Rent-A-Center, Inc. v. Commissioner

RENT-A-CENTER, INC. AND AFFILIATED SUBSIDIARIES,

PETITIONERS v. COMMISSIONER OF INTERNAL

REVENUE, RESPONDENT

Docket Nos. 8320–09, 6909–10, Filed January 14, 2014.

21627–10.

P, a domestic corporation, is the parent of numerous wholly

owned subsidiaries including L, a Bermudian corporation. P

conducted its business through stores owned and operated by

its subsidiaries. The other subsidiaries and L entered into

contracts pursuant to which each subsidiary paid L an

amount, determined by actuarial calculations and an alloca-

tion formula, relating to workers’ compensation, automobile,

and general liability risks, and, in turn, L reimbursed a por-

tion of each subsidiary’s claims relating to these risks. P’s

subsidiaries deducted, as insurance expenses, the payments to

L. In notices of deficiency issued to P, R determined that the

payments were not deductible. Held: P’s subsidiaries’ pay-

ments to L are deductible, pursuant to I.R.C. sec. 162, as

insurance expenses.

Val J. Albright and Brent C. Gardner, Jr., for petitioners.

R. Scott Shieldes and Daniel L. Timmons, for respondent.

FOLEY, Judge: Respondent determined deficiencies of

$14,931,159, $13,409,628, $7,461,039, $5,095,222, and

$2,828,861 relating, respectively, to Rent-A-Center, Inc.

(RAC), and its subsidiaries’ 2003, 1 2004, 2005, 2006, and

2007 (years in issue) consolidated Federal income tax

returns. The issue for decision is whether payments to

Legacy Insurance Co., Ltd. (Legacy), were deductible, pursu-

ant to section 162, 2 as insurance expenses.

FINDINGS OF FACT

RAC, a publicly traded Delaware corporation, is the parent

of a group of approximately 15 affiliated subsidiaries (collec-

1 Respondent,

in his amended answer, asserted an additional $2,603,193

deficiency relating to 2003.

2 Unless otherwise indicated, all section references are to the Internal

Revenue Code (Code) in effect for the years in issue, and all Rule ref-

erences are to the Tax Court Rules of Practice and Procedure.

1

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2 142 UNITED STATES TAX COURT REPORTS (1)

tively, petitioner). During the years in issue, petitioner was

the largest domestic rent-to-own company. Through stores

owned and operated by RAC’s subsidiaries, petitioner rented,

sold, and delivered home electronics, furniture, and appli-

ances. The stores were in all 50 States, the District of

Columbia, Puerto Rico, and Canada. From 1993 through

2002, petitioner’s company-owned stores increased from 27 to

2,623. During the years in issue, RAC’s subsidiaries owned

between 2,623 and 3,081 stores; had between 14,300 and

19,740 employees; and operated between 7,143 and 8,027

insured vehicles.

I. Petitioner’s Insurance Program

In 2001, American Insurance Group (AIG), in response to

a claim against RAC’s directors and officers (D&O), withdrew

a previous offer to renew RAC’s D&O insurance policy. To

address this problem, RAC engaged Aon Risk Consultants,

Inc. (Aon), which convinced AIG to renew the policy.

Impressed with Aon’s insurance expertise and concerned

about its growing insurance costs, petitioner engaged Aon to

analyze risk management practices and to broker workers’

compensation, automobile, and general liability insurance.

With Aon’s assistance, petitioner developed a risk manage-

ment department and improved its loss prevention program.

Prior to August 2002, Travelers Insurance Co. (Travelers)

provided petitioner’s workers’ compensation, automobile, and

general liability coverage through bundled policies. Pursuant

to a bundled policy, an insurer provides coverage and con-

trols the claims administration process (i.e., investigating,

evaluating, and paying claims). Travelers paid claims as they

arose and withdrew amounts from petitioner’s bank account

to reimburse itself for any claims less than or equal to peti-

tioner’s deductible (i.e., a portion of an insured claim for

which the insured is responsible). Pursuant to a predeter-

mined formula, each store was allocated, and was responsible

for paying, a portion of Travelers’ premium costs.

In 2001, after receiving a $3 million invoice from Travelers

for ‘‘claim handling fees’’, petitioner became dissatisfied with

the cost and inefficiency associated with its bundled policies.

