The IRS' War on Captives; Humana, Part I

Welcome back.  I hope that everyone had a good holiday season.  

Before delving into the Humana case, note on the right side of the blog is a new box of links, titled "The Captive Cases."  I've added links to each of the sections I've written over the last few months on the captive cases and presented them in chronological order.  If you ever want to go back and review the legal history of captives, please do so.  

Just to provide some context before moving forward, we've been looking at the captive cases in chronological order.  Before the holidays we finished with the economic family doctrine.  In the conclusion of my analysis to those cases I noted that, most importantly, the IRS was very prepared for captive litigation while the taxpayers weren't.  As a result, the IRS gained a strategic foothold in captive jurisprudence.  With Humana, we see the first really good taxpayer push back against the IRS' efforts.  To that end,we'll be spending some time delving into the decision's details.  The following is an excerpt from my book, U.S. Captive Insurance Law.

Humana was a groundbreaking case because it was the first major victory for a taxpayer in the captive insurance area.   Humana was (and is) a publicly traded health care company.     By the mid-1970s, it was incredibly difficult for the company to find adequate insurance.   The company considered going uninsured but did not have enough funds to withstand a catastrophic risk.   They also considered setting up a reserve, but payments to a reserve fund are not deductible, and the trust fund would not allow Humana to access the third-party insurance market.   A third option was combining with other hospitals in a 5-year pooling arrangement, but Humana did not want to commit to a 5-year program and was unsure about the financial viability of other possible participants.   Finally, the company could set up a captive insurance company – an option which was accepted because 

it possessed none of the perceived disadvantages associated with the other options and it would provide a regulated method of insuring risks which would both isolate funds for the settlement of claims and satisfy interested lenders, mortgagees, and securities analysts.  In addition, Option (4) [establishing a captive] would provide access to world reinsurance and excess insurance markets. 

On August 5, 1976, Humana incorporated Health Care Indemnity under the Colorado Captive Insurance Act.   The Insurance Department of Colorado approved Humana’s establishment of a captive under Colorado law.   

Health Care Indemnity (the captive’s name) issued preferred and common shares.   Humana purchased all 250,000 shares of common stock by paying “$750,000 in the form of an irrevocable letter of credit issued in favor of the commissioner of insurance of the State of Colorado.”   Each common share of stock had 5 votes.   A Humana subsidiary in the Netherlands Antilles purchased all 150,000 shares of preferred stock for $250,000.   There were no further agreements among Humana, its Netherlands Antilles subsidiary and Health Care Indemnity for the injection of any additional funds into the captive insurance company.

Health Care Indemnity issued three policies which covered the vast majority of Humana’s hospitals.   All of these policies conformed with industry standard practices.   For years 1977 to 1979 Humana (the parent) paid total premiums of $21,055,575 to Health Care Indemnity.   These payments represented amounts for the parent and its subsidiaries.   The sole issue at trial was whether these amounts were deductible as insurance premiums.   However, there were two sets of premiums.  The first was from the parent company to the captive.  The second was from the subsidiaries to the captive.  It is important to remember this distinction going forward.

Humana lost the trial case but filed a petition for reconsideration.   The tax court withdrew its memorandum opinion and issued a full opinion after review by the 19-person court.   The written opinion contains a 12-member majority opinion, an 8-person concurrence, a 2- member concurring and a 7-member dissent.   The sole reason for Humana’s petition was to get a long opinion which the company could use for the basis of an appeal. 

End excerpt.

Before moving forward, let's make some observations.

Just as the IRS often waits for the most egregious fact pattern to prosecute, this fact pattern represents a a near perfect set-up for the taxpayer to defend.  First, business necessity -- not a tax angle -- forced the taxpayer to look at the possible formation of a captive program.  This brings Humana squarely in line with the business purpose requirement of the Frank Lyons case and prevents an IRS attack based on the then most prevalent anti-avoidance theory, the sham transaction doctrine.  In addition, the taxpayer carefully considered four possible alternatives, and rejected three for good business reasons: going uninsured would expose the company to too much risk; contributions to a reserve were not deductible and forming the then equivalent of a risk retention group would expose the company to possibly weaker plan participants.  As such, the best alternative -- again, after careful deliberation -- was to form a  captive. 

