The Economic Family Cases, Part I

When looking at the economic family cases, it's important to have some type of structure.  Therefore, I'll be using the fact patterns outlined in Revenue Ruling 77-316 and then looking at the cases which most resemble those fact patterns.  What follows is an excerpt from my book U.S. Captive Insurance Law.

The first fact pattern outlined in Revenue Ruling 77-316 is entirely insular:

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]

In other words, the captive only deals with other subs – it writes no policies outside the corporate family, nor does it obtain any reinsurance.  The captive is expected to stand on its own.  Several cases successfully prosecuted by the IRS illustrate how the service attacked this fact pattern.

The plaintiff in Stearns Rogers designed and manufactured “large mining, petroleum and power generation plants.”[2]  In order to bid on projects, the company had to obtain insurance for its own contractors as well as its clients.[3]  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.”[4]  Therefore the company formed a captive insurance company under the Colorado Captive Insurance Company Act.[5]  In order to gain approval from the Colorado Insurance Commissioner, Stearns Rogers had to demonstrate the company could not find other insurance.[6]  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.[7]  Glendale did not use reinsurance.  The plaintiff agreed to indemnify the captive for up to three million dollars.  The plaintiff deducted payments it made to Glendale under the theory that the payments were insurance premiums.[8]  The service disallowed the deductions,[9] claiming the payments were in fact self-insurance or payments to a reserve which are not deductible.[10]

At trial, the service advanced its “economic family” argument,[11] while the plaintiff argued the payments were insurance premiums paid between two distinct corporate entities, thereby invoking Moline Properties.[12]  After an analysis that determined the captive was formed for a legitimate business purpose (and therefore not a sham for tax purposes), the court ruled Stearns-Rogers and Glendale Insurance were two distinct corporate entities which should be recognized.[13]  Next the court explained the “economic family” doctrine of Revenue Ruling 77-316, citing from Carnation v. Commissioner,[14] “The essence of that ruling [Carnation] is that there can be no deduction where, in actuality, there has been no shifting of risk outside the economic family.”[15]  To bolster its argument, the court distinguishes Stearns Rogers from Weber Paper Company, stating, 

“Its [Stearns Rogers] problem is that in contrast with the Weber Paper Company, it did not ally itself with others similarly situated so that the risk of any one member’s flood loss would be shifted to the “economic families” of the other insured members.[16] 

In effect, because Glendale did not insure any other company’s risks, there was no risk shifting.  There was no insurance, because “profits and losses stay within the Stearns Rogers “economic family.”  In substance the arrangement shifts no more risk from Stearns Rogers than if Stearns Rogers self-insured.”[17]

The appeals court affirmed the district court.[18]  They first noted that self-insurance plans do not constitute insurance.[19]  They next noted that risk did not leave the “parent company.”  The payments for coverage went from parent to subsidiary but the ultimate burden for losses was always on the parent.”[DL1] [20]  In effect, the court is arguing Stearns Rogers established a reserve fund without actually stating same.  In addition, the appeals court sidesteps the problems of not properly applying Moline Properties to the fact pattern by noting, 

The separation [between the companies] is not ignored.  Instead the focus must be on the nature and consequences of the payments by the parent and the Supreme Court’s requirement that there must be a shift of risk to have insurance …  The comparison of the arrangement here made to self-insurance cannot be ignored.[21]

This is the exact same reasoning offered by the service regarding the possible problems of Moline Properties:

However, we are of the view that the concept of independent corporate identity is not being challenged by the rationale espoused.  We do not propose to ignore the taxpayer’s separate identity.  Rather, the proposed ruling examines the transaction for its economic reality.[22]

The service is making an anti-abuse argument by asking the court to look beyond legally and legitimately established corporate forms to see an “economic family.”  In effect, the service is advancing a new anti-avoidance theory.