On August 5, 2002, petitioner, with the assistance of Aon,

obtained unbundled workers’ compensation, automobile, and

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 3

general liability policies from Discover Re. Pursuant to an

unbundled policy, an insurer provides coverage and a third-

party administrator manages the claims administration

process. Discover Re underwrote the policies; multiple

insurers provided coverage; 3 and Specialty Risk Services,

Inc. (SRS), 4 a third-party administrator, evaluated and paid

claims. Petitioner and its staff of licensed adjusters had

access to SRS’ claims management system and monitored

SRS to ensure the proper handling of claims. This arrange-

ment gave petitioner greater control over the claims adminis-

tration process.

Petitioner, pursuant to the Discover Re policies’

deductibles, was liable for a specific amount of each claim

against its workers’ compensation, automobile, and general

liability policies (e.g., pursuant to its 2002 workers’ com-

pensation policy, petitioner was liable for the first $350,000

of each claim). Petitioner’s retention of a portion of the risk

resulted in lower premiums.

II. Legacy’s Inception

Between 1993 and 2002, petitioner rapidly expanded and

became increasingly concerned about its growing risk

management costs. In 2002, after analyzing petitioner’s

insurance program, Aon suggested that petitioner form a

wholly owned insurance company (i.e., a captive). Aon rep-

resentatives informed David Glasgow, petitioner’s director of

risk management, about the financial and nonfinancial bene-

fits of forming a captive. Aon convincingly explained that a

captive could help petitioner reduce its costs, improve effi-

ciency, obtain otherwise unavailable coverage, and provide

accountability and transparency. Mr. Glasgow presented the

proposal to petitioner’s senior management, who concurred

with Mr. Glasgow’s recommendation to further explore the

formation of a captive. Petitioner’s senior management

directed Aon to conduct a feasibility study (i.e., relying on

petitioner’s workers’ compensation, automobile, and general

3 The following insurers provided coverage: U.S. Fidelity & Guarantee

Co., Fidelity & Guaranty Insurance Co., Discover Property and Casualty

Insurance Co., St. Paul Fire & Marine Co. of Canada, and Fidelity Guar-

anty Insurance Underwriters Inc.

4 SRS was affiliated with the Hartford Insurance Co., a well-established

insurer, and did not have a contract with Discover Re.

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4 142 UNITED STATES TAX COURT REPORTS (1)

liability loss data) and to prepare loss forecasts and actuarial

studies. Petitioner engaged KPMG to analyze the feasibility

study, review tax considerations, and prepare financial

projections.

Aon, in the feasibility study, recommended that the captive

be capitalized with no less than $8.8 million. Before deciding

where to incorporate the captive, RAC analyzed projected

financial data and reviewed multiple locations. On December

11, 2002, RAC incorporated, and capitalized with $9.9 mil-

lion, 5 Legacy, a wholly owned Bermudian subsidiary. 6

Legacy opened an account with Bank of N.T. Butterfield and

Son, Ltd., and, on December 20, 2002, filed a class 1 insur-

ance company registration application with the Bermuda

Monetary Authority (BMA), which regulated Bermuda’s

financial services sector. A class 1 insurer may insure only

the risk of its shareholders and affiliates; must be capitalized

with at least $120,000; and must meet a minimum solvency

margin calculated by reference to the insurer’s net pre-

miums, general business assets, 7 and general business liabil-

ities. See Insurance Act, 1978, secs. 4B, 6, Appleby (2008)

(Berm.); Insurance Returns and Solvency Regulations, 1980,

Appleby, Reg. 10(1), Schedule I, Figure B (Berm.). During the

years in issue, the BMA had the authority to modify pre-

scribed requirements through both prospective and retro-

active directives for special allowances. See Insurance Act,

1978, sec. 56.

Legacy planned to insure petitioner’s liabilities for the

period beginning in 2002 and ending December 31, 2003 (pro-

posed period). Aon informed petitioner that coverage pro-

5 RAC contributed $9.9 million of cash and received 120,000 shares of

Legacy capital stock with a par value of $1.

6 Legacy elected, pursuant to sec. 953(d), to be treated as a domestic cor-

poration for Federal income tax purposes. In addition, Legacy engaged Aon

Insurance Managers (Bermuda), Ltd., to monitor Legacy’s compliance with

Bermudian regulations and to provide management, financial, and admin-

istrative services.