The captive formation process was also picture perfect.  First, the captive was formed domestically.  While there is nothing inherently wrong with using an offshore jurisdiction, it can have a negative taint when mentioned in court.  As such, the fact that the captive was formed in a US domicile makes this situation appear more "on the up and up."  Next, the captive was capitalized with $1 million -- a more than adequate amount of initial capital.  Additionally, there is no formal agreement for any plan participant to provide further capital -- a fatal flaw in an earlier case.  

The captive sold three master policies to the parent company that covered the vast majority of the parent companies' risks.  The policies confirmed to industry norms.  The amount of total premiums over a three year period -- $21,055,57 -- appears to be reasonable on its face (also note this issue was not contested at trial). 

Simply put, this is a great fact pattern to defend -- which we'll begin to explore in the next post.

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The Economic Family Cases: Conclusion

This will be the last blog posting of this year; I will resume the captive section of this blog's writing with the Humana case after the first of the year.  To all, Merry Christmas and Happy New Year.

The captive cases can be broken down into two segments: the economic family cases -- where the IRS gained trial momentum for their theories, and the Humana cases, where taxpayers began scoring victories.  As such, this is an appropriate place to stop and sum up the overall captive legal situation before moving onto Humana.

Here are the salient points moving forward.

1.) Business necessity drove the formation of early captives.  In all economic family cases, some defining business need drove the formation of the captive.  For example, the taxpayer in Ocean Drilling was engaged in a business which was new (offshore oil drilling) and extremely risky; hence they could only find third party insurance from companies such as Lloyd's of London.  The taxpayer in Beech Aircraft wanted to gain control of the insurance policy drafting process.  The taxpayers in Clougherty and Carnation wanted to lower their worker's compensation costs.  In all the cases business necessity drove the transaction.  


2.) The IRS was prepared.  The service had several years to develop their legal theory.  In addition, they could pick their cases to find facts that were most beneficial to their position -- a standard IRS tactic.  Finally, they had a stable of credible experts lined up to bolster their argument.  In short, the service presented a solid case backed by the intellectual heft of their experts.


3.) The taxpayers were not prepared.  Reading the taxpayers cases and responses is like reading an appellate brief that relies on a strict reading of the law without using the resources of an appropriately credentialed expert or any in-depth analysis of the transaction beyond a cursory reading of the facts.  In essence, all the taxpayers used the argument that the IRS' theory violated the separate corporate existence as espoused in the Moline Properties case.  That is essentially where the taxpayer's argument ended.  No case provides any reference to a taxpayer expert to counter the IRS' experts.  Essentially, the taxpayers were out-maneuvered by the service.  


4.) The IRS was most successful against the single parent structure: the one case the IRS lost  was Crawford Fitting, where the insured's captive insured multiple entities and where the captive had multiple owners.  However, all single parent cases resulted in IRS victories.

5.) The overall analysis lacked a great deal of nuance:  Captives were a new business idea during this time; courts had little to no practical knowledge of these transactions, making them incredibly dependent on the IRS' arguments, documentation and experts.  Because the taxpayers had very weak cases, the courts relied extensively on the IRS' arguments, with several of the decisions more or less tracking the IRS' central legal theories.  Lacking from the decisions was a serious discussion of actuarial sciences in the insurance process or any counter-veiling theories.  With the exception of the Crawford Fitting case, the courts' decision is essentially the IRS' legal theory, nothing more.

Next up, we'll take an in-depth look at the Humana case, where taxpayers began gaining ground.

What is Fraudulent Transfer Law? Part I: Below Market Value Transfers

Let's begin the discussion of fraudulent transfer by defining its terms.

1. Dictionary.com defines fraudulent as "characterized by, involving, or proceeding from fraud,  as actions, enterprise, methods, or gains: a fraudulent scheme to evade taxes."  
2. The same site defines fraud as "deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage."
3. And finally, "transfer is defined as "to convey or remove from one place, person, etc., to another

Putting these three concepts together, we come up with the following definition: a fraudulent transfer is a conveyance of assets that proceeds from, or whose motive is, fraud. 


Let's delve deeper into this concept by looking at a specific type fraudulent transaction -- one where the person selling an asset does so for less than adequate consideration.  When most people sell something, their motive is to make a profit.  Even if they're selling something at a yard sale, they're still trying to get at least something for a particular item.  In contrast, the motive behind a fraudulent transfer is not economic, but to "hinder, defraud or delay" current or potential creditors -- that is, to make it hard if not impossible for someone to whom a person legitimately owes money to collect on their debt.  


