The Tax Deductibility of Captive Insurance Premiums: An Assessment and Alternative Perspective

Introduction Whether premiums paid to captive insurers by their parent corporations and affiliates should be tax-deductible for federal income tax purposes has been long debated. The Internal Revenue Service (IRS) and various corporations have litigated this issue in the tax court, claims court, federal district courts and in several different federal appellate courts. The tax deductibility issue has also generated academic interest and has been analyzed by Hofflander and Nye (1984), Smith (1986), Han and Lai (1991), Porat et al. (1991), and others in the insurance-economics literature. The IRS has maintained that premiums paid to wholly-owned captives by parent corporations are not tax deductible because the captives are part of an economic family (Rev. Rule. 77-316). In early cases addressing this issue, such as Carnation (1978) and Clougherty Packing (1985, 1987), the tax court determined that the premiums paid by parent corporations to captives were not tax deductible because such payments did not meet the necessary criteria for insurance required for federal income tax purposes, which were risk shifting and risk distribution. Payments to captive insurers were viewed as loss reserve contributions, rather than insurance premiums, and reclassified as "self-insurance" or no insurance. The first purpose of this study is to briefly review the court cases involving the tax deductibility issue and to discuss the concepts in these decisions involving the "economic family," risk shifting, and risk distribution. Recently, the U.S. Tax Court ruled that premiums paid by parent companies to wholly-owned captive insurers are tax deductible if the captives write "relatively large" amounts of unrelated third-party business. The rulings in three cases associated with the tax deductibility issue--AMERCO (1991), Harper (1991), and Sears (1991)--reflected a second substantial victory for companies challenging the IRS on the premium deductibility issue and were solidified on appeal to various circuit courts. (1) Although the concepts of risk shifting and risk distribution are still the focus of recent court decisions, two other considerations have become prominent: whether the exposure (or risk) is deemed to be an insurance risk and whether the alleged insurance transaction was consistent with "commonly accepted notions of insurance. " The second purpose of this article is to analyze these two issues. Specifically, we discuss the relevant insurance risks or exposures and the various risk measures associated with the tax deductibility issue and analyze the issues related to other perceptions of the transaction, including the access of captives to guaranty funds, the general treatment of captives by regulators as legitimate insurers, and the role of separate legal entities (the "corporate veil" or firewall issue). Finally, this article utilizes the concept of risk reduction to assess some unresolved tax deductibility issues. Specifically, we examine three issues: the degree of risk reduction when variances of risks are different, the issue of a small number of outside risks, and tax deductibility for owners of group captives. The next section discusses the "economic family" doctrine and an implicit definition of insurance. Then we address the existence of an insurable risk and the nature of risk measures, followed by a presentation of the perspectives on premiums paid to captives. An economic rationale for why risk reduction might be a better approach for determining tax deductibility is offered next. Some unresolved issues are then examined and, finally, conclusions drawn. "Economic Family" Doctrine v. Risk Shifting and Risk Distribution Is the "Economic Family" Doctrine Dead? The IRS introduced the "economic family" doctrine in 1977 in its Revenue Ruling 77-316. The doctrine indicates that a wholly-owned captive and its parent company may be perceived as part of the same corporate family because the parent ultimately bears the profits or losses of the captive. …