Saturday, January 7, 2012

The IRS' War on Captives; Humana, Part II

Below is an excerpt from my book on the Humana case.  As an aside, if you get a bit confused by some of the terms used, you may want to go back and read some of the earlier posts on the captive cases; see the box on the right for more detail.

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.

The court first notes the many captive cases heard before Humana that apply directly to the non-deductibility of premiums from a parent to a wholly owned subsidiary.   In this case, that would represent the payments from the Humana parent to the subsidiary.  Next, the court notes “payments to a captive insurance company are equivalent to additions to a reserve for losses.”   If these payments are not deducible as insurance payments they are not deductible at all.   The court quickly dealt with this issue – the payments from the parent to the subsidiary – by citing previous cases (such as Carnation  and Clougherty ) and disallowing the deductions.    

The court next turns to the issue of the payments from Humana’s subsidiaries to the captive, which is referred to as the brother-sister issue.  In this situation, it is important to remember the logic of the non-deductibility of payments to the captive from the parent.  A payment from the captive would reduce the value of the captive’s stock.  Because the parent owned allthe captive’s stock, the captive’s payment would lower the value of the parent’s assets on its respective balance sheet.  Therefore, there was no risk shifting according to the standard established in Helvering v. LeGierse.  In Humana, the majority “extend[ed] the rationale [of Carnation and Clougherty] to the brother-sister fact pattern.”   They did so even though none of the subsidiaries owned any of the captive’s stock. 

This is a very large conceptual problem and illustrates a few very important salient points.  First, we're dealing with a very small and highly technical area of the law and finance.  And while the tax court is full of judges who are obviously verses in the tax code, they are obviously not as versed in the nature of the insurance business.  Secondly, as I noted at the end of the economic family cases, the taxpayers who originally defended captive cases versus the IRS put on a remarkable unsophisticated  defense.  Putting these two points together, it was imperative to this case that Human's counsel lead the court to water -- which they did.  I should also add that this case is a great demonstration of a very good litigation team in action.

The trial court relied extensively on the expert opinion of the IRS' witnesses.  As this was the first case which outlined their thoughts and reasoning, I'll quote them at length:
Commercial insurance is a mechanism for transferring the financial uncertainty arising from pure risks faced by one firm to another in exchange for an insurance premium.  Such financial uncertainty is caused by the possibility of certain types of occurrences that may have only adverse financial consequences.  A corporation such as Humana that places its risks in a captive insurance company that it owns, either directly or through a parent corporation, subsidiary, or a fronting company, is not relieving itself of this financial uncertainty.  The reason for this is simply that such corporation, through its ownership position, still holds the benefits and burdens of retaining the financial consequences of its own risks.  It has a dollar-for-dollar economic interest in the result of any ‘insured‘ peril.

A term frequently used for the act of insuring is underwriting.  An essential element of the concept of underwriting is the transference of uncertainty from one firm to another, generally from the one whose activities naturally give rise to the uncertainty to one whose investors are in the business of accepting such uncertainty for the potential profit they can earn thereby.

Thus, insurers, and the interests that own them, are risk takers.  They assume the financial consequences of the risks for others in return for a premium payment.

A question that perplexes some when initially confronted with the captive insurance area is whether or not respondent has chosen to treat, either directly or indirectly, two separate legal entities as one single economic unit.  One's first impression might be that, since a parent corporation can deal at arm's length with a subsidiary in other areas besides insurance and have such transactions respected by respondent, “insurance premiums” paid to a captive should not be treated any differently.  The answer to this paradox lies in the unique nature of insurance transactions relative to other types of parent/subsidiary transactions.

True insurance relieves the firm's balance sheet of any potential impact of the financial consequences of the insured peril.  For the price of the premiums, the insured rids itself of any economic stake in whether or not the loss occurs … however as long as the firm deals with its captive, its balance sheet cannot be protected from the financial vicissitudes of the insured peril.
The above quote explains why many practitioner's (myself included) refer to the economic family argument as the balance sheet argument.  The IRS' argument is essentially that the parents ownership of captive stock did not relieve the parent of the economic loss caused by the captive's payment to the parent.  There are a few major problems with this theory.  First, it assumes the correct -- and only -- method of valuing a company (here the captive) is the pure balance sheet method, namely that assets-liabilities = book value.  There are, in fact, many ways to value a company, most of which involve cash flow -- or some multiple thereof.  In addition, another popular and often used valuation method involves a multiple of EBITDA, which the above valuation method does not take into account in any fashion.  

In addition, the above statements do not take into account the relationship between the subsidiaries and the Humana -- in which the subs did not own any Humana stock.  This structure was a big part of the Crawford Fitting case -- which most likely provided some type of blueprint for the Humana structure and argument.  Here is a summation of that structure

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.”  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.  Each of these warehouses sold to a group of independent and exclusive Crawford distributors.  Mr. Fred Lennon was the sole owner of Crawford  and was also a majority owner of each regional warehouse.  In order to obtain reasonable products and general liability insurance, the Crawford companies created Constance Insurance Company in March 1978.  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.
The diverse ownership structure was very important, and a fundamental reason the court ruled in favor of the taxpayer.  We'll build on this point in the next (and final) installment of the Humana case.

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