Source: http://www.uscaptiveinsurancelaw.com/blog/archives/04-2016
Timestamp: 2019-04-18 18:17:39+00:00

Document:
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.
On August 5, 1976, Humana incorporated Health Care Indemnity under the Colorado Captive Insurance Act. The Insurance Department of Colorado approved Humana’s establishment of a captive under Colorado law.
Health Care Indemnity (the captive’s name) issued preferred and common shares. Humana purchased all 250,000 shares of common stock by paying “$750,000 in the form of an irrevocable letter of credit issued in favor of the commissioner of insurance of the State of Colorado.” Each common share of stock had 5 votes. A Humana subsidiary in the Netherlands Antilles purchased all 150,000 shares of preferred stock for $250,000. There were no further agreements among Humana, its Netherlands Antilles subsidiary and Health Care Indemnity for the injection of any additional funds into the captive insurance company.
Health Care Indemnity issued three policies which covered the vast majority of Humana’s hospitals. All of these policies conformed with industry standard practices. For years 1977 to 1979 Humana (the parent) paid total premiums of $21,055,575 to Health Care Indemnity. These payments represented amounts for the parent and its subsidiaries. The sole issue at trial was whether these amounts were deductible as insurance premiums.
However, there were two sets of premiums. The first was from the parent company to the captive. The second was from the subsidiaries to the captive. It is important to remember this distinction going forward.
Before moving forward, let's make some observations.
Just as the IRS often waits for the most egregious fact pattern to prosecute, this fact pattern represents a a near perfect set-up for the taxpayer to defend. First, business necessity -- not a tax angle -- forced the taxpayer to look at the possible formation of a captive program. This brings Humana squarely in line with the business purpose requirement of the Frank Lyons case and prevents an IRS attack based on the then most prevalent anti-avoidance theory, the sham transaction doctrine. In addition, the taxpayer carefully considered four possible alternatives, and rejected three for good business reasons: going uninsured would expose the company to too much risk; contributions to a reserve were not deductible and forming the then equivalent of a risk retention group would expose the company to possibly weaker plan participants. As such, the best alternative -- again, after careful deliberation -- was to form a captive.
The captive formation process was also picture perfect. First, the captive was formed domestically. While there is nothing inherently wrong with using an offshore jurisdiction, it can have a negative taint when mentioned in court. The fact that the captive was formed in a US domicile makes this situation appear more "on the up and up." Next, the captive was capitalized with $1 million -- a more than adequate amount of initial capital. Additionally, there is no formal agreement for any plan participant to provide further capital -- a fatal flaw in an earlier case.
The captive sold three master policies to the parent company that covered the vast majority of the parent companies' risks. The policies confirmed to industry norms. The amount of total premiums over a three year period -- $21,055,57 -- appears to be reasonable on its face (also note this issue was not contested at trial).
This is a great fact pattern to defend -- which we'll begin to explore in the next post.
The captive cases can be broken down into two segments: the economic family cases -- where the IRS gained trial momentum for their theories, and the Humana cases, where taxpayers began scoring victories. Because we're the Humana case is next, this is an appropriate place to stop and sum up the overall captive legal situation before moving forward.
1.) Business necessity drove the formation of early captives. Market failure (a lack of insurance or very expensive coverage) led to the formation of the early captives. For example, the taxpayer in Ocean Drilling was engaged in a new business the was extremely risky; only Lloyd's of London would provide coverage. The taxpayer in Beech Aircraft wanted to gain control of the insurance policy drafting process. The taxpayers in Clougherty and Carnation wanted to lower their worker's compensation costs. Business necessity drove these transaction.
2.) The IRS was prepared. The service had several years to develop their legal theory. They could also choose their cases to find facts that were most beneficial to their position -- a standard IRS tactic. Finally, they had a stable of credible experts to support their primary argument. The service presented a solid case backed by the intellectual heft of their experts.