This leads into one of the central concepts of fraudulent transfer law: value, which is defined thusly: 

"Value is given for a transfer or an obligation if, in exchange for the transfer or obligation, property is transferred or an antecedent debt is secured or satisfied, but value does not include an unperformed promise made otherwise than in the ordinary course of the promisor’s business to furnish support to the debtor or another person."

This definition must be viewed with the Uniform Fraudulent Transfer Act's primary purpose in mind: 

"Value” is to be determined in light of the purpose of the Act to protect a debtor’s estate from being depleted to the prejudice of the debtor’s unsecured creditors."

Put into practical terms, if a debtor sells assets for less than adequate consideration or below fair market value, the court will at minimum take a deep interest in the sale and will investigate further.  The court will do this to comply with the the Act's stated intention of preventing a debtor from hindering a creditor's efforts to enforce a valid debt.


The act does not define "reasonably equivalent value," but other sections of the law provide a good working definition. The gift tax code defines the price this way: "The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. The value of a particular item of property is not the price that a forced sale of the property would produce. Nor is the fair market value of an item of property the sale price in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate."


The code breaks down a less than adequate consideration transfer into two types: transfers as to present creditors (the person making the transfer has at least one existing creditor) and transfers as to present and future creditors (this section includes a creditor whose claim arose after the transfer).


The act assumes that a transfer for less than equivalent value is fraudulent as to present creditors: 

A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.

As to present or future creditors, a transfer may be fraudulent if the debtor did so with the intent to "hinder, delay or defraud and creditor of the debtor."  To determine intent the court will determine if "the value of consideration received by the debtor was reasonably equivalent to the value of the asset transferred to the amount of the obligation incurred."  The amount of consideration received by the debtor in the transaction can be a "badge of fraud."  Here is how the commentary in the UFTA explains the consideration element:

Whether the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred: Toomay v. Graham, 151 S.W.2d 119 (Mo.App. 1941) (although mere inadequacy of consideration said not to be a badge of fraud, transfer held to be fraudulent when accompanied by badges of fraud); Texas Sand Co. v. Shield, 381 S.W.2d 48 (Tex. 1964) (inadequate consideration said to be an indicator of fraud, and transfer held to be fraudulent because of inadequate consideration, pendency of suit, family relationship of transferee, and fact that all nonexempt property was transferred); Weigel v. Wood, 355 Mo. 11, 194 S.W.2d 40 (1946) (although inadequate consideration said to be a badge of fraud, transfer held not to be fraudulent when inadequacy not gross and not accompanied by any other badge; fact that transfer was from father to son held not sufficient to establish fraud).

Let's put the above mentioned ideas into practice.  Recently, the New York Times reported,"Joe Paterno transferred full ownership of his house to his wife, Sue, for $1 in July, less than four months before a sexual abuse scandal engulfed his Penn State football program and the university."  Let's look at this transfer from the standpoint of both present and potential future creditors.


Let's assume the house has a mortgage on it, the debt has not been paid off, and the loan is in Mr. Paterno's name entirely.  In that case, the bank can rescind the transaction (unless the house is actually worth $1).  One section of the code simply assumes this is a fraudulent transaction because the debtor is attempting to shift assets to a third party at below market value.


Now, let's look at potential future creditors.  Assume that Paterno has a good idea he's about to be sued -- for example, he's been contacted by a third party lawyer requesting an interview, or something similar.  Or, as the story points out, the transfer occurred in close proximity to a serious legal situation.  In that case, the court may rescind the transaction if the creditor or potential creditor can show Paterno's  intent to hinder, delay or defraud.  One way to show this is to demonstrate the transaction was for less than adequate consideration.    In other words, in this scenario, the inadequate consideration is a factor for the court to consider, but is not entirely determinative.  It's a subtle but important difference.  Now, given the incredibly low amount of consideration in the deal, the court will probably rescind the transaction if asked.  


The message of the above situations is clear: any transfer for less than adequate consideration is a very bad idea from a planning perspective.




 




.

The IRS' War on Captives; The Economic Family Cases, Part III

When looking at the economic family cases, it's important to have an organizational template.  This is the third in series of articles on the economic family argument that uses the fact patterns outlined in Revenue Ruling 77-316  as a template.  The excerpt below is from my book, U.S. Captive Insurance Law.