In Beech Aircraft v. U.S., the plaintiff lost a jury verdict of $21,700,000 in 1971.[23]  The old insurance policy did not allow Beech to investigate claims against the company or participate meaningfully in their legal defense.[24]  As a result, Beech formed a captive insurance company in Bermuda on March 2, 1972 named Travel Air Insurance Company, Ltd.[25]  Travel Air was originally capitalized with $120,000.[26]  Beech paid a $1.5 million dollar premium to Travel Air for a $2 million dollar policy for the fiscal year September 1, 1971 to August 31, 1972.[27]  Beech made no assurances to Travel Air that Beech would “pay any losses which occurred greater than the excess insurance carried by Travel Air, nor did it agree to further enlarge the capital structure of Travel Air in any event.”[28]  Beech obtained an additional policy from Fairfax Underwriters for $10 million.[29]  While Travel Air sought outside business after 1973, that occurred after the period in question for this case.

The court’s reasoning was short.  First they noted that a transaction’s substance governs the tax consequences[30] – which is essentially an anti-avoidance argument.  The court’s primary ruling dealt with the corporate inter-relationship of Beech and Travel Air; because Beech owned a majority of Travel Air’s stock, a payment from Travel Air would lower Beech’s net worth: “Here the gain or loss enjoyed or suffered by Travel Air is reflected directly on the net worth of the parent Beech.[31] In addition, because Travel Air had a capitalization of $150,000, they would have to ask Beech for additional capital in the event of a payout larger than $150,000.[32]

Not stated, but certainly implied by the ruling, is the circular nature of the cash flows.  Beech paid a premium to Travel Air who would in turn pay Beech in the event of a claim against Beech.  In effect, Travel Air was a reserve fund for Beech that simply stored funds until requested by Beech.  Hence, the court’s quoting of the primary anti-avoidance concept of substance over form in conjunction with this concern: “It is conceivable, though unlikely, that if no losses were encountered, the deduction of purported insurance premiums could become a tax loophole for the parent company.”[33]

---

[1] Rev. Rul 77-316.

[2] Stearns-Rogers Corp., Inc. v. U.S., 577 F. Supp. 833, 834, (Colorado 1984).

[3] Id.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id at 834-835.

[9] Id at 835.

[10] Id .

[11] Id .

[12] Id at 835-836.

[13] Id at 836.

[14] Carnation Co. v. Commissioner, 640 F.2d 1010 (9^th Circuit 1981).

[15] Stearns-Rogers at 837.

[16] Id at 838.

[17] Id.

[18] Stearns Rogers Corp. v. U.S., 774 F.2d 414, (10^th Circuit 1985).

[19] Id at 415.

[20] Id.

[21] Id at 416.

[22] Gen. Coun. Memo. 35349 (May 15, 1973).

[23] Beech Aircraft v. U.S., 1984 WL 988 at 1.

[24] Id .

[25] Id.

[26] Id.

[27] Id.

[28] Id at 2.

[29] Id.

[30] Gregory v. Helvering.

[31] Id at CONCLUSIONS OF LAW paragraph 4.

[32] Id at paragraph 5.

[33] Id at ADDITIONAL SPECIFIC FINDINGS OF FACT paragraph 14.

---

 [DL1]Where is the start of this quote?

The Economic Family Doctrine; The IRS' Argument

The primary argument advanced by the IRS against captives was the economic family argument, which was formally announced in Revenue Ruling 77-316, but which was developed over a series of now published internal IRS Memorandums.

In 77-316, the IRS outlines three common captive insurance scenarios:

Situation 1

 

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.

 

Situation 2

 

The facts are the same as set forth in Situation 1 except that domestic corporation Y and its domestic subsidi­aries paid amounts as casualty insur­ance premiums to M, an unrelated domestic insurance company. This in­surance was placed with M under a contractual arrangement that pro­vided that M would immediately transfer 95 percent of the risks under reinsurance agreements to S2 , the wholly owned foreign "insurance" sub­sidiary of Y. However, the contractual arrangement for reinsurance did not relieve M of its liability as the primary insurer of Y and its domestic subsidi­aries; nor was there any collateral agreement between M and Y, or any of Y's subsidiaries, to reimburse M in the event that S2 could not meet its reinsurance obligations.

 

Situation 3

 

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 percent of the risk through reinsurance agreements to an unrelated insurance company, W.

Situation 1 is a standard captive arrangement; the parent forms a captive and then insures various risks through the captive.  Situation 2 involves a standard reinsurance arrangement, where the parent insures risks through an insurance company who then reinsures a percentage of the risk with the parent's captive.  This is usually done to obtain access to the credit rating of the third party insurer and is referred to as a fronting arrangement.  In situation 3, the parent's captive transfers a certain percentage of the risk outside the captive to a third party.  

