Captive insurance arrangements limited, not eliminated.

• Author: Owens, Kevin

The Sixth Circuit has reversed the Tax Court's decision in Malone & Hyde, Inc., 62 F3d 835 (1995), and held that "brother-sister" insurance contracts were not insurance contracts for Federal tax purposes. The Sixth Circuit did not, however, reverse its own holding in Humana, 881 F2d 247 (1989). Accordingly, contracts between brother-sister companies can be considered to be insurance contracts for Federal tax purposes, provided that these insurance arrangements meet the requirements established by the Sixth Circuit in Humana and the following additional requirements now set out in Malone & Hyde

* There is a legitimate business reason for entering into the insurance arrangement. * The captive insurance company is adequately capitalized, not measured solely by reference to the minimum legal capitalization requirement of the jurisdiction in which the insurance company is located. * The parent or affiliates have not entered into indemnification or "hold-harmless" agreements relating to the captive insurance company.

In 1977, Malone & Hyde established a wholly owned Bermuda insurance subsidiary, Eastland, to provide reinsurance for itself and its subsidiaries. Eastland was capitalized at the minimum requirement under Bermuda law ($120,000). During the years in question, Eastland did not insure the risks of any unrelated third party. Northwestern provided primary coverage for Malone & Hyde and its wholly owned operating subsidiaries and divisions, providing workers' compensation, automobile liability and general liability insurance coverage.

Under a reinsurance agreement between Eastland and Northwestern, Northwestern reinsured the first $150,000 of coverage per claim with Eastland. Malone & Hyde also executed hold-harmless agreements with Northwestern under which Malone & Hyde agreed that in the event Eastland defaulted on its obligations as reinsurer of Northwestern, Malone & Hyde would hold Northwestern harmless for any liability.

In its original memorandum opinion, the Tax Court held that Malone & Hyde was not entitled to deduct as business expenses those portions of the amounts paid to Northwestern as insurance premiums that were in turn paid or "ceded" by Northwestern to Eastland as reinsurance premiums. Malone & Hyde filed a motion for reconsideration and requested permission to supplement the record on the brother-sister" issue in light of the Sixth Circuit's decision in Humana. On reconsideration, the Tax Court applied the Humana decision...