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The Captive Insurance Case Law Timeline: UPS, Pt. I

5/30/2016

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On Wednesday, June 15th, we're hosting a webinar titled "An Introduction to Captive Insurance."  It starts at 1PM CST and will last for about half an hour.  You can sign up at this link.

We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. 
​

The UPS case is the last big captive case.  However, there is a bit of history between UPS and Harper that we need to explain before moving forward.

In the 1990s, the IRS expanded the scope of their captive litigation, targeting bigger companies.  Humana was one of the first truly large, fortune 500 style companies subject to captive litigation.  It was not the last.  Harper was a large, international company.  The service went so far as to argue Allstate -- then a subsidiary of Sears -- was a captive, even though Allstate wrote a a very small part of their business with Sears.  UPS fits with this general case theory of the service generally targeting larger companies after establishing a legal foundation with smaller companies.  However, this tactic did not work.  The dam started to burst with the Humana .  The service began to abandon the economic family doctrine in the Kidde caseby arguing a corporation was in fact a Nexus of contracts.  However, the court did not buy this argument which meant the service would again have to change their tactics in the UPS case if they wanted to continue litigating against captives.

Many practitioners argue that UPS represents the "final nail in the coffin" of captive litigation.  This is a generous reading that is belied by the facts of the case. First, the IRS won at trial by basing their argument on the assignment of income doctrine.  While the appellate court over-turned the trial court, they should not have as the lower court's decision was the correct outcome.  Simply put, UPS was a poorly designed transaction that should have gone against the taxpayer.  What's surprising about this result is that UPS' counsel was sophisticated enough to propose a diverse share ownership structure to avoid CFC application to the original captive, but completely blind when it came to the issue of anti avoidance law.  The lesson here is clear: if you're involved with captives (or any tax based planning) and you can't name the five anti-avoidance doctrines in US law (or, for good measure, the assignment of income doctrine), you have some CLE in your future.

While the lower court's decision prints at over 105 pages on Lexis, the appellate court's decision is 7 pages.  The lower court's decision goes into extensive detail supporting its decision, reprinting long excerpts from relevant testimony and explaining the law in "law review" detail.  The appellate court , frankly, could care less.  I often wonder whether they even read the entire decision.  They begin their legal analysis thusly: "It is not perfectly clear on what judicial doctrine the holding rests."  A reading of the case would have dispelled this statement, as the lower court was very clear.  In retrospect, I believe UPS represents more exhaustion than legal theory, as the appellate court is basically stating that, regardless of the thoroughness of the arguments at trial, captives will stand as a business tool.

Let's move forward with a basic outline of the case's facts.  The following excerpt is from my book, U.S. Captive Insurance Law: 

United Parcel Service (UPS) charged its clients an extra fee to insure packages above $100 in value.   This was income to UPS.   UPS’ insurance broker suggested UPS restructure this transaction to avoid the addition to UPS’ gross income of excess value charges.   UPS implemented this plan by forming a Bermudan captive named Overseas Partners (OPL) in 1983.   UPS then purchased an insurance policy from National Union Fire Insurance Company (NUF), who in turn purchased reinsurance from OPL.   As a result, the payment from UPS to NUF would be classified as an insurance premium and therefore deductible under 26 USC 162(a).  

The IRS attacked this arrangement, arguing “that the excess-value payment remitted ultimately to OPL had to be treated as gross income to UPS.”   In effect, the IRS was now making an assignment–of-income argument in an attempt to thwart UPS’ captive arrangement.   There were two reasons for this change of tactic.  First, the IRS’ previous arguments were not successful; no court had accepted the “economic family” doctrine, and after the court in Humana rejected that argument, the service made a new and unsuccessful use of the “corporations are a series of contracts” argument.  Secondly, the assignment of income doctrine avoided having to work around the separate corporate entity issue of the captive that had plagued previous captive cases.   



Next, I'll start to look at the lower court's legal reasoning.
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Reasons for Forming a Captive: Spiking Premium Costs

5/25/2016

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On Wednesday, June 15th, we're hosting a webinar titled "An Introduction to Captive Insurance."  It starts at 1PM CST and will last for about half an hour.  You can sign up at this link.

We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. 
​     

   While the laws of supply and demand affect the cost of insurance, the singular nature of the insurance business adds unique nuances to the pricing calculus.  The most important is the negative impact caused by higher than anticipated claims.  A number of sizeable payouts indicates insurers charged too little, a problem that can only be solved by increasing current rates.  Spiking premiums are a recurring cause of captive formation: they led to the creation of several early structures, contributed to the mid-1980s “insurance crisis” that led to Congress passing section 831(b), and are currently driving the formation of captives that underwrite cyber-liability coverage.