The service explained its reasoning thusly:

Under the three situations described, there is no economic shifting or distributing of risks of loss with respect to the risks carried or retained by the wholly owned foreign subsidi­aries, S1 , S2 , and S3, respectively. In each situation described, the insuring parent corporation and its domestic subsidiaries, and the wholly owned "insurance" subsidiary, though sepa­rate corporate entities, represent one economic family with the result that those who bear the ultimate economic burden of loss are the same persons who suffer the loss. To the extent that the risks of loss are not retained in their entirety by (as in Situation 2) or reinsured with (as in Situation 3) insurance companies that are unre­lated to the economic family of in­sureds, there is no risk-shifting or risk­distributing, and no insurance, the premiums for which are deductible under section 162 of the Code.

Notice the lack of solid legal analysis explaining the service's reasoning; they simply state the corporate group is an economic family and essentially leave it at that.  There are no cases cited, no doctrines quoted, no theories proffered.   They simply put forward an idea.

The internal memorandums which develop this legal theory offer no substantive guidance.  General Council Memorandum 35340 develops the legal reasoning for the first fact situation.  Regarding the fact situation, it concludes:

Inasmuch as S does not underwrite any substantial risks from outside the affiliated group, the requisite shifting and distribution of insurance risk is absent. Accordingly, the amounts paid by P and its affiliates to S do not constitute premiums for insurance deductible under Int. Rev. Code of 1954, § 162 [hereinafter cited as Code].

The service bases their arguments on two points.  First,

In Rev. Rul. 60-275, 1960-2 C.B. 43, taxpayer, a common carrier, leased facilities bounded by a river which exposed the property to potential flood damages. The taxpayer entered into a reciprocal flood insurance exchange agreement with other subscribers wherein each paid an annual premium deposit. The funds were paid into reserves for the payment of losses.

The agreement provided that each subscriber's risks would be divided into classes according to the nature of its business, flood hazard, location, and flood district. The ruling stated that inasmuch as the classification of taxpayer with other subscribers will be limited to specific groups within the same flood district each facing the same flood hazards that there is no real staring and distribution of insurance risks. In the event of flood damage to any of the subscribers in that group, there is a strong likelihood that all subscribers would be similarly affected. Therefore, any proceeds would merely be a return of subscriber's premium deposit. The ruling thus concluded that in the absence of the essential risk-sharing element, the premium deposits were not deductible as insurance premiums in accordance with Code § 162(a).2

Remember -- this is the legal basis for the service's objection to the insurance arrangement in the flood plane cases -- an analysis already rejected by at least one court.  However, the above fact pattern quoted is situation 1 is different from at least one of the flood plane cases which insured risks of a group of insureds rather than the risk of a single insured (see here and here for further discussion).  But the memo does not make a distinction between single parent and group; instead it attempts to apply itself to all captive insurance situation, making it that much less potent.

The service's second argument borders on anti-avoidance:

Although we agree with the rationale and the conclusion of the proposed revenue ruling, we recognize that the road to favorable judicial resolution is pervaded by the concept of separate corporate identity. Only in exceptional circumstances are the courts willing to disregard the corporate entity. New Colonial Company v. Helvering, 292 U.S. 435, 442 (1934). To successfully defeat corporate identity, it must be shown that the corporation was formed solely for tax purposes and has no substantive business activity, Moline Properties v. Commissioner, 319 U.S. 436 (1943), or that it is a mere skeleton, Perry R. Bass, 50 T.C. 595, 600 (1968). When the corporation is sufficiently capitalized and maintains the indicia of business operations, its corporate identity is rarely denied. Compare, Lloyd F. Noonan, 52 T.C. 907 (1969), aff'd per curiam 28 A.F.T.R.2d ¶71-6042 (9th Cir. 1971) with Perry R. Bass, 50 T.C. 595 (1968). In the instant case, to consider the affiliated group in the aggregate for the purpose of determining the lack of a substantial shift of risk, it may be argued that the separate corporate identity of each member of the group is improperly ignored.⁴

However, we are of the view that the concept of independent corporate identity is not being challenged by the rationale here espoused. We do not propose to ignore any taxpayer's separate identity . Rather, the proposed ruling examines the transaction for its economic reality. The payments here are simply not being made for insurance. The arrangement is basically designed to obtain a deduction by indirect means which would be denied if sought directly.

