Opinion ID: 548352
Heading Depth: 2
Heading Rank: 2

Heading: Deductibility of Insurance Premiums Paid to Insurance

Text: Subsidiary 63 Under I.R.C. Sec. 162(a), insurance premiums are deductible as ordinary and necessary business expenses. The premium is the means by which two unrelated parties measure the cost of the risk-shifting. Whereas insurance premiums are deductible expenses, amounts entered into self-insurance funds are not. Clougherty Packing Co. v. Comm'r, 811 F.2d 1297, 1300 (9th Cir.1987). As the Supreme Court stated in Le Gierse, both [h]istorically and commonly insurance involves risk-shifting and risk-distributing. Le Gierse, 312 U.S. at 539, 61 S.Ct. at 649. Thus, to be permitted to take an insurance deduction, the relationship between the parties must actually result in a shift of risk. Id. at 540-41, 61 S.Ct. at 649-50. 64 Gulf asserts that it meets this standard because it created a separate legal identity in Insco for risk shifting and, in fact, Insco insured the risks of unrelated parties, evidence of risk distributing. (In tax year 1975, 2 percent of Insco's premium income came from unrelated parties.) 65 The threshhold question we must address is whether Insco's insurance coverage to Gulf and its affiliates satisfies both the element of risk transfer and that of risk distribution, regardless of whether Insco insured risks of unrelated parties, if Gulf and its affiliates, both domestic and foreign, are each viewed as separate entities. Where separate agreements are interdependent, they must be considered together so that their overall economic effect can be assessed. Clougherty Packing Co., 811 F.2d at 1301. 66 In Moline Properties v. Comm'r, 319 U.S. 436, 439, 63 S.Ct. 1132, 1134, 87 L.Ed. 1499 (1943), the Court held that a corporation must be recognized as a separate taxable entity if that corporation's purpose is the equivalent of a business activity or is followed by the carrying on of a business. The Court of Appeals for the Sixth Circuit relied on this proposition in Humana Inc. v. Comm'r, 881 F.2d 247, 252 (6th Cir.1989), when it held that fellow subsidiaries of a captive insurer, i.e. in a brother-sister relationship, could properly deduct insurance premium payments to that insurer. 67 In Humana, the Tax Court expressly recognized the legal, financial and economic substance of insurance provided by a wholly owned insurance subsidiary to its brother-sister affiliates. Humana Inc. v. Comm'r, 88 T.C. 197 (1987). Nonetheless, on appeal, the court of appeals suggested that a parent's insured loss paid by the insurance subsidiary would have a dollar-for-dollar impact on the parent's net worth. Although many of the facts in Humana are similar to those in this case, critical distinguishing facts exist. In contrast to the facts here, (1) the captive insurer in Humana was fully capitalized initially; (2) no agreement ever existed under which Humana, Inc. or any Humana subsidiary would contribute additional capital to the insurer; and (3) Humana, Inc. and the hospital subsidiaries never contributed additional amounts to the insurer nor took any steps to insure the insurer's performance. In contrast, Insco began as an undercapitalized subsidiary and Gulf executed guarantees in effect during the tax years at issue to protect its primary insurers, AIG and OIA, should Insco fail to meet its obligations as reinsurer. It is thus difficult to see that Gulf truly transferred the risk to Insco during the years in question. 68 We conclude that the Tax Court did not err in finding that the risk was not here appropriately shifted to the insurance subsidiary during 1974 and 1975. Gulf's arguments that it actually paid premiums to Insco, that Insco was required to establish and maintain appropriate reserves and to satisfy other regulatory requirements imposed by Bermuda law, that each insured had rights against Insco under insurance contracts, and that the source for payment of their claims included premiums paid by others and Insco's capital, do not address the crucial question of whether there was transfer of financial risk. Le Gierse, 312 U.S. at 540, 61 S.Ct. at 649, Clougherty Packing Co., 811 F.2d at 1300. 69 Our decision is consistent with previous opinions of the Tax Court. The Tax Court has held that payments to a captive subsidiary, designated as premiums, whether from the parent corporation or from other subsidiaries, did not represent payments for insurance. See Carnation Co. v. Comm'r, 71 T.C. 400 (1978), aff'd, 640 F.2d 1010 (9th Cir.1981); Clougherty Packing Co., 84 T.C. 948 (1985); Humana v. Comm'r, 88 T.C. 197 (1987), aff'd in part, rev'd in part, 881 F.2d 247 (6th Cir.1989) (disallowing insurance premium deductions on the parent-subsidiary relationship, allowing brother-sister subsidiary to deduct the insurance premiums). Thus, the Tax Court has plainly held that where the captive was wholly owned by its parent, and the captive insured risks only within the affiliated group, the risk is not truly distributed. 