The third situation outlined in Revenue Ruling 77-316 is the same as the first situation:

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]

However:

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% of the risk through reinsurance agreements to an unrelated insurance company, W.[2]

According to the service, any amount not retained by the group is a deductible amount under 26 USC 162(a).[3]  Therefore, under situation number 3, the 90% transferred out of the corporate group is insurance and can therefore be deducted.  The reason is this amount is not “under the control of the parent”[4] as it is under the control of a third party.

The primary case that illustrates this point is Crawford Fitting Co. v. U.S.[5]  Crawford involved three sets of companies.  The first set was Crawford, Nupro, Whitey and Cajon, all of which manufactured “valves and fittings … used in numerous applications.”[6]  The second set of companies was the regional warehouses that purchased the manufacturers’ products.  The warehouses were broken down regionally, with one warehouse each for the eastern, southern, central and western U.S.[7]  Each of these warehouses sold to a group of independent and exclusive Crawford distributors.[8]  Mr. Fred Lennon was the sole owner of Crawford[9]  and was also a majority owner of each regional warehouse.[10]  In order to obtain reasonable products and general liability insurance, the Crawford companies created Constance Insurance Company in March 1978.[11]  Each regional warehouse owned 20% of Constance while the remaining 20% was owned by a Crawford executive and one attorney who did extensive work for Crawford.[12]

Constance was capitalized with $1 million and did not receive any other capital infusion.[13]  Additionally, no other Crawford company or subsidiary indemnified or guaranteed Constance’s payment.[14]  Constance issued a general liability policy for 45 Crawford companies and 115 independent distributors.[15]  Alexander wrote the policies.[16]  Constance paid for Alexander’s services.[17]  Constance provided $1.5 million in coverage but only retained $100,000 of the risk by reinsuring $1.4 million of the coverage with independent third-party insurers.[18]  Crawford paid $157,028 to Constance for the year in question.[19]  The service disallowed $20,485 of the deductions, arguing that this is the amount of risk that Constance retained.[20]  The issue for the court was whether or not the entire payment was deductible as an insurance premium.[21]

The U.S.’s argument boiled down to the now familiar “economic family” argument: any risk that remained within the same “economic family” was in fact a reserve fund and therefore not a legitimate expense for insurance.[22]  The plaintiff argued that the payment was a legitimate insurance payment, because it was “an arms-length transaction, and Constance is not ‘related’ to Crawford.[23]  However, 

[i]t is undisputed that to the extent Constance reinsured the remainder of the risk, in the amount of $1,400,000.00, with the Bermuda Fire & Marine Insurance Co., Ltd., an unrelated insurance company, plaintiff is entitled to a deduction for the insurance premium for that amount of coverage.[24]

In other words, the only point of contention was the amount of risk retained by Constance.

After a review of the then decided captive cases, the court noted that Crawford was different:

First, looking at the nature of the ownership of the plaintiff and the captive insurance company, the Court finds it is somewhat different in the case at bar than in the cases aforementioned.  In this case, plaintiff Crawford Fitting Company is a separately incorporated entity from the wholly owned captive insurance company, and is not the parent company of the captive.[25]

The parent’s direct ownership of the captive is the basis of the service’s “economic family” argument.  Under that theory, when the captive makes a payment to the parent, the captive’s stock value drops.  This in turn lowers the parent’s assets by the amount of the captive’s payment.  As a result, there is in fact no risk shifting.  However, in this case, the parent did not own the captive’s stock.  Therefore, when the captive made a payment to the parent, the parent’s assets did not decrease.  Hence, risk shifting did occur.  The court noted:

However, in the instant case, the Court finds that the taxpayer and the other shareholders of the captive insurance company, as well as the insureds, are not so economically related that their separate financial transactions must be aggregated and treated as the transactions of a single taxpayer, the plaintiff.  The Court further finds that the economic risk of loss of the plaintiff was shifted and distributed among the shareholders of the captive insurance company and its insureds.[26]

The service pointed out that the same person – Fred Lennon – owned a majority of Crawford and each warehouse.[27]  However, none of the companies owned each other.  While they had one common individual owner, there were non-common corporate owners.  As the court explained:

However, we note that Crawford Fitting Company, as earlier pointed out, was not the parent company of the warehouses, nor was it the parent company of the captive insurance company.  The fact that Fred A. Lennon owns Crawford and a percentage of the warehouses does not mean that the warehouses' 80% ownership interest in Constance is the same as an 80% ownership by Crawford.  Any gain or loss enjoyed or suffered by Constance does not affect the net worth of Crawford.  The Court thus finds Fred A. Lennon's ownership interest in the different companies inconsequential where each in fact was incorporated for a valid business purpose independent from the others, and the creation of each was followed by legitimate business activity.[28]

In other words, each corporation was a unique corporation with a single individual owner.  This provided all the differentiation the court needed to rule that risk shifting had occurred.