 When a tax lawyer sees the phrase "economic reality" we immediately think, "substance over form" or "anti-avoidance."  This is a judicial doctrine which allows the courts to recast a transaction if its form diverges from its substance.  By this time in the development of anti-avoidance law, the doctrine had morphed into the sham transaction doctrine, which was the predecessor to the now codified economic family doctrine.  Regardless of the terms used, the memorandum offers no further analysis; it simply uses the key phrase and stops  This greatly weakens the IRS argument in this practitioner's opinion.

GCM 35629 developed the services reasoning for situation 2 from 77-316.   However, the reasoning is just as weak.  The service states:

Under the facts of the instant case, *** sought to authenticate its so-called insurance premium payment by introducing an independent insurer between it and its subsidiaries and *** The substance of the transaction, however, was that *** insured only *** percent of the risk involved and was contemporaneously guaranteed reinsurance at specified rates with *** The whole transaction then was carefully orchestrated to produce a single result-eventual placement of the insurance with *** The economic reality in this case is no different from that found to exist in *** there is no economic shift or distribution of *** percent of the risk ‘insured’.

Note that the IRS is making sweeping legal conclusions regarding the transaction.  It's highly likely that this is a fronting arrangement -- a common occurrence in the insurance world as explained above.  Yet the service is assuming a fraudulent intent without any analysis or presentation of the facts by the taxpayer.

GCM 37040 outlines the services argument to situation 3 from Revenue Ruling 77-316

Thus, in the *** case, the captive, through reinsurance agreements with unrelated insurance companies, shifts and distributes the risk of loss outside the corporate family thereby providing insurance under the LeGierse standard. Likewise, because the reinsuring insurance companies are unrelated to the corporate family of insureds, the premiums allocable to the reinsurance are not under the control of or withdrawable by any of the insureds, and are therefore ‘paid or incurred’ within the meaning of Code § 162. See Rev. Rul. 60-275, 1960-2 C.B. 43; and Rev. Rul. 69-512, 1969-2 C.B. 24. Accordingly, we agree with your conclusion, both in the March 16th memorandum and in the proposed revenue ruling, that under an *** type of captive insurance arrangement, the domestic parent and its subsidiaries should be allowed to deduct premiums paid to the captive to the extent that the premiums are used to transfer the risk through reinsurance to unrelated insurance companies.

In G.C.M. 35340, ***, I-4712 (May 15, 1973), we considered a typical captive insurance arrangement and concluded that, to the extent the risk of loss is assumed by the captive and not distributed or spread outside the corporate economic family of the parent and its subsidiaries, the contracts made with the captive do not provide for insurance and the premiums paid therefor are not deductible under Code § 162. The conclusion that the typical captive, considered in G.C.M. 35340, does not provide insurance is based on a consideration of the fundamental characteristics of insurance, that is, ‘risk-shifting’ and ‘risk-distributing’. Helvering v. LeGierse, 312 U.S. 531 (1941). In a captive insurance arrangement, the various members of the corporate family involved wish to ‘insure’ against future risk of loss by making payments to the captive. The flaw in the plan, rendering the benefits not insurance and the premium payments not deductible under Code § 162, lies in the fact that the so-called policyholders are limited to one economic family, which lacks the risk-shifting and risk-distributing required for insurance. However, to the extent that the captive does provide the requisite shifting and distributing of risk outside the corporate economic family, the captive does provide insurance for the family members. The facts in the *** case as set forth in the March 16th memorandum present a new variation in captive insurance arrangements. Under the *** arrangement, the captive, which was organized to insure the risks of its domestic parent and the parent's subsidiaries, cedes or transfers 90 percent of the corporate family's risk of loss to unrelated insurance companies through reinsurance agreements.

Accordingly, we agree with your conclusion, both in the March 16th memorandum and in the proposed revenue ruling, that under an *** type of captive insurance arrangement, the domestic parent and its subsidiaries should be allowed to deduct premiums paid to the captive to the extent that the premiums are used to transfer the risk through reinsurance to unrelated insurance companies.

