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Tax court decides captive issue in taxpayers' favor.

Tax Court Decides Captive Issue in Taxpayers' Favor P. Bruce Wright is a member of the New York Bar. He is also a member of the law firm LeBoeuf, Lamb, Leiby and MacRae.

The Tax Court decided three cases this year that allow taxpayers to deduct premiums paid to their wholly owned affiliated insurers. The cases of AMERCO v. Commissioner, The Harper Group v. Commissioner and Sears Roebuck & Co. v. Commissioner are convincing taxpayer victories. They also, no doubt, come as somewhat of a surprise to the Internal Revenue Service, which generally succeeds in these types of cases.

In all three cases the affiliated insurer had written a substantial amount of third party business. The amount varied from case to case, with more than 99 percent being unrelated in Sears to slightly less than 30 percent in The Harper Group. Although both Sears and AMERCO involved insurers established under the general insurance company laws of a state, and were thus regulated by a U.S. insurance commissioner, Harper involved a captive formed in Hong Kong and regulated under its laws.

Insurance Risk

The three cases rely on four principles enunciated first in AMERCO. The first principle, the presence of insurance risk, was interpreted as the presence of a hazard," wherein an insured contracts with an insurer to accept a premium in exchange for a promise to perform an act when a loss occurs. The court made it clear, however, that insurance risk is required and that investment risk is insufficient. If the facts demonstrate that all elements of insurance risk have been eliminated, the court stated that "insurance" is not present.

Regarding the principle of risk shifting and risk distributing, the court stated: "'Risk shifting' means one party shifts his risk of loss to another and 'risk distributing' means that the party assuming the risk distributes his potential liability, in part, among others." Risk shifting is thus defined to be determined from all facts and circumstances and to require that loss be shifted away from the taxpayer and that the arrangement not be the same as a reserve for self insurance.

Risk distributing is then described to emphasize insurance pooling; for example, an insurance contract involving many coverages combined to distribute risk among insureds. In two of the cases, the court noted that more money came from unrelated risks than from the taxpayer and its affiliates.

The third principle involved commonly accepted notions of insurance. The court, which was not clear as to what constituted "commonly accepted notions of insurance," stated in AMERCO: "We think that the technical indicia of insurance discussed above, supplemented by our analysis of the substance of the transactions at issue, combine to create insurance in the commonly accepted sense." Perhaps this factor will be clarified in future cases.

Federal Income Tax

Last, regarding general principles of federal income taxation, the court noted that the decisions in each of the three cases are consistent with federal tax principles, including general respect for separate corporate identity, consideration of substance as well as form, close examination of related party transactions and, as proffered in the case Gregory v. Helvering, "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits..."

An appeal of one or more of the cases as well as captive owners scrutinizing unrelated business is expected. However, a cautious approach will probably be taken regarding the assumption of third party business, given the poor experience many captives had during the 1980s when they assumed unrelated business.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Legal Considerations
Author:Wright, P. Bruce
Publication:Risk Management
Date:Apr 1, 1991
Words:597
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