7 The Bermuda Insurance Act, the Insurance Accounts Regulations, and

the Insurance Returns and Solvency Regulations reference ‘‘general busi-

ness’’, ‘‘admitted’’, and ‘‘relevant’’ assets. See Insurance Act, 1978, sec. 1,

Appleby (2008) (Berm.); Insurance Accounts Regulations, 1980, Appleby,

Schedule III, Pt. 1, 13 (Berm.); Insurance Returns and Solvency Regula-

tions, 1980, Appleby, Reg. 10(3), 11(4) (Berm.). For purposes of this Opin-

ion, there is no significant difference among these terms.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 5

vided by unrelated insurers would be more costly than Aon’s

estimate of Legacy’s premiums and that some insurers would

not be willing to offer coverage. In response to a quote

request, Discover Re stated that it was not in the market to

provide the coverage Legacy contemplated. Discover Re esti-

mated, however, that its premium (i.e., if it were to write one

relating to the proposed period) would be approximately $3

million more than Legacy’s.

III. Petitioner’s Policies

During the years in issue, petitioner obtained unbundled

workers’ compensation, automobile, and general liability poli-

cies from Discover Re. Pursuant to these policies, Discover

Re provided petitioner with coverage above a predetermined

threshold relating to each line of coverage. In addition,

Legacy wrote policies that covered petitioner’s workers’ com-

pensation, automobile, and general liability claims below the

Discover Re threshold. Petitioner, depending on the amount

of a covered loss, could seek payment from Legacy, Discover

Re, or both companies.

The annual premium Legacy charged petitioner was

actuarially determined using Aon loss forecasts and was allo-

cated to each RAC subsidiary that owned covered stores.

RAC was a listed policyholder pursuant to the Legacy poli-

cies. No premium was attributable to RAC, however, because

it did not own stores, have employees, or operate vehicles.

RAC paid the premiums relating to each policy, 8 estimated

petitioner’s total insurance costs (i.e., Legacy policies, Dis-

cover Re policies, third-party administrator fees, overhead,

etc.), and established a monthly rate relating to each store’s

portion of these costs. The monthly rate was based on three

factors: each store’s payroll, each store’s number of vehicles,

and the total number of stores. At the end of each year, RAC

adjusted the allocations to ensure that its subsidiaries recog-

nized their actual insurance costs. SRS administered all

claims relating to petitioner’s workers’ compensation, auto-

8 From

December 31, 2002, through September 12, 2003, Legacy incurred

a $4,861,828 liability relating to claim reimbursements due petitioner. This

amount was netted against petitioner’s September 12, 2003, premium pay-

ment (i.e., petitioner paid a net premium of $37,938,472 rather than the

$42,800,300 gross premium).

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6 142 UNITED STATES TAX COURT REPORTS (1)

mobile, and general liability coverage. During the years in

issue, the terms of Legacy’s coverage varied, Legacy progres-

sively covered greater amounts of petitioner’s risk, and

Legacy did not receive premiums from any unrelated entity.

From December 31, 2002, through December 30, 2007,

Legacy earned net underwriting income of $28,761,402. See

infra p. 10.

A. Legacy’s Deferred Tax Assets

Pursuant to the Legacy policies, coverage began on

December 31 of each year. Because petitioner was a calendar

year accrual method taxpayer, these policies created tem-

porary timing differences between income recognized for tax

purposes and income recognized for financial accounting

(book) purposes. 9 For example, on December 31, 2002, when

Legacy’s second policy became effective, Legacy recognized,

for tax purposes, the full amount of the premium (i.e.,

$42,800,300) relating to the taxable year ending December

31, 2002. See sec. 832(b)(4). For book purposes, however,

Legacy in 2002 recognized only 1/365 of the premium (i.e.,

$117,261), and the remaining $42,683,039 constituted a

reserve. This timing difference created a deferred tax asset

(DTA) because in 2002 Legacy ‘‘prepaid’’ its tax liability

relating to income it recognized, for book purposes, in 2003.