Note the  IRS' use of the phrase "withdrawable by the insured."  The insureds immediate access to the captive funds is still a prime concern for the service, as it makes the captive look like a reserve fund rather than an insurance company.  In situation 3, it's the captive shifting of funds outside the family group -- and therefore outside the control of the parent -- that makes that portion of the insurance premium legitimate.  Any fund which can be immediately accessed by the parent company is therefore not a legitimate insurance premium.

Several conclusions emerge when looking at the IRS' reasoning for challenging captives.  First, they are on legally shaky ground.  They are challenging an intra-company transfer -- which the courts will almost always honor as the doctrine of separate corporations is firmly entrenched in US law.  Secondly, they are hinting at making an anti-avoidance argument, yet never fully developing same.  Third, they are partially relying on legal theory which was already rejected by a court in one of the flood plane cases.

However, their primary concern is still readily apparent: the ability of the insured to immediately access funds and use them for a non-insurance purpose.  This is an important point to remember going forward, and even has strong implications for those creating captives currently.

 

The Economic Family Doctrine: Moline Properties and Risk Shifting and Risk Distribution

The economic family doctrine was the IRS' primary legal argument against captive insurance.  This theory was developed over a series of internal memorandums which I'll discuss in a later post.  But to understand the economy family doctrine -- and the primary arguments against it -- there are two legal concepts we need to explain.

The legally separate nature of corporations.  

While it seems common sense that a court would treat each corporation as a separate legal entity, this is a concept that had to be established in case law in Moline Properties.  The following is from my book:

In Moline, Uly Thompson organized Moline Properties as a Florida Corporation. Thompson transferred a mortgaged property to the corporation in 1928.  A trustee who represented Thompson’s creditors held the stock of the corporation as security for another of Thompson’s loans.  The corporation sold the property in 1933.  The corporation reported a loss in 1934 and a profit in 1935 and 1936.  Thompson “filed a claim for refund on petitioner’s behalf in 1934 and sought to report the 1935 gain as his individual return.”  Thompson also reported the 1936 gain on his individual return.  In other words, the primary shareholder attempted to report corporate income as individual income.  The question is whether the corporation or Thompson is responsible for the taxes from the sale of property.  The court ruled thusly:

The doctrine of corporate entity fills a useful purpose in business life.  Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity

In other words, the corporate form will be respected so long as it serves a legitimate business purpose. 

Central to the IRS' primary anti-captive argument is the concept of corporate family, meaning the service focuses on the tax implications of a corporate group rather then for an individual company.  In all the major economic family cases, the taxpayers would argue that the economic family theory violated the separate nature of corporate entities.

Risk Shifting and Risk Distribution

These are two concepts that are inherent in insurance.  Again from my book:

Helvering is a landmark decision in insurance law because it provides the basic legal definition of insurance: “Historically and commonly insurance involves risk shifting and risk distributing.”  All future captive cases will use this definition and expand on it. 

In Helvering,Helvering, an 80-year-old woman purchased an annuity and a life insurance contract. She paid $4,179 for the annuity and $22,946 for the life insurance policy making her total payment $27,125.  The annuity contract allowed her to receive $589.80 per year for life.The life insurance contract paid $25,000 on her death.  From an actuarial perspective, the purchaser would have to live to 84 in order for her total payout to exceed her amount paid (and that assumes the insurance company does not invest the money received).  She purchased these policies one month before her death.  The insurance company would not issue one policy without the other.  The proceeds of the life insurance policy went to her daughter who did not include the amount of the life insurance policy in the estate tax return.  The commissioner disallowed the exclusion, and included the total amount of the insurance policy in the decedent’s estate.

To determine if the commissioner made the correct determination, the court had to define “insurance.”  The court first looked through the various insurance statutes before arriving at this definition:  “We think the fair import of subsection [g] is that the amounts must be received as the result of a transaction which involved an actual ‘insurance risk’ at the time the transaction was executed.  Historically and commonly insurance involves risk shifting and risk distributing.”

Unfortunately, the court did not define either of these terms, leaving that task to later decisions, which have arrived at the following explanations.