3.) The taxpayers were poorly prepared. The taxpayers' cases relied on a strict reading of the law. None used an expert or presented any in-depth analysis of the transaction. All the taxpayers argued that the IRS' theory violated the separate corporate existence as espoused in the Moline Propertiescase. That is where the taxpayer's argument ended. The taxpayers were out-maneuvered by the service.
4.) The IRS was most successful against the single parent structure: the one case the IRS lost was Crawford Fitting, where the insured's captive insured multiple entities and where the captive had multiple owners. However, all single parent cases resulted in IRS victories.
5.) The overall analysis lacked a great deal of nuance: Captives were a new business; courts lacked practical knowledge them, making judges dependent on the IRS' arguments, documentation and experts. The thinness of the taxpayers' cases exacerbated this trend. The decisions lacked a serious discussion of actuarial sciences, the insurance process or any counter-veiling theories. With the exception of the Crawford Fitting case, the courts' decision is essentially the IRS' legal theory, nothing more.
Next up, we'll take an in-depth look at the Humana case, where taxpayers began gaining ground.
Situation 2 of Revenue Ruling 77-316 is the same as situation 1, except that the parent and subsidiaries pay premiums to a non-affiliated third party who reinsures 95% of the risk with a captive insurance company. General Counsel Memorandum 35629 fleshes out the service’s thinking regarding situation 2. The service argues the taxpayer should be allowed to deduct any payment not reinsured through the taxpayer’s captive. In other words, risks that are outside the “economic family” and that follow proper insurance protocol are deductible whereas any payments – either directly or indirectly – to an insurance company that is a member of the same corporate family are not allowed. The service believes that in situation 2 the taxpayer is attempting to “authenticate its so-called insurance premium payment by introducing an independent insurer between it and its subsidiaries … The whole transaction was carefully orchestrated to produce a single result – eventual placement of the insurance with [the captive].”Again, the IRS is arguing this is essentially a sham transaction yet does not invoke any specific anti-avoidance doctrine.
The service made four arguments against this arrangement. First, under the arrangement, there was no risk shifting as required by law. Secondly, the plan was nothing more than a reserve whose contributions were disallowed as deductions under law. Third, the 90% payment ceded to Three Flowers remained within the same economic family and was therefore not “paid or incurred.” Fourth, in order for a deduction to occur, the payor must receive something of value. Because the petitioner ultimately bore the risk of loss, he received nothing of value and therefore could not take a legitimate deduction under 26 USC 162.
Carnation responded by noting the service’s arguments were premised on Carnation’s and Three Flowers’ not being separate entities. Carnation then noted Moline Properties prevents this conclusion. In addition, the two companies filed separate tax returns, indicating that for tax purposes Three Flowers was not part of a Carnation consolidated group.
The court based its analysis on the method established in Helvering v. LeGierse. The court noted the insurance contracts in that case were inter-related; therefore, the court should analyze the facts in Carnation in a similar manner. Additionally, the court noted the insurance contract between Carnation and American Home and American Home and Three Flowers were also inter-related and should be analyzed together. This blunted Carnation’s argument for the court to consider the companies as separate and distinct entities.
In the event of a covered casualty, the loss suffered by Carnation ultimately would be borne 90% by Three Flowers and 10% by American Home. The agreement to purchase additional shares of Three Flowers by Carnation bound Carnation to an investment risk that was directly tied to the loss payment fortunes of Three Flowers, which in turn were wholly contingent upon the amount of property loss suffered by Carnation. The agreement by Three Flowers to “reinsure” Carnation's risks and the agreement by Carnation to capitalize Three Flowers up to $3 million on demand counteracted each other. Taken together, these two agreements are void of insurance risk. As was stated by the court in LeGierse, “in this combination the one neutralizes the risk customarily inherent in the other.
Flowers.However, Carnation was the company making the claim that was depleting Three Flower’s capital. In short, a claim or combination of claims over $120,000 would force Carnation to pay itself, making this deal a pure example of self-insurance. The court did rule that the 10% of the risk that stayed with American Home was an insurance risk and was therefore deductible. This was in line with Revenue Ruling 77-316.
