Tax Court releases decisions favorable for captive insurance risk distribution qualification.

• Author: Fairbanks, Greg A.

The Tax Court's decision regarding captive insurance arrangements in Rent-A-Center, 142T.C.No. 1 (2014), was an overall taxpayer-friendly result--albeit a lengthy opinion with a concurrence and two dissenting opinions. The Tax Court reached a similar decision in Securitas Holdings, Inc., T.C. Memo. 2014-225. Although both cases had complex facts (that ultimately favored the taxpayers) and both rulings delved into many aspects of captive insurance law, this item focuses specifically on the implications for satisfying the "risk distribution" requirement for having a valid captive insurance arrangement.

Captive insurance arrangements are often pursued as an alternative to third-party insurance and risk protection.

In a captive arrangement, a controlled subsidiary of a group of entities (often corporations) typically operates as an insurance company, providing insurance against loss risks affecting those entities. The captive insurance subsidiary can provide insurance to the various brother-sister members of the group and/or write insurance policies to third-party customers outside the group. From a business perspective, this type of arrangement may provide a better method for managing group risks as well as potentially reducing the premiums needed to insure against those risks. (This is because the insurance company within the group may have lower overhead costs than a third-party insurer, or the group overall may have less risk of loss and would pay higher rates to a third-party insurer that also covered riskier insureds.) From a tax perspective, the captive insurance arrangement provides the benefit of a deduction for loss reserves. Also, insureds are allowed to deduct insurance premiums paid.

Case law has developed a four-factor test for determining whether a putative captive insurance arrangement qualifies as a Sec. 831 insurance company (and, thus, can derive the tax benefits above): (1) The risks being insured must be insurable; i.e., there must be a probability of a future risk-of-loss event's occurring and a quantification of possible loss (e.g., if a loss event has already occurred and the only issue is the extent of the damages, that is not insurance); (2) the arrangement must be insurance in the commonly accepted sense; thus, the putative captive company should operate like a true insurance company--a "Potemkin village" arrangement, in which the captive does not act in substance like a true insurer, will not do; (3) risk shifting...