Insurance in the captive setting.

• Author: Cuddy, Michael J.

In 1991, the Tax Court released its opinions in three separate cases, each involving an insurance company that insured both related and unrelated insureds: Sears, Roebuck and Co., 96 TC 61; The Harper Group, 96 TC 45; and AMERCO, 96 TC 18. In each case the IRS had disallowed deductions for all premium payments made by a corporation to an affiliated insurance company, based on the theory that no transfer of insurance risk had taken place. The Tax Court disagreed with the Service and held in each case that risk shifting and risk distribution had been accomplished through the pooling of related and unrelated risks; therefore, the premiums paid by the corporations affiliated with the captive insurance company were deductible.

In analyzing captive insurance cases, the IRS, and now the Tax Court, have formulated a distinct theory based on the principle that an insurance relationship exists only if risk shifting and risk distribution are present. However, they have fundamentally different ideas about when risk shifting and risk distribution are present in a given case. Additionally, the Tax Court has indicated that two more requirements must be met; there must be an insurance risk present, and the transaction must constitute insurance in its commonly accepted sense.

Relying on LeGierse, 312 US 531 (1941), the Service has developed the "economic family" doctrine to analyze captive insurance cases. As first announced in Rev. Rul. 77-316, and later amplified and clarified in Rev. Rul. 88-71, a parent company can never shift risk to its wholly owned subsidiary. This theory, which has been the IRS's cornerstone argument in every captive case decided to date, was concisely summarized in Sears. The parent company can never shift risk, or obtain true insurance, from its wholly-owned subsidiary because all of the subsidiary's underwriting losses on the business of its affiliates will ultimately impact the common parent company's income statement and balance sheet assets on a dollar-for-dollar basis.

In a number of previous decisions the Tax Court rejected the economic family theory, but nevertheless found that risk shifting and risk distribution were not present when a captive provided insurance primarily to related parties. In determining whether a transaction was truly insurance, the Tax Court based its decision on the facts and circumstances of each case. The court made no attempt to formulate a single analysis to ascertain whether risk shifting and...