In a recent case, the Tax Court upheld deductions for insurance premiums paid by a parent company's wholly owned subsidiaries to another wholly owned captive insurance subsidiary ( Rent-A-Center, Inc. , 142 T.C. No. 1 (2014)). In Rent-A-Center , the Tax Court reexamined the Sixth Circuit's decision in Humana, Inc. , 881 F.2d 247 (6th Cir. 1989), which had overturned, in part, the Tax Court's earlier decision (88 T.C. 197 (1987)) that risk shifting could not be accomplished in a brother-sister corporate subsidiary arrangement.
Elements of Insurance
Business insurance premiums are generally deductible expenses (Sec. 162(a) and Regs. Sec. 1.162-1(a)). Although the term "insurance" is not defined in either the Code or the regulations, the Supreme Court established two elements that must be present for an arrangement to be viewed as insurance: risk shifting and risk distribution ( Helvering v. Le Gierse , 312 U.S. 531 (1941)). Risk shifting occurs where an identifiable risk is shifted from the insured to the insurer ( Treganowan , 183 F.2d 288 (2d Cir. 1950), cert. denied, 340 U.S. 853 (1950)). Risk distribution looks at whether the insurer has pooled enough unrelated risks together to be generally unaffected by the occurrence of a single loss event ( Beech Aircraft Corp. , 797 F.2d 920 (10th Cir. 1986), aff'g No. 82-1369 (D. Kan. 7/3/84)).
The Tax Court has added two more criteria for an arrangement to constitute insurance. First, an arrangement must involve an insurance risk, and second, the characteristics of the arrangement must resemble a commonly accepted notion of insurance ( Amerco , 96 T.C. 18 (1991), aff'd, 979 F.2d 162 (9th Cir. 1992)). Without meeting the above-established criteria, deductions may be postponed and characterized as self-insurance reserves requiring the self-insuring taxpayer to wait until losses occur and economic performance is met by actual payment ( Clougherty Packing Co. , 811 F.2d 1297 (9th Cir. 1987)).
Captive Insurance Companies
Captive insurance refers to an arrangement set up, usually by a large corporation, to secure the traditional benefits of insurance coverage, including the tax benefits, by placing its insurance business with a corporate entity owned by or related to the taxpayer. The IRS generally takes the position that a taxpayer has not bought insurance when it pays premiums to an entity it owns either directly or indirectly (or with whom it shares a parent) because the required elements of risk shifting and risk distribution are not present. Therefore, the taxpayer paying the premium is not entitled to a deduction under Sec. 162 and Regs. Sec. 1.162-1(a) for insurance premiums paid.
The IRS has routinely challenged insurance expense deductions arising from captive insurance arrangements, resulting in a number of court decisions addressing whether payments made by a corporate parent to a captive insurance subsidiary were currently deductible as insurance expenses. In Carnation Co. , 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir. 1981), the court held that risk did not shift to the captive because the balance sheet of the parent corporation was economically impaired as the captive subsidiary incurred losses. Carnation was followed by Clougherty Packing Co. , in which the court ruled similarly in a parent-subsidiary captive arrangement.
In Humana , the Tax Court denied deductions for insurance payments a parent corporation made to its captive subsidiary in a parent-subsidiary arrangement as well as payments made to the captive by other wholly owned subsidiaries of the parent corporation in a brother-sister arrangement. However, the Sixth Circuit reversed with respect to the brother-sister arrangement, finding that the assets of brother-sister subsidiaries were not affected when the captive incurred losses, and thus risk shifting had indeed been accomplished.
Rent-A-Center Inc. (RAC) is a publicly traded corporation in the rent-to-own business with approximately 15 affiliated subsidiaries. During the years RAC was under examination, its subsidiaries operated between 2,623 and 3,081 stores in all 50 states, the District of Columbia, Puerto Rico, and Canada. The subsidiaries employed between 14,300 and 19,740 people and operated between 7,143 and 8,027 vehicles.
Beginning in 2001, RAC began having problems in both managing its rapidly increasing insurance costs and obtaining the insurance coverage it desired. To address this growing business problem, RAC engaged a risk consulting firm, which suggested RAC consider using a captive insurance company. RAC's senior management followed up on the risk consultant's recommendation and engaged the risk consultant to perform a feasibility study. RAC also engaged an accounting firm to analyze the feasibility study, review the tax considerations, and prepare financial projections.
