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.
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The following is an excerpt from our book, "U.S. Captive Insurance Law, Second Edition."
The first fact pattern outlined in Revenue Ruling 77-316 is entirely insular:
During the taxable year domestic corporation X and its domestic subsidiaries entered into a contract for fire and other casualty insurance with S1, a newly organized wholly owned foreign “insurance” subsidiary of X. S1 was organized to insure properties and other casualty risks of X and its domestic subsidiaries. X and its domestic subsidiaries paid amounts as casualty insurance premiums directly to S1. Such amounts reflect commercial rates for the insurance involved. S1 has not accepted risks from parties other than X and its domestic subsidiaries.
In other words, the captive only deals with other subs – it writes no policies outside the corporate family, nor does it obtain any reinsurance. The captive is expected to stand on its own. Several cases successfully prosecuted by the IRS illustrate how the service attacked this fact pattern.
The plaintiff in Stearns Rogers designed and manufactured “large mining, petroleum and power generation plants.” In order to bid on projects, the company had to obtain insurance for its own contractors as well as its clients. Starting in the early 1970s, the company “found it difficult or impossible to obtain from traditional companies the types and huge amounts of coverage needed.” Therefore the company formed a captive insurance company under the Colorado Captive Insurance Company Act. In order to gain approval from the Colorado Insurance Commissioner, Stearns Rogers had to demonstrate the company could not find other insurance. The plaintiff named the company Glendale Insurance Company, which only issued insurance policies for the plaintiff, the plaintiff’s subsidiaries and the plaintiff’s clients. Glendale did not use reinsurance. The plaintiff agreed to indemnify the captive for up to three million dollars. The plaintiff deducted payments it made to Glendale under the theory that the payments were insurance premiums. The service disallowed the deductions, claiming the payments were in fact self-insurance or payments to a reserve which are not deductible.
At trial, the service advanced its “economic family” argument, while the plaintiff argued the payments were insurance premiums paid between two distinct corporate entities, thereby invoking Moline Properties. After an analysis that determined the captive was formed for a legitimate business purpose (and therefore not a sham for tax purposes), the court ruled Stearns-Rogers and Glendale Insurance were two distinct corporate entities which should be recognized. Next the court explained the “economic family” doctrine of Revenue Ruling 77-316, citing from Carnation v. Commissioner, “The essence of that ruling [Carnation] is that there can be no deduction where, in actuality, there has been no shifting of risk outside the economic family.” To bolster its argument, the court distinguishes Stearns Rogers from Weber Paper Company, stating,
“Its [Stearns Rogers] problem is that in contrast with the Weber Paper Company, it did not ally itself with others similarly situated so that the risk of any one member’s flood loss would be shifted to the “economic families” of the other insured members.
In effect, because Glendale did not insure any other company’s risks, there was no risk shifting. There was no insurance, because “profits and losses stay within the Stearns Rogers “economic family.” In substance the arrangement shifts no more risk from Stearns Rogers than if Stearns Rogers self-insured.”
The appeals court affirmed the district court. They first noted that self-insurance plans do not constitute insurance. They next noted that risk did not leave the “parent company.” The payments for coverage went from parent to subsidiary but the ultimate burden for losses was always on the parent.”[DL1]  In effect, the court is arguing Stearns Rogers established a reserve fund without actually stating same. In addition, the appeals court sidesteps the problems of not properly applying Moline Properties to the fact pattern by noting,
The separation [between the companies] is not ignored. Instead the focus must be on the nature and consequences of the payments by the parent and the Supreme Court’s requirement that there must be a shift of risk to have insurance … The comparison of the arrangement here made to self-insurance cannot be ignored.
This is the exact same reasoning offered by the service regarding the possible problems of Moline Properties:
However, we are of the view that the concept of independent corporate identity is not being challenged by the rationale espoused. We do not propose to ignore the taxpayer’s separate identity. Rather, the proposed ruling examines the transaction for its economic reality.
The service is making an anti-abuse argument by asking the court to look beyond legally and legitimately established corporate forms to see an “economic family.” In effect, the service is advancing a new anti-avoidance theory.
In Beech Aircraft v. U.S., the plaintiff lost a jury verdict of $21,700,000 in 1971. The old insurance policy did not allow Beech to investigate claims against the company or participate meaningfully in their legal defense. As a result, Beech formed a captive insurance company in Bermuda on March 2, 1972 named Travel Air Insurance Company, Ltd. Travel Air was originally capitalized with $120,000. Beech paid a $1.5 million dollar premium to Travel Air for a $2 million dollar policy for the fiscal year September 1, 1971 to August 31, 1972. Beech made no assurances to Travel Air that Beech would “pay any losses which occurred greater than the excess insurance carried by Travel Air, nor did it agree to further enlarge the capital structure of Travel Air in any event.” Beech obtained an additional policy from Fairfax Underwriters for $10 million. While Travel Air sought outside business after 1973, that occurred after the period in question for this case.
The court’s reasoning was short. First they noted that a transaction’s substance governs the tax consequences – which is essentially an anti-avoidance argument. The court’s primary ruling dealt with the corporate inter-relationship of Beech and Travel Air; because Beech owned a majority of Travel Air’s stock, a payment from Travel Air would lower Beech’s net worth: “Here the gain or loss enjoyed or suffered by Travel Air is reflected directly on the net worth of the parent Beech. In addition, because Travel Air had a capitalization of $150,000, they would have to ask Beech for additional capital in the event of a payout larger than $150,000.
Not stated, but certainly implied by the ruling, is the circular nature of the cash flows. Beech paid a premium to Travel Air who would in turn pay Beech in the event of a claim against Beech. In effect, Travel Air was a reserve fund for Beech that simply stored funds until requested by Beech. Hence, the court’s quoting of the primary anti-avoidance concept of substance over form in conjunction with this concern: “It is conceivable, though unlikely, that if no losses were encountered, the deduction of purported insurance premiums could become a tax loophole for the parent company.”
 Rev. Rul 77-316.
 Stearns-Rogers Corp., Inc. v. U.S., 577 F. Supp. 833, 834, (Colorado 1984).
 Id at 834-835.
 Id at 835.
 Id .
 Id .
 Id at 835-836.
 Id at 836.
 Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Circuit 1981).
 Stearns-Rogers at 837.
 Id at 838.
 Stearns Rogers Corp. v. U.S., 774 F.2d 414, (10th Circuit 1985).
 Id at 415.
 Id at 416.
 Gen. Coun. Memo. 35349 (May 15, 1973).
 Beech Aircraft v. U.S., 1984 WL 988 at 1.
 Id .
 Id at 2.
 Gregory v. Helvering.
 Id at CONCLUSIONS OF LAW paragraph 4.
 Id at paragraph 5.
 Id at ADDITIONAL SPECIFIC FINDINGS OF FACT paragraph 14.