In addition, the large number of insureds provided risk distribution.  Constance provided insurance for each Crawford Company, each warehouse, 115 Crawford distributors and several individuals associated with the Crawford companies.[29]  These were each independent risks that made “the sum of the risks carried by the captive company less than the sum of the risks insured.”[30]  Finally, Constance was adequately capitalized and no company provided a financial guarantee in the event Crawford was unable to meet a financial obligation.[31]

---

[1] Rev. Rul. 77-316.

[2] Id.

[3] Id.

[4] Id.

[5] Crawford Fitting Co. v. U.S., 606 F.Supp. 136 (N.D. Ohio 1985).

[6] Id at 137.

[7] Id.

[8] Id .

[9] Id.

[10] Id at 137.

[11] Id at 138.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

[21] Id at 140.

[22] Id at 141.

[23] Id.

[24] Id.

[25] Id at 145.

[26] Id.

[27] Id at 146.

[28] Id at .

[29] Id at 146-147.

[30] Id at 147.                                                          

[31] Id at 147.

What Is Asset Protection and Who Should "Protect" Their Assets?

The phrase "asset protection" is bandied about a great deal.  There are web sites that claim to provide "asset protection" advice and services, various companies who continually tell us about the importance of asset protection and numerous books that help to educate the public on this topic of law.  After looking at all the hoopla, you'd think that if you didn't engage in some type of plan, you were foolish beyond your years.  However, often missing from this discussion are answers to two questions: what exactly is asset protection and do I need to engage an attorney to create and oversee an asset protection plan?

Before providing a definition, let's pull the lens back and take a 30,000 foot view of an individual's financial and legal life.  There are several events which can negatively impact their financial well-being.  In general, these are bankruptcy, litigation, divorce, physical/mental incapacitation and death (this actually impacts the decedents family, but it can still harm a family financially if not dealt with properly).  Asset protection looks at each of these events, and then asks this fundamental question: "how can we mitigate the financial damage these events have the potential to cause?"  Or, put another way, asset protection is the legal discipline of mitigating , or attempting to mitigate, the negative impact of various financially and legally catastrophic events.  As should be obvious from the previous list of events, asset protection "law" actually involves small and large pieces of a number of different legal disciples, but being chiefly comprised of estate planning, debtor/creditor law, business entities, tax law and litigation.  It also helps to have at least a basic knowledge of economics and financial dealings, if not a full-fledged thorough understanding thereof.  And, some grounding in international law (especially taxation) will probably help.  In short, asset protection law is really a hodgepodge of various legal concepts and ideas.

Pay particular attention to the phrase "attempting to mitigate."  No asset protection plan is fool-proof; the success thereof depends a great deal on the facts and circumstances of the claim involved.  As an extreme example, assume a client is a doctor who performs surgery while intoxicated and seriously mains a patient.  If this case gets to a jury, expect a large pay-out -- and don't expect any sympathy from a creditor attempting to enforce the judgment.  And then there is bankruptcy, where the court has tremendous power and where the definition of "bankruptcy estate" is extremely broad -- in fact there are very clearly written statutory exemptions to the definition of bankruptcy estate and, frankly, that's about it.  In short, anyone promising you the moon regarding an asset protection plan is pulling the wool over your eyes regarding what is possible.

Now that we're defined asset protection, the next questions is who should engage in asset protection? There are several ways to answer that question:

1.) Are you in a line of work that attracts a high degree of litigation?  While we all face the possibility of litigation, some professions are more likely to be targeted than others.  So, if you're in the line of fire, an asset protection plan makes sense.  Here is a list of businesses that are more likely to be in the "legal line of fire:"

• Doctors and other professionals
• Manufacturers
• Construction Related Professions
• Oil and Gas
• Commercial Property Owners
• Transportation Companies 

While the list isn't exhaustive, it does give you an idea of who is a more likely target.