The risk consultant advised RAC that a captive could provide coverage more economically than unrelated insurers and even offer coverage some insurers were not willing to provide. Accordingly, in December 2002, RAC formed Legacy Insurance Co. as a wholly owned and duly registered Bermudian insurance subsidiary. RAC obtained high-deductible policies for workers' compensation, automobile, and general liability from an unrelated insurer. Legacy provided coverage for the same risk categories for the claims below the unrelated insurer's thresholds.
The premiums Legacy charged to RAC's subsidiaries were actuarially determined and were allocated based upon each subsidiary's actual payroll, number of stores, and number of vehicles. RAC's subsidiaries deducted the premiums paid to Legacy as insurance expenses, which the IRS determined were not deductible when it examined RAC's consolidated federal income tax returns. RAC challenged the disallowance in Tax Court.
The IRS made two arguments why RAC was not entitled to insurance expense deductions for the premium payments made by its subsidiaries to Legacy. First, it asserted that Legacy was a sham corporation without a legitimate business purpose that RAC had created to generate income tax savings. Second, the IRS asserted that arrangements between Legacy and RAC and its subsidiaries did not qualify as insurance and that therefore the payments to Legacy were not deductible insurance expenses. The Tax Court rejected both of the IRS's arguments and held that RAC was entitled to deductions for the payments it made to Legacy.
With respect to the first issue, the court found that RAC had formed Legacy as a bona fide insurance company for prudent and legitimate business reasons, including actual reductions in its cost of insurance and flexibility in obtaining otherwise unobtainable coverage. The court noted that while tax considerations were evaluated, the formation of Legacy was not tax-driven. Although the IRS contended that Legacy was an "accounting device" and used an impermissible "circular flow of funds," the court (and the IRS's expert) found that Legacy did not engage in any related-party "circular flow of funds" transactions. This negated the IRS's argument that Legacy was a sham. Further countering the IRS's contention that Legacy was a sham, the court referred to the landmark case of Moline Properties , 319 U.S. 436 (1943), noting that the separate taxable treatment of captives will be respected so long as there is no finding of a lack of business purpose or a sham.
Having determined that Legacy was a bona fide insurance company and not a sham, the court examined whether the agreements were insurance, based on the four elements of insurance described above. The IRS conceded that the policies at issue involved insurable risk. The court also found with little analysis that the arrangement between Rent-A-Center and Legacy constituted insurance in the commonly accepted sense, based on the characteristics of Legacy itself and the policies between it and the other RAC subsidiaries. The court noted that Legacy was adequately capitalized, regulated by the Bermuda Monetary Authority, and organized and operated as an insurance company and that the company issued valid and binding policies, charged and received actuarially determined premiums, and paid claims.
On the requirement of risk shifting, the court found persuasive the Sixth Circuit's critique of its prior analysis of the brother-sister arrangement in Humana and distinguished the fact patterns of Carnation and Clougherty , where risk shifting was found lacking in a parent-subsidiary captive arrangement. The court said, "The policies at issue shifted risk from RAC's insured subsidiaries to Legacy, which was formed for a valid business purpose; was a separate, independent, and viable entity; was financially capable of meeting its obliga tions; and reimbursed RAC's subsidiaries when they suffered an insurable loss" (slip op. at 34). Lastly, the court noted, and the IRS's expert conceded, that payments from Legacy to RAC's subsidiaries did not reduce the subsidiaries' assets or net worth, evidencing risk shifting. Thus, the court found that the risk-shifting requirement was met.
With respect to risk distribution, the court noted the substantial number of stores, employees, and vehicles insured by Legacy as well as the three types of risks that were insured: workers' compensation, automobile, and general liability. Accordingly, the court concluded that by insuring RAC's subsidiaries, Legacy insured a sufficient number of statistically independent risks to achieve risk distribution.
Note: An article in the December 2013 issue of The Tax Adviser provides several cautionary notes on the need for taxpayers using captive insurance arrangements to seek the advice and assistance of reputable and competent professional advisers (Mahany, "Captive Insurance Arrangements Face IRS Scrutiny," 44 The Tax Adviser 809 (December 2013)).
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
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