Risk shifting is seen from the insureds perspective and is accomplished through a valid insurance contract.  Essentially, when X happens to the insured, Y pays.  For example, if I purchase home owners insurance that covers fire and my house burns down, then insurance company pays a claim and makes me whole.  Factually what matters here is that the insurance contract is valid.  This element is rarely challenged.

Risk distribution, however, is an entirely different matter.  This concept is seen from the insurance company's perspective.  First -- remember that the IRS' primary concern with captives was that the captive was in fact a reserve fund set up by the parent company.  Central to this concept is that the parent is only contributing its own money and not co-mingling it with other insureds.  In contrast, insurance companies take premiums from a larger number of insureds and pool them, which accomplishes two goals.  First, it pools risk, so that the possibility of a catastrophic loss forcing the insurance company into bankruptcy is minimized.  Secondly, it pools smaller premiums into a large pool of money (from an economic perspective, an insurance company is a financial intermediary like a bank or mutual fund).  Put another way, by insuring a larger number of insureds, an insurance company is distributing its risk.

Courts later defined this concept in several ways.  Some courts simply noted that a successful captive would include enough money from a non-parent so that a paid claim would include enough non-parent monies to make the insurance company valid. A second way of explaining this concept was that the captive had to comply with the law of large numbers:  

In probability theory, the law of large numbers (LLN) is a theorem that describes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.

Regardless of the definition used, an insurance company must have risk distribution in order to be legally recognized.  Central to the economic family argument is the idea that the captive has insufficient risk distribution to be considered a viable insurance company.

With these two concepts in mind, we'll next turn to the IRS' primary anti-captive argument the economic family doctrine as expressed over a series of internal memos.

The Flood Plane Cases, Part II

Last week, we looked at the first flood plane case Consumers Oil.  This week, we'll take a look at the second flood plane case -- U.S. v. Weber Paper Company.

To place this case in perspective, here is a bit of relevant history:

In mid-July 1951, heavy rains led to a great rise of water in the Kansas River and other surrounding areas. Flooding resulted in the Kansas, Neosho, Marais Des Cygnes, and Verdigris river basins. The damage in June and July 1951 exceeded $935 million dollars in an area covering eastern Kansas and Missouri, which, adjusting for inflation, is nearly $7 billion dollars in 2005.^[1] The flood resulted in the loss of 17 lives and displaced 518,000 people.^[2]

^{Like the taxpayer in Consumer Oil, the taxpayer in Weber couldn't find insurance due to the above mentioned flood.  To solve this problem, a group at the Kansas City Chamber of Commerce suggested that the parties form a reciprocal insurance exchange, which was organized under the insurance laws of Missouri, which -- along with the state of Kansas -- granted the exchange a license to conduct the business of insurance.  One participant went to far as to obtain a Private Letter Ruling stating the government would treat the deduction as allowable under 26 USC 162(a); another participant did not obtain a ruling, as it was then believed that the business deduction statute was sufficiently clear to allow the deduction.}

^{The taxpayer made a $10,000 premium deposit for the first year's insurance policy, paying $1,000 with the application and tendering an additional $9,000 when the policy was issued.  The policy covered $100,000 of risk.  The policy issued was directly derived from policies then currently in force in New York, with changes made to comply with the laws of both Missouri and Kansas.}

The policy contained the following clauses:

‘10. The credit balance in our Catastrophe Loss Account shall not be withdrawn by us except upon sixty (60) days prior written notice effective immediately after the end of our current policy year. In the event of withdrawal, our credit in this account will be adjusted to reflect the then average market value of investments owned by the exchange.
 .....

‘13. This agreement is strictly limited to the uses and purposes herein expressed and may be terminated at any time by the undersigned or by the Attorney, by either giving the other five days' notice in writing. Our liability created by virtue of this instrument shall begin and end simultaneously with liability of other subscribers to us and no liability shall accrue against us hereunder after termination.’

The policy itself contains a provision reading as follows:

‘Cancellation of policy. This policy shall be cancelled by the insured or by the Company by either giving the other five days' notice in writing.’

Remember the IRS' primary concern with captive insurance -- that the insured was not in fact buying insurance, but instead was creating a reserve fund which allowed the company to take a current year's deduction while at the same time timing the inclusion of income into a future year when taxable income was lower.  The above clause creates the impression that the insurance exchange was in fact a reserve which allowed the insured to manipulate his earnings.  However, the trial court noted that the taxpayer could not withdraw the money in the policy year, but instead had to wait until after the policy year to withdraw the funds.