     Spiking insurance costs forced two pioneering captive companies to form a captive.  In the late 1960s, the Humana Hospital chain’s general liability policy became so expensive the company almost went without coverage.  And Stearns Rogers, a construction company specializing in building large manufacturing facilities, couldn’t find affordable general liability insurance during the same time period.  Rather than go “naked” (sometimes referred to as “self-funding”), both formed their own captive to address their needs. 

     This situation repeated in the 1980s.  The roots of the “liability crisis” can be traced to the late 1960s, when the plaintiff’s bar began filing cases alleging products liability, medical malpractice and environmental damage.  The latter category became the insurance industry’s Achilles’ heel, eventually causing astronomically large payouts.  Some companies went bankrupt; others were left less financially sound.  The end result was a large increase in insurance premiums.

     The situation is repeating today in the cyber liability market.  During the last year and half, retail chain Target, hospitals, and even central banks have reported large cyber breaches.  These have led to a “hardening” of the cyber liability market.  According to Reuters:

A rash of hacking attacks on U.S. companies over the past two years has prompted insurers to massively increase cyber premiums for some companies, leaving firms that are perceived to be a high risk scrambling for cover.

On top of rate hikes, insurers are raising deductibles and in some cases limiting the amount of coverage to $100 million, leaving many potentially exposed to big losses from hacks that can cost more than twice that.

These premium increases are normal and to be expected.

  Have you seen large increases in your insurance premiums?  If so, then forming a captive may be a viable option.  Please contact us at 832.330.4101 to discuss this idea in more detail.
     
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The IRS Losses: An Overview

5/22/2016

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On Wednesday, June 15th, we're hosting a webinar titled "An Introduction to Captive Insurance."  It starts at 1PM CST and will last for about half an hour.  You can sign up at this link.

We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. 
​

   Had the service continued to focus on smaller companies, it is entirely likely courts would have continued to rule in their favor.  However, beginning with Humana and continuing through the UPS case, the IRS sought bigger game.  At the time of trial in 1978, Humana was a publicly traded company that operated 92 hospitals over 23 states.[1]  Amerco -- more popularly known a U-Haul -- had 250 subsidiary corporations by 1984.[2]  Sears Roebuck was one of the largest retailers in the US and its “captive” Allstate was one of the country’s largest insurers.[3]  Harper was an international transportation company with subsidiaries throughout the world, including Taiwan, Singapore, Thailand, U.K., South Africa, Canada and Australia.[4]   
 
   In addition to the larger companies forming captives, three important structural developments emerged in response to the IRS victories.  First, most captives in these transactions had significant third party risk: the Harper captive contained 30% non-parent risk;[5] the Sears captive contained over 99% non-parent risk;[6] the captive in Amerco contained between 52%-74% non-parent risk[7] while the Ocean Drilling captive underwrote 56% and 57% non-parent business in the years in question.[8]  These large amounts of non-corporate group insureds gave the captive a sufficiently large pool of clients over which to distribute risk, allowing each to comply with the second prong of the Helvering standard.  Second, the captive insurance operations for most captives were elevated to legitimate corporate divisions with an adequate level of staff, separate books and records and their own offices.[9] 

   But most importantly, IRS victories were premised on a parent-captive relationship so inter-twined that the captive was conceptually transformed from a separate company to a financial account on the parent’s balance sheet -- a concept based on the parent owning all the captive’s stock.[10]  In direct contrast to the IRS victories, the captives in the IRS losses were insuring a larger group of “brother-sister” companies, meaning the companies purchasing insurance had no captive ownership interest.  This issue has its conceptual origins in the Clougherty case where the parent owned 100% of its insurance subsidiary.  There the court ruled for the IRS, noting

   When petitioner sustains losses covered by its workers' compensation insurance, 92 percent 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. … We hasten to point out, nevertheless, that parents and wholly owned subsidiaries are involved in Carnation and here. We express no opinion, however, as to situations where the taxpayer does not completely own the subsidiary [italics added].[11]
           
   This issue came to the forefront in the Humana case, where the holding company owned all the stock of various subsidiaries, one of which was captive.  While the lower and appellate courts determined Humana’s parent’s insurance premiums were non-deductible (because it owned 75% of the captive’s stock and therefor directly analogous to the fact pattern of the IRS victories), the appellate court ruled the premiums paid by the “brother-sister” companies were deductible because the brother sister companies had no ownership interest in the captive.  Central to this reasoning was the analysis provided by Dr. Irving Plotkin who noted,