Each day Legacy recognized a portion of its premium income

(i.e., $117,261) for book purposes and reduced its reserve by

the same amount. On December 30, 2003, the reserve was

fully depleted. Upon the issuance of a new policy on

December 31, 2003, a new DTA was created because Legacy

recognized, for tax purposes, in 2003 the full amount of the

premium; a corresponding tax liability was incurred; the pre-

mium reserve increased; and most of the premium income

attributable to the 2003 policy was recognizable, for book

purposes, in 2004.

9 Each

premium was generally paid in September of the year following

the year in which the policy became effective. Use of the recurring item

exception allowed petitioner to claim a premium deduction relating to the

year in which the policy became effective, rather than the following year

when the premium was actually paid. See sec. 461(h)(3)(A)(iii). On August

28, 2007, petitioner filed Form 3115, Application for Change in Accounting

Method, requesting permission to revoke its use of the recurring item ex-

ception.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 7

1. Bermuda’s Minimum Solvency Margin Requirement

Pursuant to the Bermuda Insurance Act, an insurance

company must maintain a minimum solvency margin. See

Insurance Act, 1978, sec. 6. More specifically, a class 1

insurer’s general business assets must exceed its general

business liabilities by the greatest of : $120,000; 10% of the

insurer’s loss and loss expense provisions plus other insur-

ance reserves; or 20% of the first $6 million of net premiums

plus 10% of the net premiums which exceed $6 million. See

Insurance Returns and Solvency Regulations, 1980, Appleby,

Reg. 10(1), Schedule I, Figure B. DTAs generally may be

treated as general business assets only with the BMA’s

permission.

2. Legacy Receives Permission To Treat DTAs as General

Business Assets Through 2003

In the minimum solvency margin calculation set forth in

its insurance company registration application, Legacy

treated DTAs as general business assets. On March 11, 2003,

Legacy petitioned the BMA for the requisite permission to do

so. The following letter from RAC accompanied the request:

We write to confirm to you that Rent-A-Center, Inc., * * * will guar-

antee the payment to Legacy Insurance Company, Ltd. (the ‘‘Company’’),

* * * of all amounts reflected on the projected balance sheets of the

Company previously delivered to you as deferred tax assets arising from

timing differences in the amounts of taxes payable for tax and financial

accounting purposes. This guaranty of payment will take effect in the

event of any change in tax laws that would require recognition of an

impairment of the deferred tax asset, and will be effective to the extent

of the amount of the impairment.

On March 13, 2003, the BMA granted Legacy permission

to treat DTAs as general business assets on its statutory bal-

ance sheet through December 31, 2003. 10 The BMA also

informed Legacy that from December 31, 2002, through

March 13, 2003, it ‘‘wrote insurance business without being

in receipt of its Certificate of Registration and was therefore

in violation of the [Bermuda Insurance] Act as it engaged in

insurance business without a license.’’ Despite this violation,

the BMA registered Legacy as a class 1 insurer effective

10 See infra pp. 9–10.

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8 142 UNITED STATES TAX COURT REPORTS (1)

December 20, 2002 (i.e., the date Legacy filed its insurance

registration request and before it issued policies relating to

the years in issue).

3. The Parental Guaranty: Facilitating the Treatment of

DTAs as General Business Assets Through 2006

In response to the recurring DTA issue, Legacy requested

that RAC guarantee DTAs relating to subsequent years. On

September 17, 2003, RAC’s board of directors authorized the

execution of a guaranty of ‘‘the obligations of Legacy to

comply with the laws of Bermuda.’’ On the same day, RAC’s

chairman and chief executive officer executed a parental

guaranty and sent it to Legacy’s board of directors. The

parental guaranty provided:

The undersigned, Rent-A-Center, Inc. a Delaware corporation (‘‘Rent-A-

Center’’) is sole owner of 100% of the issued and outstanding shares in

your share capital and as such DOES HEREBY GUARANTEE financial

support for you, Legacy Insurance Co., Ltd., * * * and for your business,

as more particularly set out below, which is to say:

Under the [Bermuda] Insurance Act * * * and related Regulations (the

‘‘Act’’), Legacy Insurance Co., Ltd., must maintain certain solvency and

liquidity margins and, in order to ensure continued compliance with the

Act, it is necessary to support Legacy Insurance Co., Ltd. with a guar-

antee of its liabilities under the Act (the ‘‘Liabilities’’) not to exceed

Twenty-Five Million US dollars (US $25,000,000).

