Friday, December 9, 2011

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]


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.

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