“True insurance relieves the firm’s balance sheet of any potential impact of the financial consequences of the insured peril…[However] as long  as the firm deals with its captive, its balance sheet cannot be protected from the financial vicissitudes of the insured peril.”[12]  As the brother-sister companies did not own the captive’s stock, an indemnification payment would have no negative impact on their respective balance sheets, thereby removing the reasoning underlying the premium non-deductibility.[13]    

    And finally, one can’t help but conclude the sheer weight of the historical tide forced the courts to develop some type of compromise regarding the legality of captive insurance companies.  Perhaps the strongest historical thread was the continual implementation of captives for legitimate risk management purposes.  Insurance advisors also continued to promote and recommend this structure as a legitimate risk management tool while several US states passed captive insurance statutes with the obvious intent to attract business.  All these events occurred over the clearly stated objections of the service in its two Revenue Rulings and their continued filing of cases challenging the substance of a captive insurance company.  Unlike the numerous tax evasion cases and schemes of the 1990s, there was a clear business need for this concept.



[1] Humana Inc. v. Comm’r of Internal Revenue, 88 T.C. 197, 199 (1987)

[2] Amerco v. Comm’r of Internal Revenue 96 T.C. 18, 21 (1991)

[3] Sears, Roebuck and Co. v. Comm’r of Internal Revenue 96 T.C. 61, 63 (1991)

[4] The Harper Group v. Comm’r of Internal Revenue 96 T.C. 45, 49 (1991)

[5] Ocean Drilling and Exploration Corp. v. United States, 24 Cl. Ct. 714, 726 (1991); see also Harper at 51 (see chart showing that unrelated parties premium comprised between 29% to 72% of the captives premium income from 1974-1983)

[6] Id; see also Sears at 63 (“The total premiums for policies issued to Sears by Allstate represented approximately .25% to 1% percent o the total premiums earned by Allstate from all insureds on all lines of business for the years in issue.)”

[7] Id; see also Amerco at 26 (“Non-U-Haul policies provided a wide variety of insurance and reinsurance coverages.”)

[8] Id

[9] See Harper at 49 (“Rampart maintained its own books of account, business records, bank accounts and investments…Rampart conducted its business in a manner consistent with its status as a separate corporation.”); Amerco at 21 (“In 1979 it [the captive] was licensed in 12 states; by the end of 1985 it was licensed in 45 states and the District of Columbia.  Republic Western held A.E. Best Rating of “A” for 1980 through 1984.”; Allstate was one of the largest insurance companies in the United States;

[10] Mobil Oil Co.v United States, 8 Cl. Ct. 555, 566 (1985)(“Any losses suffered by the insurance affiliate would be reflected on Mobil’s financial statement.” See also Beech Aircraft Corp. v. United States, 1984 U.S. Dist. LEXIS 15251, page 11 (1984)(“…if and when a loss occurred and was paid by Travel Air, the net worth of Beech was reduced to approximately the same extent as though Beech had paid the loss itself.”); see discussion above

[11] Clougherty at 958-959

[12] Humana 88 T.C 197 at 211

[13] Humana 881 F.2d 247 at 250
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Reasons For Forming a Captive: A Complete Lack of Coverage

5/18/2016

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If you'd like to learn more, we'll be holding a webinar on June 15th, at 11AM, titled "An Introduction to Captive Insurance." You can sign up at this link.

We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. ​

     One of the most common questions we’re asked is, “Should my company form a captive insurance company?”  It’s not as easy to answer as you might think.  While some would respond “yes” simply to gain a client, the answer is actually more nuanced.  Forming and running a captive is unlike any business.  Not only will you have to hire a group of professionals such as a captive manager, actuaries, and CPAs, but you’ll also have to become familiar with concepts such as “duration matching” and “liquidity management.”  It’s not an undertaking for everybody.  And it helps if one of four fact patterns is driving the parent company’s decision making process, starting with the complete absence of any insurance coverage for a particular risk.