Accordingly, Rent-A-Center DOES HEREBY GUARANTEE to you the

payment in full of the Liabilities of Legacy Insurance Co., Ltd. and fur-

ther to indemnify and hold harmless Legacy Insurance Co., Ltd. from

the Liabilities up to the maximum dollar amount [$25,000,000] indicated

in the foregoing paragraph.

Seeking regulatory approval to treat DTAs as general busi-

ness assets in subsequent years, Legacy, on October 30,

2003, petitioned the BMA and attached the parental guar-

anty.

On November 12, 2003, the BMA issued a directive which

‘‘approved the Parental Guarantee from Rent-A-Center, Inc.

dated 17th September, 2003 up to an aggregate amount of

$25,000,000 for utilization as part of * * * [Legacy]’s capital-

ization’’. This approval was granted for the years ending

December 31, 2003, 2004, 2005, and 2006. Legacy used the

parental guaranty only to meet the minimum solvency

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 9

margin (i.e., to treat DTAs as general business assets). 11 On

December 30, 2006, RAC unilaterally canceled the parental

guaranty because Legacy met the minimum solvency margin

without it.

B. Legacy’s Ownership of RAC Treasury Shares

Legacy purchased RAC treasury shares during 2004, 2005,

and 2006. The BMA approved the purchases and allowed

Legacy to treat the shares as general business assets for pur-

poses of calculating its liquidity ratio (i.e., its ratio of general

business assets to liabilities). Pursuant to Bermuda solvency

regulations, an insurer fails to meet the liquidity ratio if the

value of its general business assets is less than 75% of its

liabilities. See Insurance Returns and Solvency Regulations,

1980, Appleby, Reg. 11(2). During the years in issue, Legacy

met its liquidity ratio and did not resell the shares.

C. Legacy’s Financial Reports

For each policy period, Legacy’s auditor, Arthur Morris &

Co. (Arthur Morris), prepared, and provided to RAC and the

BMA, reports and financial statements. In these reports and

statements, Arthur Morris calculated Legacy’s DTAs, 12 min-

imum solvency margin, 13 premium-to-surplus ratio, 14 and

net underwriting income. 15 During each of the years in

issue, Legacy’s total statutory capital and surplus equaled or

exceeded the BMA minimum solvency margin. In calculating

total statutory capital and surplus, Arthur Morris took into

account the following four components: contributed surplus,

statutory surplus, capital stock, and other fixed capital (i.e.,

assets deemed to be general business assets). During 2003,

2004, and 2005, Legacy included portions of the parental

guaranty as general business assets. During the years in

11 See

infra pp. 9–10.

12 See

supra p. 6.

13 See supra p. 7.

14 Premium-to-surplus ratio is one measure of an insurer’s economic per-

formance. On Legacy’s reports and statements, Arthur Morris referred to

Legacy’s premium-to-surplus ratio as the ‘‘premium to statutory capital &

surplus ratio’’. For purposes of this Opinion, there is no significant dif-

ference between these terms.

15 Net underwriting income equals gross premiums earned minus under-

writing expenses.

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10 142 UNITED STATES TAX COURT REPORTS (1)

issue, the amounts of Legacy’s DTAs exceeded the portions of

Legacy’s parental guaranty treated as general business

assets. See table infra. Arthur Morris calculated Legacy’s

statutory surplus by adding statutory surplus at the begin-

ning of the year and income for the year, subtracting divi-

dends paid and payable, and making other adjustments

relating to changes in assets.

The following table summarizes key details relating to Leg-

acy’s policies:

Parental Minimum Net

Policy guaranty Total statutory solvency Premium-to- underwriting

period Premium DTAs asset capital & surplus margin surplus ratio income

2003 $42,800,300 $5,840,613 $4,805,764 $5,898,192 $5,898,192 8.983:1 $1,587,542

2004 50,639,000 6,275,326 4,243,823 7,036,573 7,036,572 7.695:1 (982,000)

