The IRS' War on Captives; The Harper Test

If you have further questions about captives, please see my website.

Today's posting will be a bit shorter than most.  Although they lost the Humana case, the service continued to file challenges to various captive insurance arrangements.  The Harper case -- which was a 1991 decision -- is important because it gives us a three prong test which a captive must comply with in order to be a "bona fide" captive.  The following is from my book:

The court introduced a new three-prong test to determine “the propriety of claimed insurance deductions by a parent or affiliated company to a captive insurance company.”   The three prongs are:
 
(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk  distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense.


In addition,

the tax treatment of an alleged insurance payment by a parent or affiliated company to a captive insurance company is to be governed by (1) the facts and circumstances of the particular case, and (2) principles of Federal taxation, rather than economic and risk management theories.
 
Regarding the first point, the court noted:  “Basic to any insurance transaction must be risk.  An insured faces some hazard; an insurer accepts a premium and agrees to perform some act if or when the loss event occurs.”   This is a fairly easy point to prove, as all companies face at least general liability.  The second point is further codification of Helvering v. LeGierse, which was explained earlier.  Regarding the third point, the court will look at the facts to determine if the company was in fact a legitimate insurance company.  In this case, the court analyzed the facts thusly:


Rampart was organized and operated as an insurance company.  It was regulated by the Insurance Registry of Hong Kong.  The adequacy of Rampart’s capitalization is not in dispute.  The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm’s-length transactions.  The policies issued by Rampart were valid and binding.  In sum, such polices were insurance policies and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense. 


In other words, courts will now look at the entire insurance structure to determine if the company is a legitimate, stand-alone insurer.  If so, it will pass the Harper test.

End excerpt.

What's important about this test is the court is now adopting a facts and circumstances test to determine the validity of a captive insurance arrangement. Instead of the IRS arguing for an application of the economic family argument and the taxpayer defending with Moline Properties, the court will now look at the totality of the transaction to determine of the captive is in fact a viable, stand-alone insurance company.

The lesson for practitioners is clear: the captive must perform its affairs as a standard-alone company.  Accounts must be separate, regular meetings must be performed, separate and complete corporate records must be maintained, stock certificates must be issued, voting records must be kept, portfolios must look like an insurance company's portfolio, contracts must be up to date (not back-dated) etc....