Secondly, the IRS argued that because all the insureds were located in the same flood plane, they would all be impacted in the same manner, thereby preventing risk distribution from taking place.  This was the intellectual basis of Revenue Ruling 60-275, which outlined a fact pattern directly analogous to this case.  The service stated the following:

Since the eventual classification of the taxpayer with other member subscribers of the exchange will be limited to specific groups within the same flood district, each facing similar flood hazards, there is little likelihood that there could be a real sharing of the risks, because the occurrence of a major flood probably would affect all properties in a particular flood basin. Inasmuch as each subscriber to the instant exchange is substantially underinsured, any proceeds received by the taxpayer in the event of flood damage would, in effect, be a return of the taxpayer's own money.

The trial court simply noted the facts of the case were inconsistent with the Revenue Rulings, and left it at that.  In short, the trial and appellate court disagreed with the IRS' contention regarding the case.

As I note in my book, the IRS could have used this opportunity to develop a basic legal theory to deal with or explain captives.  However, instead they decided to issue Revenue Ruling 64-72, which states:

Although certiorari was not applied for in the Weber Paper Com pany case, the decision will not be followed as a precedent in the disposition of similar cases, and the position of the Service, as set forth in Revenue Ruling 60-275, C.B. 1960-2, 43, will be maintained pending further judicial tests.

This set-up the series of challenges based on the economic family doctrine, which I'll address next.

The Flood Plane Cases, Part I

Although we think that the first important legal battle for captive insurance occurred during the economic substance cases that started in the 1970s, the reality is two cases from the 1950s (US. v. Weber and Consumers Oil Corp v. US) have all the hallmarks of modern-day captive insurance programs.  Most importantly, at their conclusion, these cases offered the IRS the opportunity to clearly outline specific rules and regulations related to captives.  However, the IRS declined to do so, instead issuing a Revenue Ruling stating they would not follow the conclusion of the cases and instead continue to litigate captive insurance cases.

First, let's set the stage by explaining what caused the need to create one of these captives in the first place: the Trenton Flood of 1955

The worst natural catastrophe to befall Trenton was the flood of 1955.

City streets were turned into rivers and hundreds of families were evacuated as the normally  placid Delaware River surged over its banks.

Flood damage totaled $100 million in New Jersey, mostly in property damage, with $500,000  coming from the destruction of Mercer County roads.

In the weeks leading up to the flood, the area had been scorched with temperatures hitting  the 90s nearly every day in July and early August.

Worse yet, there had been little rain to ease the record-setting temperatures, as most towns  considered water rationing measures.

The earth became parched, reservoirs dried up, and sewers backed up due to a loss of water  pressure.

Area residents, especially Burlington County farmers who had suffered severe crop damage due to the heat, were probably praying for rain, ignoring the adage, "Be careful what you  wish for."

After the drought came the deluge, as Mother Nature flashed her fickle side.

The drought broke on Aug. 7, when 2.9 inches of rain fell on Trenton.

As a result, finding flood plane insurance in the NJ area in the years afterwords was nearly impossible.  To solve this problem, The Consumers Oil Company established its own trust fund.

The plaintiff, by a written agreement with three of its officers and directors, established a ‘trust fund’ which was to be administered by the latter and held by them as insurance against possible liability for property damage resulting from flood. The trust agreement was subject to automatic termination upon cessation of the plaintiff's business, and was unilaterally revocable by the plaintiff upon determination that continuance of the trust was no longer feasible ‘as a matter of business expediency and sound business operation.’ (Paragraphs 10 and 11 of the Agreement.) The balance in the fund was repayable to the plaintiff upon termination or revocation of the agreement. The agreement was executed on December 16, 1955, and was in effect during the years here in question.