     In fact, this fact pattern led to the formation of the earliest captives when two companies that owned property near a river couldn’t find any flood insurance.  Recent flooding made it unprofitable for commercial insurers to sell this policy, forcing the Weber Paper Company and Consumers’ Oil Company to form their own insurers.  Weber formed a captive with other companies, while Consumers’ Oil formed a “single parent captive” – a captive that only insures the risk of one company.  The IRS challenged both transactions, arguing neither was an insurance company.  The Service won their case against Consumers’ Oil, but lost their challenge against Weber.  The outcomes aren’t as important as the fact that market failure, here the complete absence of any flood policies, forced businesses to find an alternate solution. 
​
     The absence of insurance is hardly a one-off event.  For example, the entire U.S. business market experienced an insurance shortage in the 1980s – a situation some refer to as the “commercial liability crisis.”  The situation was so dire that Time Magazine devoted an entire issue to the topic: they published it on March 24, 1986 and titled it, “Sorry America, Your Insurance Has Been Canceled.”  Academics and industry experts disagree on causation, but as with the case outcomes above, that’s not material.  The point is that a service many expected to be routinely available wasn’t.
​
     This situation repeated itself in the late 1990s, when Texas experienced a mold epidemic.  Due to a very humid environment, Texans use a large amount of air conditioning, which, in addition to cooling a building also de-humidifies it.  The water removed from the air has to go somewhere.  Unfortunately, at least some moisture winds up being trapped in the duct work.  The combination of excessive moisture and Texas heat led to mold colonies growing in a large number of buildings.  While some homeowners successfully sued their insurers to pay for mold remediation, the situation became too costly for some insurers, who eventually stopped writing the policy altogether.

      So, when looking at your insurance coverages, ask yourself, “have I been unable to locate a key coverage? Maybe you derive a significant percentage of your revenue from a key customer.  Or, perhaps your business is in California where it’s impossible to obtain hourly wage violation insurance.  Please call us at 832.330.4101 for a free review of your current policies to determine if certain coverages are unavailable in the third-party market making a captive a viable possibility.
    
     


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The Captive Insurance Case Law Timeline: The Harper Test

5/15/2016

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We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. 

Although they lost the Humana case, the service continued to file challenges to various captive insurance arrangements.  The Harper case -- which was a 1991 decision -- is important because it gives us a three prong test which a captive must comply with in order to be a "bona fide" captive.  The following is from our book:

The court introduced a new three-prong test to determine “the propriety of claimed insurance deductions by a parent or affiliated company to a captive insurance company.”   The three prongs are:
 

(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk  distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense. 


In addition, 

the tax treatment of an alleged insurance payment by a parent or affiliated company to a captive insurance company is to be governed by (1) the facts and circumstances of the particular case, and (2) principles of Federal taxation, rather than economic and risk management theories. 
 

Regarding the first point, the court noted:  “Basic to any insurance transaction must be risk.  An insured faces some hazard; an insurer accepts a premium and agrees to perform some act if or when the loss event occurs.”   This is a fairly easy point to prove, as all companies face at least general liability.  The second point is further codification of Helvering v. LeGierse, which was explained earlier.  Regarding the third point, the court will look at the facts to determine if the company was in fact a legitimate insurance company.  In this case, the court analyzed the facts thusly:

Rampart was organized and operated as an insurance company.  It was regulated by the Insurance Registry of Hong Kong.  The adequacy of Rampart’s capitalization is not in dispute.  The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm’s-length transactions.  The policies issued by Rampart were valid and binding.  In sum, such polices were insurance policies and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense. 

In other words, courts will now look at the entire insurance structure to determine if the company is a legitimate, stand-alone insurer.  If so, it will pass the Harper test.

End excerpt.

What's important about this test is the court is now adopting a facts and circumstances test to determine the validity of a captive insurance arrangement. Instead of the IRS arguing for an application of the economic family argument and the taxpayer defending with Moline Properties, the court will now look at the totality of the transaction to determine if the captive is in fact a viable, stand-alone insurance company.

The lesson for practitioners is clear: the captive must perform its affairs as a standard-alone company.  Accounts must be separate, regular meetings must be performed, separate and complete corporate records must be maintained, stock certificates must be issued, voting records must be kept, portfolios must look like an insurance company's portfolio, contracts must be up to date (not back-dated) etc....
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The Captive Insurance Case Law Timeline: Humana, Part III

5/8/2016

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We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. 