Clougherty Packing Co. involved a different company but remarkably similar facts. Clougherty was a California company which had an Arizona subsidiary, which in turn owned an insurance company named Lombardy. Because Clougherty was involved in slaughterhouse operations, they had numerous workers’ compensation claims. Under California law they were required to obtain insurance to cover these claims. In 1976, Clougherty’s insurance broker submitted a proposal to Clougherty regarding the formation of a captive insurance company. Clougherty’s management agreed, although they believed the captive should reinsure risks rather than provide direct insurance. The company believed a captive would lower their workers’ compensation costs. Clougherty formed Lombardy insurance on July 22, 1977 and capitalized Lombardy with $1 million dollars. Later that year, Clougherty agreed to a reinsurance plan with Freement Indemnity, which called for Freement to provide the primary insurance policy to Clougherty, while Lombardy provided the first $100,000 of reinsurance to Freemont. Under the plan, Clougherty would pay Freemont, who in turn would remit 92% of the premiums to Lombardy. Clougherty made no promises or guarantees regarding future payments to its captive Lombardy. Clougherty deducted $840,000 in 1978 and $1,457,500 in 1979 as insurance premiums. The service disallowed the portion of the premiums remitted to Lombardy.
When petitioner sustains losses covered by its workers' compensation insurance, 92% is sustained by Lombardy.Accordingly, because petitioner, through its wholly owned Arizona corporation, owns all of Lombardy, it has not shifted the risk of sustaining such losses to unrelated parties in exchange for insurance premiums, because the premiums were paid to the wholly owned subsidiary of its wholly owned subsidiary.
The court’s reasoning is that the payment from the captive will deplete the company’s cash account, which in turn will lower the captive’s stock value.Because the parent company owns all the captive’s stock, the parent’s balance sheet would decrease in value in proportion to the cash payment from the captive.
There are numerous situations in the tax law, both statutory and case law, where the separate nature of the entity is not disregarded, but the transaction, as cast between the related parties, is reclassified to represent something else, e.g. reasonable compensation or dividend, loans or contributions to capital, loans or dividends, deposits or payments, or other recharacterization such as permitted under section 482, Internal Revenue Code of 1954, as amended. We have done nothing more inCarnation and here than to reclassify, as nondeductible, portions of the payments which the taxpayers deducted as insurance premiums but which were received by the taxpayer's captive insurance subsidiaries.
In effect, the court, in its ruling, is recognizing the separate nature of the companies. However, the court must recast the transaction (which it has the statutory authority to do), because there is no risk shifting and therefore no insurance.
This is the key problem of the majority’s opinion. While the insurance company in Carnation was inadequately capitalized, leading to an adverse decision, Clougherty’s captive had $1 million in reserves and no agreement to receive additional funds from the parent. All indications from the case indicate that the insurance policies complied with industry norms.In addition, there is no indication that the company was in any way attempting to evade taxation. In fact, the company could lower its workers’ compensation expenses as a result of using a captive. The only problem with Clougherty is that the insurance company is owned by the insured. As the dissent points out, this is not possible in any form under the majority’s ruling. In effect, the majority has run headlong into Moline Properties yet achieved a different result.
 Gen. Coun. Mem. 35629 (January 17, 1974).
 Carnation Co. v. C.I.R., 71 T.C. 400, 401 (1978).
 See Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78, (10th Circuit 1930) and Pan American Hide Co. v. Commissioner, 1 B.T.A. 1249 (1925).
 Cougherty Packing Co. v. C.I.R., 84 T.C. 948 (1985).
 Stearns Rogers Co. v. United States, 577 F.Supp. 833 (D. Colorado 1984), Beech Aircraft Corp. v. United States, 54 AFTR 2d 84-6173), Crawford Fitting Co. v. United States606 Fed. Supp. 136 (N.D. Ohio 1985).
 In Carnation, the petitioner initially capitalized its captive with $120,000. In addition, a contract existed between the parent and the captive that either could demand the parent to purchase an additional $2.8 million in preferred stock.

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