70 We recognize that with regard to the tax year 1975, the majority of the Tax Court held that the 2% net premiums from unrelated parties was de minimis and did not demonstrate the existence of a true transfer of risk. One concurring judge of the Tax Court warns that the court's opinion will create a problem because at some point the majority's analysis will require a line to be drawn as to when third party premiums are no longer de minimis. He argued that, as far as risk transfer is concerned, there can be no true risk transfer when a captive insurance company is involved. In response, another concurring judge rejected that analysis as not invoking insurance law principles but relying, rather, on economic theory. The lone dissenter would have adopted the concurring economic theory, but disagreed with the majority's overreaching opinion. 71 We need not reach the issue which divided the judges of the Tax Court--whether the addition of unrelated insurance premiums into the insurance pool for tax year 1975 establishes risk transfer and justifies the deduction of insurance premiums paid by the unrelated party to the insurance pool. It is clear to us that, because of the guarantee to the primary insurers, Gulf and Insco did not truly transfer the risk, nor was there a de facto risk distribution to third parties, elements crucial to the allowance of a premium deduction.C. Constructive Dividends 72 We turn now to the insurance premiums paid by Gulf's foreign affiliates to Insco and to the claims paid by Insco to Gulf and its domestic affiliates, which the Commissioner argues constitute constructive dividends to Gulf. His theory is that where funds are transferred from one such sibling corporation to another, ... the funds pass from the transferor to the common stockholder as a dividend and then to the transferee as a capital contribution. Sammons, 472 F.2d at 453. 73 In Sammons, the Court of Appeals for the Fifth Circuit formulated a two-part test to determine whether a transfer of property from one corporation to another corporation constitutes a constructive dividend to a common shareholder in both corporations. The first prong of the test is objective and requires a determination that there was a distribution of funds. 74 A transfer of funds by a corporation to another corporation which the former owns directly or indirectly can be a constructive dividend to the individual controlling stockholder only if (1) the funds are diverted from the parent-subsidiary corporate structure and come within the control of the stockholder, and (2) no adequate consideration for the diversion passes from the stockholder to the corporation, i.e., there must be a net distribution. 75 Sammons, 472 F.2d at 453-54. The second prong of the Sammons test is a subjective determination. Thus, a constructive dividend will be found where, in addition to the determination of distribution, the business justifications [for the transfer] put forward are not of sufficient substance to disturb a conclusion that the distribution was primarily for shareholder benefit. Sammons, 472 F.2d at 452 (emphasis in original). 76 The Tax Court found that the second prong was not met since the insurance premium payments in question were for the benefit of the affiliates, i.e., the affiliates were provided risk coverage. In other words, there was an adequate business reason for the payment of funds, here risk insurance, by the affiliates to Insco. The benefit to Gulf was tangential, the same benefit it would have received if an outside third-party insurer were to insure the losses of Gulf's affiliates. 77 The Commissioner provides no strong reason, support or authority to compel us to overturn either the Tax Court's factual determination of an adequate business reason for the transfer or the legal conclusion that the payments in question do not constitute constructive dividends to Gulf. D. Conclusion 78 The Tax Court did not err in denying a Sec. 162 business expense deduction for insurance premiums paid to Gulf's captive insurance subsidiary (Insco) by Gulf and its domestic affiliates or in refusing to categorize the insurance premiums paid by Gulf's foreign affiliates to Insco and claims paid by Insco to Gulf's domestic affiliates as constructive dividends. 79 We will thus affirm the Tax Court's decision on these cross-appeals.