By way of background, in Part I, we looked at the background facts of the case, and learned that Human was a near-perfect set-up for a captive. The company was forced by business circumstances to form a captive, considered a variety of options (and obviously documented same) and then formed a stand-alone company that was adequately capitalized, independently managed and charged a fair price for its insurance. In Part II, we see a very well tried case for the plaintiff who take full advantage of the facts. In addition, we get the first real explanation (at lease in a case record) of the thinking behind the economic family doctrine. Finally, we see the first real cracks in the economic family doctrine, thanks to some of the insureds not being owners of captive stock. As such, the appellate court gives us the first taxpayer victory in a captive case.
With regard to the second issue, the brother-sister issue, we believe that the tax court incorrectly extended the rationale of Carnation and Clougherty in holding that the premiums paid by the subsidiaries of Humana Inc. to Health Care Indemnity, as charged to them by Humana Inc., did not constitute valid insurance agreements with the premiums deductible under Internal Revenue Code § 162(a) (1954). We must treat Humana Inc., its subsidiaries and Health Care Indemnity as separate corporate entities under Moline Properties. When considered as separate entities, the first prong of LeGierse is clearly met. Risk shifting exists between the subsidiaries and the insurance company. There is simply no direct connection in this case between a loss sustained by the insurance company and the affiliates of Humana Inc. as existed between the parent company and the captive insurance company in both Carnation and Clougherty
While Humana -- the parent company -- owned the captive in the form of stock ownership, Humana subsidiaries did not own captive stock. As such, the crux of the economic family argument -- that a payment from the captive to the parent would decrease the captive's stock value thereby preventing any real risk shifting from occurring -- did not apply. And while the captive was part of the same economic family, the court had to treat it as a legally separate entity under the Moline Properties doctrine. Also of importance was the Crawford case, which was the only economic family case that had separate and extremely divided ownership of the captive.
There is a second point from the court's reasoning that should be mentioned. From the case:
The tax court misapplies this substance over form argument. The substance over form or economic reality argument is not a broad legal doctrine designed to distinguish between legitimate and illegitimate transactions and employed at the discretion of the tax court whenever it believes that a taxpayer is taking advantage of the tax laws to produce a favorable result for the taxpayer … In general, absent specific congressional intent to the contrary, as is the situation in this case, a court cannot disregard a transaction in the name of economic reality and substance over form absent a finding of sham or lack of business purpose under the relevant tax statute
Throughout captive litigation, the service had hinted at an anti-avoidance argument, but never made a full argument along these lines. What the court is saying above is this: if the service is going to rely on an anti-avoidance argument, they need to make the argument openly. At his time (the late 1980s) the two primary anti-avoidance arguments were the sham transaction and (lack of) business purpose doctrines (an argument could be made that the sham transaction had morphed into economic substance doctrine by this time, but I think the point is clear). Please stop hinting at the argument.
Humana was a watershed case accomplished several important goals. First, it stopped the IRS' momentum in the captive cases. Put in military terms, this case stopped the IRS' advance. Secondly, it exposed the primary flaw of the economic family doctrine -- that a captive which insures a non-parent (a subsidiary of the parent) is providing insurance. Third, it provided taxpayers with a planning blueprint for moving forward.