2.) Once an individual reaches a certain income and/or asset level, they naturally become a target.  I use the "accredited investor" definition ($1 million in assets and/or $200,000/year in income for the last two years) as a standard bench mark.  At this level, some asset protection is mandatory.

3.) All businesses with assets over $1 million should have an attorney look at their structure and operations to minimize liability.

There are other situations that require some planning, but these are less comprehensive and fall under other disciplines in addition to legal asset protection.  For example, all individuals should consider whether or not they want to formally sign an advance directive decree, but this is less about asset protection and more about estate planning.  And purchasing life insurance or a disability policy -- while clear designed to protect assets -- is as much a financial or insurance decision.

However, if you are in one of the above mentioned categories -- or you have clients that are in these categories -- an asset protection plan is probably needed and warranted.

 

The Economic Family Cases -- Part II

When looking at the economic family cases, it's important to organize them in a comprehensible way. This installment looks at cases with fact patterns similar to Scenario 2 from Revenue Ruling 77-316. The following is taken directly from my book, U.S. Captive Insurance Law

Situation 2 of Revenue Ruling 77-316 is the same as situation 1, except that the parent and subsidiaries pay premiums to a non-affiliated third party who reinsures 95% of the risk with a captive insurance company.[1] General Counsel Memorandum 35629 fleshes out the service’s thinking regarding situation 2.[2] The service argues the taxpayer should be allowed to deduct any payment not reinsured through the taxpayer’s captive.[3] In other words, risks that are outside the “economic family” and that follow proper insurance protocol are deductible whereas any payments – either directly or indirectly – to an insurance company that is a member of the same corporate family are not allowed.[4] The service believes that in situation 2 the taxpayer is attempting to “authenticate its so-called insurance premium payment by introducing an independent insurer between it and its subsidiaries … The whole transaction was carefully orchestrated to produce a single result – eventual placement of the insurance with [the captive].”[5] Again, the IRS is arguing this is essentially a sham transaction yet does not invoke any specific anti-avoidance doctrine.

The petitioner in Carnation was a food company that also made its own cans.[6] As a result, the company had workers’ compensation insurance claims.[7] Carnation’s board of directors resolved to “organize an insurance company in Bermuda to carry on the business of insurance and reinsurance of various multiple line risks, including those of petitioner and its subsidiaries.[8] As a result, Three Flowers Assurance Co. was formed on August 26, 1971.[9] Carnation purchased 120,000 shares of Three Flowers stock for $1 per share.[10] In addition, the two companies signed an agreement whereby either could demand that Carnation purchase an additional 288,000 shares of Three Flowers preferred stock at $10 per share.[11] Next, Carnation applied for and received an insurance policy from American Home Assurance (a division of AIG), whereby American Home would insure up to $500,000 of loss from any one event.[12] This policy with American Home had a $100,000 deductible.[13] On the same day that Carnation purchased the insurance policy from American Home, American Home purchased a reinsurance policy from Three Flowers, whereby Three Flowers would reinsure 90% of American Homes’ liability from the Carnation policy.[14] American Home also agreed to cede 90% of the premium it received from Carnation to Three Flowers.[15] American Home would not sign the contract unless Carnation somehow provided assurances that Three Flowers was financially capable of paying on its policies.[16] To assuage this concern, Carnation represented that “it would provide for the capitalization of Three Flowers up to $3 million.”[17]

The service made four arguments against this arrangement. First, under the arrangement, there was no risk shifting as required by law.[18] Secondly, the plan was nothing more than a reserve whose contributions were disallowed as deductions under law.[19][20] Third, the 90% payment ceded to Three Flowers remained within the same economic family and was therefore not “paid or incurred.”[21] Fourth, in order for a deduction to occur, the payor must receive something of value. Because the petitioner ultimately bore the risk of loss, he received nothing of value and therefore could not take a legitimate deduction under 26 USC 162.[22]

Carnation responded by noting the service’s arguments were premised on Carnation’s and Three Flowers’ not being separate entities.[23] Carnation then noted Moline Properties prevents this conclusion.[24] In addition, the two companies filed separate tax returns, indicating that for tax purposes Three Flowers was not part of a Carnation consolidated group.[25]

The court based its analysis on the method established in Helvering v. LeGierse.[26] The court noted the insurance contracts in that case were inter-related; therefore, the court should analyze the facts in Carnation in a similar manner.[27] Additionally, the court noted the insurance contract between Carnation and American Home and American Home and Three Flowers were also inter-related and should be analyzed together.[28] This blunted Carnation’s argument for the court to consider the companies as separate and distinct entities.

