Seventh Circuit opens door for captive insurance.

• Author: Stretch, C. Clinton

The past few years have witnessed an increasing erosion of the IRS's anticaptive insurance position. The latest loss for the Service comes in the Seventh Circuit's affirmation of a Tax Court ruling that Sears, Roebuck and Co.'s payment of premiums to its wholly owned subsidiary, Allstate Insurance, was a deductible payment of insurance premiums. Although most observers felt that the IRS was bound to lose in litigation on the Sears-Allstate arrangement, the Seventh Circuit decision is notable for its departure from the course set in prior captive insurance litigation.

Pre-1989 case law

and Humana

Starting with Rev. Rul. 77-316, the Service took the position that, when members of the same affiliated group attempted to create insurance between them, they failed to do so; it was not possible to accomplish a shifting and a distribution of insurance risk, as required by the definition of insurance articulated in Helvering v. Le Gierse, 312 US 531 (1941). The essence of the IRS position was that risk shifting and risk distribution could not, as a matter of law, occur within the same economic family.

Taxpayers argued that, under Moline Properties, 319 US 436 (1943), the separate corporate entities within a group of related corporations had to be respected.

Before 1989, the courts almost uniformly agreed with the substance of the IRS's position while explicitly rejecting the economic family argument. Instead, the courts relied on the Le Gierse test and found that insurance by a parent with its subsidiary failed to create the requisite risk shift (from the parent) and risk distribution (with other insureds).

The extent to which the Service was winning its battle against captive insurance arrangements could be seen in the Ninth Circuit's decision in Clougherty Packing Co., 811 F2d 1297 (9th Cir. 1987). In that case, the court squarely addressed the Moline Properties argument and held that, even respecting the separate nature of the entities, the purported insured had not effectuated a transfer of its risk when it insured with a subsidiary because its assets (either directly or in the form of its investment in the subsidiary) remained at risk for any loss.

See, also, for example, the almost perfunctory manner in which the Third Circuit affirmed the Tax Court in Gulf Oil, 914 F2d 396 (3d Cir. 1990), aff'g 89 TC 1010 (1987), by citing Le Gierse and Clougherty Packing along with a number of other cases treating transactions between parents and subsidiaries as not creating insurance for the parent.

Two 1987 Tax Court decisions (Gulf Oil and Humana, 88 TC 197 (1987)), however, contained the seeds of later defeats on the captive insurance issue. In Gulf Oil, the IRS challenged a classic captive insurance arrangement and prevailed. The taxpayer, however, argued that the presence of insured third-party risks allowed the arrangement to satisfy the Le Gierse test.

The court rejected the taxpayer's argument, because for the years at issue premiums from third parties were de minimis (22% of total premiums). However, the court added the following footnote:

Without expert testimony, we decline to determine what portion of unrelated premiums would be sufficient for the affiliated group's premiums to be considered payments for insurance. However, if at least 50 percent are unrelated, we cannot believe that sufficient risk transfer would not be...