The plaintiff made two payments into the trust fund, and attempted to deduct these amounts from its income tax -- a deduction which was disallowed by the service.  The court agreed, largely because this scenario looked remarkably similar to a reserve fund:

The fund thus created remained wholly within the control of the plaintiff and the balance remaining therein was subject to repayment upon either the cessation of its business or the unilateral revocation of the agreement. The payments entailed nothing more than a voluntary segregation of funds out of income as a reserve against a contingent liability and were, therefore, not allowable deductions

Central to the court's decision was the structure of the trust established by the company.  The trust was administered by directors of the company, making it look remarkably similar to a reserve fund.  In addition, the trust automatically terminated on the cessation of the company's business or if the company decided termination was warranted by business exigencies. This would allow the company to bring the earnings back on their income statement, which could allow them to manipulate their earnings -- a primary reason why the IRS fought against the establishment of reserves.

There are two important issues to mention regarding this case's facts.  First, the company did not set up an insurance company; instead, they set-up a trust.  There was no claims department, no formal insurance contract etc...  Under current law, this transaction would violate the third prong of the Harper Test (the arrangement would not be for insurance in its commonly accepted sense).  Secondly, there is no mention of any tax evasion concepts; that is, no one went to the company and said, "I've got a great way to lower your taxes."  What did happen is business exigencies (risk management) drove the transaction.  This is incredibly important, as we will see this as a fundamental part of the captive cases going forward.

What Was The IRS' Beef With Captives?

Starting in the mid-1970s, and continuing through the UPS case, the IRS fought captives tooth and nail.  Over the course of these cases, they advanced three different legal arguments against captive insurance: the economic family argument, the nexus of contracts and the assignment of income doctrine. 

However, it's important to ask this question regarding the IRS' legal battle: "what was it about captives that the IRS didn't like?"  To answer that question, we need to go back to a series of cases from the early 20th century called the reserve cases.  In all of these cases, a taxpayer foresaw a particular adverse event and started to place money into a reserve fund in anticipation of future payment. In all of these cases, the taxpayer attempted to deduct the amount paid into the fund as a legitimate, section 162 deduction.  The Bureau of Tax Appeals (B.T.A.) heard all of these cases and struck down the deduction.  They advanced several reasons for these denials.

1. The tax code allowed a deduction for business expenses, but not for amounts paid into an    internally held reserve.  This is supported by a strict reading of the statute.
2. Moving funds internally – from cash to a reserve or from one corporate “pocket” to another – does not shift the risk as required by insurance. 
3. Preventing the manipulation of gross income through the use of “reserves” and “contingency funds” as outlined in the case Spring Canyon Coal. 
4. Both accrual and cash accounting methods require the taxpayer to deduct specific “realized” amounts.  A taxpayer cannot deduct a speculative amount. 

Point number one requires only a strict reading of the tax code. 26 U.S.C. 162 and the accompanying Treasury Regulations do not allow a deduction for payments into a reserve fund; the wording is simply not in the statute.  Point number 2 is basic accounting; paying into a reserve fund would debit cash and credit the reserve fund, but there would not be a net change on the balance sheet; the taxpayer is simply moving money internally (this concept would become part of the intellectual backbone of the economic family argument, the service's primary, anti-captive argument). 

Point number three is, I believe, the most pointed argument.   A good example of this situation occurred in 2006 when Exxon earned a record amount of revenue.  At the time, there were calls for a windfall profits tax on the company.  If Exxon could set aside money in a reserve for this contingency and then deduct the payment to the fund Exxon could manipulate its earnings.  In the year of the deduction, it could lower its taxable income be claiming there was a possible contingency, and then when its taxable income was low, it could argue the contingency no longer existed (and it would not, as there would be no windfall profits) and then bring the reserve back onto its income  statement.  In short, the company would be able to time it's earnings to, from the court's perspective, an uncomfortable degree.

Point number four is a bit weak, as the courts focused on the amounts paid from the contingency fund rather than the amounts deducted.  However, the point, I believe, is that in all these situations, the taxpayers underlying analysis of the payment from the company's perspective was a bit weak.  Instead of looking at the risk from an actuarial perspective, all the company's simply eyeballed the amounts and started making payments.       

While not stated in the any of the reserve cases, central to all of these arguments is this point: the company is engaging in accounting maneuvers rather than insuring risk.  In addition, the taxpayer is attempting to obtain a tax benefit (in the form of lower taxable income) because of these maneuvers.   These two, inter-twinging issues, need to be continually on the minds of planners, even today.