In Part I_, we looked at the background facts of the case, and learned that Humana was a near-perfect fact pattern.   Business circumstances forced the parent company to form a captive.  They considered a variety of options (and obviously documented same) and then formed a stand-alone company that was adequately capitalized, independently managed and charged a fair price for its insurance.  In Part II, we see a very well tried case for the plaintiff who took full advantage of the facts.  In addition, we get the first real explanation (at lease in a case record) of the thinking behind the economic family doctrine.  Finally, we see the first real cracks in the IRS' attacks, thanks to some of the insureds not being owners of captive stock.  The appellate court gives us the first taxpayer victory in a captive case:

With regard to the second issue, the brother-sister issue, we believe that the tax court incorrectly extended the rationale of Carnation and Clougherty in holding that the premiums paid by the subsidiaries of Humana Inc.  to Health Care Indemnity, as charged to them by Humana Inc., did not constitute valid insurance agreements with the premiums deductible under Internal Revenue Code § 162(a) (1954).  We must treat Humana Inc., its subsidiaries and Health Care Indemnity as separate corporate entities under Moline Properties.  When considered as separate entities, the first prong of LeGierse is clearly met.  Risk shifting exists between the subsidiaries and the insurance company.  There is simply no direct connection in this case between a loss sustained by the insurance company and the affiliates of Humana Inc. as existed between the parent company and the captive insurance company in both Carnation and Clougherty

Humana subsidiaries did not own captive stock.  The crux of the economic family argument -- that a payment from the captive to the parent would decrease the captive's stock value thereby preventing any real risk shifting from occurring -- did not apply.  And while the captive was part of the same economic family, the court had to treat it as a legally separate entity under the Moline Properties doctrine.  Also of importance was the Crawford case, which was the only economic family case that had separate and  divided captive ownership.

There is a second point from the court's reasoning that should be mentioned.  From the case:

The tax court misapplies this substance over form argument.  The substance over form or economic reality argument is not a broad legal doctrine designed to distinguish between legitimate and illegitimate transactions and employed at the discretion of the tax court whenever it believes that a taxpayer is taking advantage of the tax laws to produce a favorable result for the taxpayer … In general, absent specific congressional intent to the contrary, as is the situation in this case, a court cannot disregard a transaction in the name of economic reality and substance over form absent a finding of sham or lack of business purpose under the relevant tax statute

The service hinted at an anti-avoidance argument throughout its captive attacks, yet never fully developed the argument. In Humana, the court tells the Service make the argument openly.  At his time (the late 1980s) the two primary anti-avoidance arguments were the sham transaction and (lack of) business purpose doctrines (an argument could be made that the sham transaction had morphed into economic substance doctrine by this time, but I think the point is clear).  The Service did neither, which clearly impacted their credibility.

Humana was a watershed case that accomplished several important goals.  First, it stopped the IRS' momentum in the captive cases.  Second, it exposed the primary flaw of the economic family doctrine -- that a captive which insures a non-parent (a subsidiary of the parent) is providing insurance.  Third, it provided taxpayers with a planning blueprint for moving forward. 
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The Captive Insurance Case Law Timeline: Humana, Part II

5/1/2016

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We formed and operate the first series LLC in Montana (named Aegis) for captive insurers.  Several other firms provide key services such as accounting, audit and actuarial work.  Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company. 

We're presenting a webinar on Friday, May 6th, titled, "What Kind of Insurance Policies Does a Captive Issue, Anyway?" During the presentation, we'll provide a basic overview of common policy exclusions covered by captives, along with an explanation of other standard captive policies.  You can sign up at this link.

Humana lost the trial case but filed a petition for reconsideration.   The tax court withdrew its memorandum opinion and issued a full opinion after review by the 19-person court.   The written opinion contains a 12-member majority opinion, an 8-person concurrence, a 2- member concurring and a 7-member dissent.   The sole reason for Humana’s petition was to get a long opinion which the company could use for the basis of an appeal. 

The court first notes the many captive cases heard before Humana that apply directly to the non-deductibility of premiums from a parent to a wholly owned subsidiary.   In this case, that would represent the payments from the Humana parent to the subsidiary.  Next, the court notes “payments to a captive insurance company are equivalent to additions to a reserve for losses.”   If these payments are not deducible as insurance payments they are not deductible at all.   The court quickly dealt with this issue – the payments from the parent to the subsidiary – by citing previous cases (such as Carnation  and Clougherty ) and disallowing the deductions.     

The court next turns to the issue of the payments from Humana’s subsidiaries to the captive, which is referred to as the brother-sister issue.  In this situation, it is important to remember the logic of the non-deductibility of payments to the captive from the parent.  A payment from the captive would reduce the value of the captive’s stock.  Because the parent owned allthe captive’s stock, the captive’s payment would lower the value of the parent’s assets on its respective balance sheet.  Therefore, there was no risk shifting according to the standard established in Helvering v. LeGierse.  In Humana, the majority “extend[ed] the rationale [of Carnation and Clougherty] to the brother-sister fact pattern.”   They did so even though none of the subsidiaries owned any of the captive’s stock. 

