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, (10th 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.
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