In ruling against Carnation, the court relied on the circular nature of the cash flows within this deal:

In the event of a covered casualty, the loss suffered by Carnation ultimately would be borne 90% by Three Flowers and 10% by American Home. The agreement to purchase additional shares of Three Flowers by Carnation bound Carnation to an investment risk that was directly tied to the loss payment fortunes of Three Flowers, which in turn were wholly contingent upon the amount of property loss suffered by Carnation. The agreement by Three Flowers to “reinsure” Carnation's risks and the agreement by Carnation to capitalize Three Flowers up to $3 million on demand counteracted each other. Taken together, these two agreements are void of insurance risk. As was stated by the court in LeGierse, “in this combination the one neutralizes the risk customarily inherent in the other.[29]

In short, the combination of the undercapitalization of Three Flowers and Carnation’s agreement to provide additional capital to Three Flowers was this structure’s Achilles’ heel. Three Flowers only reinsured risks from Carnation. Were Carnation to have several claims totaling more than $120,000 (Three Flowers original capital from its sale of stock to Carnation), Carnation would have to provide additional capital to Three Flowers. However, Carnation was the company making the claim that was depleting Three Flower’s capital. In short, a claim or combination of claims over $120,000 would force Carnation to pay itself, making this deal a pure example of self-insurance. The court did rule that the 10% of the risk that stayed with American Home was an insurance risk and was therefore deductible.[30] This was in line with Revenue Ruling 77-316.[31]

Clougherty Packing Co. involved a different company but remarkably similar facts.[32] Clougherty was a California company which had an Arizona subsidiary, which in turn owned an insurance company named Lombardy.[33] Because Clougherty was involved in slaughterhouse operations, they had numerous workers’ compensation claims.[34] Under California law they were required to obtain insurance to cover these claims.[35] In 1976, Clougherty’s insurance broker submitted a proposal to Clougherty regarding the formation of a captive insurance company.[36] Clougherty’s management agreed, although they believed the captive should reinsure risks rather than provide direct insurance.[37] The company believed a captive would lower their workers’ compensation costs.[38] Clougherty formed Lombardy insurance on July 22, 1977 and capitalized Lombardy with $1 million dollars.[39] Later that year, Clougherty agreed to a reinsurance plan with Freement Indemnity, which called for Freement to provide the primary insurance policy to Clougherty, while Lombardy provided the first $100,000 of reinsurance to Freemont.[40] Under the plan, Clougherty would pay Freemont, who in turn would remit 92% of the premiums to Lombardy.[41] Clougherty made no promises or guarantees regarding future payments to its captive Lombardy.[42] Clougherty deducted $840,000 in 1978 and $1,457,500 in 1979 as insurance premiums.[43] The service disallowed the portion of the premiums remitted to Lombardy.[44]

In ruling against Clougherty, the court based its decision on several factors. First, they noted that “the operative facts in the instant case are indistinguishable from the facts in Carnation.”[45] As such, the court made its decision regarding Clougherty from “within the parameters of Carnation.”[46] The court first noted that three separate courts[47] had used the rationale of Carnation with no criticism – essentially validating the court’s overall legal reasoning in Carnation. The petitioner tried to distinguish the facts in Clougherty by noting that the captive in Clougherty was adequately capitalized and did not have an agreement for an infusion of capital from the parent.[48][49] The court responded that the “financial viability of the captive is not controlling. The test continues to be whether the risk of loss was shifted away from the taxpayer who seeks to deduct insurance premiums.[50] To that end, the court noted:

When petitioner sustains losses covered by its workers' compensation insurance, 92% is sustained by Lombardy. Accordingly, because petitioner, through its wholly owned Arizona corporation, owns all of Lombardy, it has not shifted the risk of sustaining such losses to unrelated parties in exchange for insurance premiums, because the premiums were paid to the wholly owned subsidiary of its wholly owned subsidiary.[51]

The court’s reasoning is that the payment from the captive will deplete the company’s cash account, which in turn will lower the captive’s stock value. Because the parent company owns all the captive’s stock, the parent’s balance sheet would decrease in value in proportion to the cash payment from the captive.

