IRS's captive appeals fall on deaf ears; mortgage issue is lost as well.

• Author: Shuster, Addison H.

The Seventh Circuit (in Sears Roebuck, 972 F2d 858 (1992), aff'g 96 TC 61 (1991)) and the Ninth Circuit (in AMERCO, 979 F2d 162 (1992), aff'g 96 TC 18 (1991), and Harper, 979 F2d 1341 (1992), aff'g 96 TC 45 (1991)) have affirmed the validity of an insurance arrangement between a parent corporation and its wholly owned subsidiary insurer.

In these three cases, the Tax Court had ruled that when a captive had insured both related and unrelated risks, all risks qualified as insurance. The U.S. Claims Court reached the same conclusion in Ocean Drilling, 24 Cl. Ct. 714 (1991).

The amount of unrelated risks in each of the Tax Court cases varied significantly. Unrelated risk in Sears exceeded 99% of its subsidiary's (Allstate) total business, while the unrelated risks in AMERCO ranged from 52% to 74%, and in Harper from 29% to 33%. Clearly the high level of unrelated risks in Sears helped prove that the combined risk pool of related and unrelated risks was sufficient to distribute the risk that Sears was placing, thus lowering its overall risk of loss. However, even with significantly lower levels in AMERCO and Harper, the Ninth Circuit concluded that the combined risk pool was sufficient to produce the necessary elements of risk shifting and risk distribution, thus affirming the existence of insurance. In addition, the Ninth Circuit's acceptance of the Tax Court's three-part definition of insurance as (1) the presence of insurance risk, (2) risk shifting and risk distribution and (3) insurance in its commonly accepted sense appears to have opened the door for captives to qualify even when unrelated risks are under 50%.

In each of the cases, a great deal of emphasis was placed on the definition of insurance. Based on the 1941 Supreme Court decision in LeGierse, 312 US 531, the Tax Court had determined that an insurance arrangement must include elements of both risk shifting and risk distribution in order to be treated as insurance for tax purposes.

The Seventh Circuit took a different approach. Calling any attempt to define insurance for tax purposes a "tricky definitional" problem the court noted that "it is a blunder to treat a phrase in an opinion [in LeGierse] as if it were statutory language."

The Seventh Circuit (and by agreement, the Ninth Circuit) went on to state that perhaps the provision of risk shifting and risk distribution was of lesser consequence than the form of the transaction and the form of the corporate structure. The court...