This is a very large conceptual problem and illustrates a few very important salient points.  First, we're dealing with a very small and highly technical area of the law and finance.  And while the tax court is full of judges who are obviously verses in the tax code, they are obviously not as versed in the nature of the insurance business.  Secondly, as I noted at the end of the economic family cases, the taxpayers who originally defended captive cases versus the IRS put on a remarkable unsophisticated  defense.  Putting these two points together, it was imperative to this case that Human's counsel lead the court to water -- which they did.  I should also add that this case is a great demonstration of a very good litigation team in action.

The trial court relied extensively on the expert opinion of the IRS' witnesses.  As this was the first case which outlined their thoughts and reasoning, I'll quote them at length:

Commercial insurance is a mechanism for transferring the financial uncertainty arising from pure risks faced by one firm to another in exchange for an insurance premium.  Such financial uncertainty is caused by the possibility of certain types of occurrences that may have only adverse financial consequences.  A corporation such as Humana that places its risks in a captive insurance company that it owns, either directly or through a parent corporation, subsidiary, or a fronting company, is not relieving itself of this financial uncertainty.  The reason for this is simply that such corporation, through its ownership position, still holds the benefits and burdens of retaining the financial consequences of its own risks.  It has a dollar-for-dollar economic interest in the result of any ‘insured‘ peril. 

A term frequently used for the act of insuring is underwriting.  An essential element of the concept of underwriting is the transference of uncertainty from one firm to another, generally from the one whose activities naturally give rise to the uncertainty to one whose investors are in the business of accepting such uncertainty for the potential profit they can earn thereby.

Thus, insurers, and the interests that own them, are risk takers.  They assume the financial consequences of the risks for others in return for a premium payment. 

A question that perplexes some when initially confronted with the captive insurance area is whether or not respondent has chosen to treat, either directly or indirectly, two separate legal entities as one single economic unit.  One's first impression might be that, since a parent corporation can deal at arm's length with a subsidiary in other areas besides insurance and have such transactions respected by respondent, “insurance premiums” paid to a captive should not be treated any differently.  The answer to this paradox lies in the unique nature of insurance transactions relative to other types of parent/subsidiary transactions.

True insurance relieves the firm's balance sheet of any potential impact of the financial consequences of the insured peril.  For the price of the premiums, the insured rids itself of any economic stake in whether or not the loss occurs … however as long as the firm deals with its captive, its balance sheet cannot be protected from the financial vicissitudes of the insured peril.


The above quote explains why many practitioner's (myself included) refer to the economic family argument as the balance sheet argument.  The IRS' argument is essentially that the parents ownership of captive stock did not relieve the parent of the economic loss caused by the captive's payment to the parent.  There are a few major problems with this theory.  First, it assumes the correct -- and only -- method of valuing a company (here the captive) is the pure balance sheet method, namely that assets-liabilities = book value.  There are, in fact, many ways to value a company, most of which involve cash flow -- or some multiple thereof.  In addition, another popular and often used valuation method involves a multiple of EBITDA, which the above valuation method does not take into account in any fashion.   
In addition, the above statements do not take into account the relationship between the subsidiaries and the Humana -- in which the subs did not own any Humana stock.  This structure was a big part of the Crawford Fitting case -- which most likely provided some type of blueprint for the Humana structure and argument.  Here is a summation of that structure

Crawford involved three sets of companies.  The first set was Crawford, Nupro, Whitey and Cajon, all of which manufactured “valves and fittings … used in numerous applications.”  The second set of companies was the regional warehouses that purchased the manufacturers’ products.  The warehouses were broken down regionally, with one warehouse each for the eastern, southern, central and western U.S.  Each of these warehouses sold to a group of independent and exclusive Crawford distributors.  Mr. Fred Lennon was the sole owner of Crawford  and was also a majority owner of each regional warehouse.  In order to obtain reasonable products and general liability insurance, the Crawford companies created Constance Insurance Company in March 1978.  Each regional warehouse owned 20% of Constance while the remaining 20% was owned by a Crawford executive and one attorney who did extensive work for Crawford.

The diverse ownership structure was very important, and a fundamental reason the court ruled in favor of the taxpayer.  We'll build on this point in the next (and final) installment of the Humana case.
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