There are several other important points from the decision. First, the court expressly stated it would not use the term “economic family.”[52] This is an important point, as an acceptance of this concept would have cemented the IRS’ anti-captive argument into case law. In addition, the court noted they were not disregarding the separate corporate nature of the parent and captive. Instead, they were recasting the nature of the transaction:

There are numerous situations in the tax law, both statutory and case law, where the separate nature of the entity is not disregarded, but the transaction, as cast between the related parties, is reclassified to represent something else, e.g. reasonable compensation or dividend, loans or contributions to capital, loans or dividends, deposits or payments, or other recharacterization such as permitted under section 482, Internal Revenue Code of 1954, as amended. We have done nothing more in Carnation and here than to reclassify, as nondeductible, portions of the payments which the taxpayers deducted as insurance premiums but which were received by the taxpayer's captive insurance subsidiaries.[53]

In effect, the court, in its ruling, is recognizing the separate nature of the companies. However, the court must recast the transaction (which it has the statutory authority to do), because there is no risk shifting and therefore no insurance.

The dissent makes great hay of the majority’s arguments. First, it notes, “… the new theory would disallow a deduction solely because of the ownership relationship between an insured and insurer.”[54] This is a solid point. The majority have now prevented any company from owning an insurance company and then purchasing insurance form that subsidiary. Next the dissent notes: “There is no explanation as to the reason or principle that automatically precludes insurance between related entities.”[55]

This is a natural by-product of the Carnation decision – a company cannot own an insurance company and then purchase an insurance policy from that company, even if the policy conforms to industry standards and is issued at market rates. The majority has simply made it impossible for that to happen. Finally, “[t]he majority has stated, but not explained, how it is able to disregard the transaction in this case without crashing head-on into the holding of Moline Properties.”[56]

This is the key problem of the majority’s opinion. While the insurance company in Carnation was inadequately capitalized, leading to an adverse decision, Clougherty’s captive had $1 million in reserves[57] and no agreement to receive additional funds from the parent. All indications from the case indicate that the insurance policies complied with industry norms. In addition, there is no indication that the company was in any way attempting to evade taxation. In fact, the company could lower its workers’ compensation expenses as a result of using a captive. The only problem with Clougherty is that the insurance company is owned by the insured. As the dissent points out, this is not possible in any form under the majority’s ruling. In effect, the majority has run headlong into Moline Properties yet achieved a different result.

---

[1] Id.

[2] Gen. Coun. Mem. 35629 (January 17, 1974).

[3] Id.

[4] Id.

[5] Id.

[6] Carnation Co. v. C.I.R., 71 T.C. 400, 401 (1978).

[7] Id.

[8] Id at 402.

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id at 404.

[17] Id.

[18] Id at 405.

[19] Id.

[20] See Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78, (10^th Circuit 1930) and Pan American Hide Co. v. Commissioner, 1 B.T.A. 1249 (1925).

[21] Carnation at 405.

[22] Id at 405-406.

[23] Id at 406.

[24] Id.

[25] Id.

[26] Id at 407-408.

[27] Id at 408.

[28] Id.

[29] Id at 409.

[30] Id.

[31] Rev. Rul. 77-316.

[32] Cougherty Packing Co. v. C.I.R., 84 T.C. 948 (1985).

[33] Id at 949.

[34] Id.

[35] Id.

[36] Id at 951.

[37] Id.

[38] Id.

[39] Id.

[40] Id at 952.

[41] Id at 953.

[42] Id.

[43] Id at 954.

[44] Id.

[45] Id at 956.

[46] Id .

[47] Stearns Rogers Co. v. United States, 577 F.Supp. 833 (D. Colorado 1984), Beech Aircraft Corp. v. United States, 54 AFTR 2d 84-6173), Crawford Fitting Co. v. United States 606 Fed. Supp. 136 (N.D. Ohio 1985).

[48] Id.

[49] In Carnation, the petitioner initially capitalized its captive with $120,000. In addition, a contract existed between the parent and the captive that either could demand the parent to purchase an additional $2.8 million in preferred stock.

[50] Clougherty at 957.

[51] Id at 958-959.

[52] Id at 959.

[53] Id at 960.

[54] Id at 966.

[55] Id at 967.

[56] Id.

[57] Id at 951.