts by the taxpayer.

GCM 37040 outlines the services argument to situation 3 from Revenue Ruling 77-316
Thus, in the *** case, the captive, through reinsurance agreements with unrelated insurance companies, shifts and distributes the risk of loss outside the corporate family thereby providing insurance under the LeGierse standard. Likewise, because the reinsuring insurance companies are unrelated to the corporate family of insureds, the premiums allocable to the reinsurance are not under the control of or withdrawable by any of the insureds, and are therefore ‘paid or incurred’ within the meaning of Code § 162. See Rev. Rul. 60-275, 1960-2 C.B. 43; and Rev. Rul. 69-512, 1969-2 C.B. 24. Accordingly, we agree with your conclusion, both in the March 16th memorandum and in the proposed revenue ruling, that under an *** type of captive insurance arrangement, the domestic parent and its subsidiaries should be allowed to deduct premiums paid to the captive to the extent that the premiums are used to transfer the risk through reinsurance to unrelated insurance companies.
In G.C.M. 35340, ***, I-4712 (May 15, 1973), we considered a typical captive insurance arrangement and concluded that, to the extent the risk of loss is assumed by the captive and not distributed or spread outside the corporate economic family of the parent and its subsidiaries, the contracts made with the captive do not provide for insurance and the premiums paid therefor are not deductible under Code § 162. The conclusion that the typical captive, considered in G.C.M. 35340, does not provide insurance is based on a consideration of the fundamental characteristics of insurance, that is, ‘risk-shifting’ and ‘risk-distributing’. Helvering v. LeGierse, 312 U.S. 531 (1941). In a captive insurance arrangement, the various members of the corporate family involved wish to ‘insure’ against future risk of loss by making payments to the captive. The flaw in the plan, rendering the benefits not insurance and the premium payments not deductible under Code § 162, lies in the fact that the so-called policyholders are limited to one economic family, which lacks the risk-shifting and risk-distributing required for insurance. However, to the extent that the captive does provide the requisite shifting and distributing of risk outside the corporate economic family, the captive does provide insurance for the family members. The facts in the *** case as set forth in the March 16th memorandum present a new variation in captive insurance arrangements. Under the *** arrangement, the captive, which was organized to insure the risks of its domestic parent and the parent's subsidiaries, cedes or transfers 90 percent of the corporate family's risk of loss to unrelated insurance companies through reinsurance agreements.
Accordingly, we agree with your conclusion, both in the March 16th memorandum and in the proposed revenue ruling, that under an *** type of captive insurance arrangement, the domestic parent and its subsidiaries should be allowed to deduct premiums paid to the captive to the extent that the premiums are used to transfer the risk through reinsurance to unrelated insurance companies.

Note the  IRS' use of the phrase "withdrawable by the insured."  The insureds immediate access to the captive funds is still a prime concern for the service, as it makes the captive look like a reserve fund rather than an insurance company.  In situation 3, it's the captive shifting of funds outside the family group -- and therefore outside the control of the parent -- that makes that portion of the insurance premium legitimate.  Any fund which can be immediately accessed by the parent company is therefore not a legitimate insurance premium.

Several conclusions emerge when looking at the IRS' reasoning for challenging captives.  First, they are on legally shaky ground.  They are challenging an intra-company transfer -- which the courts will almost always honor as the doctrine of separate corporations is firmly entrenched in US law.  Secondly, they are hinting at making an anti-avoidance argument, yet never fully developing same.  Third, they are partially relying on legal theory which was already rejected by a court in one of the flood plane cases.

However, their primary concern is still readily apparent: the ability of the insured to immediately access funds and use them for a non-insurance purpose.  This is an important point to remember going forward, and even has strong implications for those creating captives currently.