In looking at the cases, a few points immediately become apparent.
First, all the captives that were challenged by the IRS were formed because of business necessity. They are all great examples of the business purpose test outlined in the Frank Lyon case, where has the following factors:
- there is a genuine multiple-party transaction
- with economic substance that is
- compelled or encouraged by business or regulatory realities,
- that is imbued with tax-independent considerations, and
- that is not shaped solely by tax-avoidance features to which meaningless labels are attached.
Humana was a groundbreaking case because it was the first major victory for a taxpayer in the captive insurance area. Humana was (and is) a publicly traded health care company. By the mid-1970s, it was incredibly difficult for the company to find adequate insurance. The company considered going uninsured but did not have enough funds to withstand a catastrophic risk. They also considered setting up a reserve, but payments to a reserve fund are not deductible, and the trust fund would not allow Humana to access the third-party insurance market. A third option was combining with other hospitals in a 5-year pooling arrangement, but Humana did not want to commit to a 5-year program and was unsure about the financial viability of other possible participants. Finally, the company could set up a captive insurance company – an option which was accepted because
it possessed none of the perceived disadvantages associated with the other options and it would provide a regulated method of insuring risks which would both isolate funds for the settlement of claims and satisfy interested lenders, mortgagees, and securities analysts. In addition, Option (4) [establishing a captive] would provide access to world reinsurance and excess insurance markets.
Also note that Humana could demonstrate this need before they formed the captive; they had corporate records that clearly outlined and demonstrated the decision making process that led to their creation of a captive. Corporate minutes were maintained that outlined the research that went into the decision.
Stearns Rogers also shows a clear business purpose. The following excerpt is from my book:
The plaintiff in Stearns Rogers designed and manufactured “large mining, petroleum and power generation plants.” In order to bid on projects, the company had to obtain insurance for its own contractors as well as its clients. Starting in the early 1970s, the company “found it difficult or impossible to obtain from traditional companies the types and huge amounts of coverage needed.” Therefore the company formed a captive insurance company under the Colorado Captive Insurance Company Act. In order to gain approval from the Colorado Insurance Commissioner, Stearns Rogers had to demonstrate the company could not find other insurance. The plaintiff named the company Glendale Insurance Company, which only issued insurance policies for the plaintiff, the plaintiff’s subsidiaries and the plaintiff’s clients.
While there were other issues with captive, their problem was not a lack of business purpose.
The above mentioned Frank Lyon factors should first and foremost, always be at the forefront of our thinking when putting captives together.