Captive insurance arrangement survives Tax Court scrutiny.

• Author: Puckett, Mark D.

In a recent case, the Tax Court upheld deductions for insurance premiums paid by a parent company's wholly owned subsidiaries to another wholly owned captive insurance subsidiary (Rent-A-Center, Inc., 142 T.C. No. 1 (1/14/14)). In Rent-A-Center, the Tax Court reexamined the Sixth Circuit's decision in Humana, Inc., 881 F.2d 247 (6th Cir. 1989), which had overturned, in part, the Tax Court's earlier decision (88 T.C. 197 (1987)) that risk shifting could not be accomplished in a brother-sister corporate subsidiary arrangement.

Elements of Insurance

Business insurance premiums are generally deductible expenses (Sec. 162(a) and Regs. Sec. 1.162-1(a)). Although the term "insurance" is not defined in either the Code or the regulations, the Supreme Court established two elements that must be present for an arrangement to be viewed as insurance: risk shifting and risk distribution (Helvering v. Le Gierse, 312 U.S. 531 (1941)). Risk shifting occurs where an identifiable risk is shifted from the insured to the insurer {Treganowan, 183 F.2d 288 (2d Cir. 1950), cert, denied, 340 U.S. 853 (1950)). Risk distribution looks at whether the insurer has pooled enough unrelated risks together to be generally unaffected by the occurrence of a single loss event (Beech Aircraft Corp., 797 F.2d 920 (10th Cir. 1986), aff'g No. 82-1369 (D. Kan. 7/3/84)).

The Tax Court has added two more criteria for an arrangement to constitute insurance. First, an arrangement must involve an insurance risk, and second, the characteristics of the arrangement must resemble a commonly accepted notion of insurance {Amerco, 96 T.C. 18 (1991), aff'd, 979 F.2d 162 (9th Cir. 1992)). Without meeting the above-established criteria, deductions may be postponed and characterized as self-insurance reserves requiring the self-insuring taxpayer to wait until losses occur and economic performance is met by actual payment {Clougherty Packing Co., 811 F.2d 1297 (9th Cir. 1987)).

Captive Insurance Companies

Captive insurance refers to an arrangement set up, usually by a large corporation, to secure the traditional benefits of insurance coverage, including the tax benefits, by placing its insurance business with a corporate entity owned by or related to the taxpayer. The IRS generally takes the position that a taxpayer has not bought insurance when it pays premiums to an entity it owns either directly or indirectly (or with whom it shares a parent) because the required elements of risk shifting and...