2005 54,148,912 7,659,009 3,987,916 8,379,436 8,379,435 6.369:1 8,411,912

2006 53,365,926 8,742,425 -0- 10,014,206 9,284,601 6.326:1 8,810,926

2007 63,345,022 9,689,714 -0- 12,428,663 10,888,698 5.221:1 10,933,022

2008 64,884,392 9,607,661 -0- 23,712,022 11,278,359 2.538:1 18,391,392

IV. Procedural History

Respondent sent petitioner, on January 7, 2008, a notice of

deficiency relating to 2003; on December 22, 2009, a notice

of deficiency relating to 2004 and 2005; and on August 5,

2010, a notice of deficiency relating to 2006 and 2007 (collec-

tively, notices). In these notices, respondent determined that

petitioner’s payments to Legacy were not deductible pursuant

to section 162. On April 6, 2009, March 22, 2010, and Sep-

tember 29, 2010, respectively, petitioner, whose principal

place of business was Plano, Texas, timely filed petitions

with the Court seeking redeterminations of the deficiencies

set forth in the notices. After concessions, the remaining

issue for decision is whether payments to Legacy were

deductible.

OPINION

In determining whether payments to Legacy were deduct-

ible, our initial inquiry is whether Legacy was a bona fide

insurance company. See Harper Grp. v. Commissioner, 96

T.C. 45, 59 (1991), aff ’d, 979 F.2d 1341 (9th Cir. 1992);

AMERCO v. Commissioner, 96 T.C. 18, 40–41 (1991), aff ’d,

979 F.2d 162 (9th Cir. 1992). We respect the separate taxable

treatment of a captive unless there is a finding of sham or

lack of business purpose. See Moline Props., Inc. v. Commis-

sioner, 319 U.S. 436, 439 (1943); Harper Grp. v. Commis-

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 11

sioner, 96 T.C. at 57–59. Respondent contends that Legacy

was a sham entity created primarily to generate Federal

income tax savings.

I. Legacy Was Not a Sham.

A. Legacy Was Created for Significant and Legitimate

Nontax Reasons.

After successfully resolving petitioner’s D&O insurance

problem, Aon evaluated petitioner’s risk management depart-

ment. Petitioner, with Aon’s assistance, improved risk

management practices, switched from bundled to unbundled

policies, and hired SRS as a third-party administrator. Aon

proposed that petitioner form a captive, and petitioner deter-

mined that a captive would allow it to reduce its insurance

costs, obtain otherwise unavailable insurance coverage, for-

malize and more efficiently manage its insurance program,

and provide accountability and transparency relating to

insurance costs. Petitioner engaged KPMG to prepare finan-

cial projections and evaluate tax considerations referenced in

the feasibility study. Federal income tax consequences were

considered, but the formation of Legacy was not a tax-driven

transaction. See Moline Props., Inc. v. Commissioner, 319

U.S. at 439; Britt v. United States, 431 F.2d 227, 235–236

(5th Cir. 1970); Bass v. Commissioner, 50 T.C. 595, 600

(1968). To the contrary, in forming Legacy, petitioner made

a business decision premised on a myriad of significant and

legitimate nontax considerations. See Jones v. Commissioner,

64 T.C. 1066, 1076 (1975) (‘‘A corporation is not a ‘sham’ if

it was organized for legitimate business purposes or if it

engages in a substantial business activity.’’); Bass v. Commis-

sioner, 50 T.C. at 600.

B. There Was No Impermissible Circular Flow of Funds.

Respondent further contends that Legacy was ‘‘not an inde-

pendent fund, but an accounting device’’. In support of this

contention, respondent cites a purported ‘‘circular flow of

funds’’ through Legacy, RAC, and RAC’s subsidiaries.

Respondent’s expert, however, readily acknowledged that he

found no evidence of a circular flow of funds, nor have we.

Legacy, with the approval of the BMA, purchased RAC

treasury shares but did not resell them. Furthermore, peti-

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12 142 UNITED STATES TAX COURT REPORTS (1)

tioner established that there was nothing unusual about the

manner in which premiums and claims were paid. Finally,

respondent contends that the netting of premiums owed to

Legacy during 2003 is evidence that Legacy was a sham. We

disagree. This netting was simply a bookkeeping measure

performed as an administrative convenience.

C. The Premium-to-Surplus Ratios Do Not Indicate That

Legacy Was a Sham.

Respondent emphasizes that, during the years in issue,

Legacy’s premium-to-surplus ratios were above the ratios of

U.S. property and casualty insurance companies and Ber-

muda class 4 insurers 16 (collectively, commercial insurance

companies). On cross-examination, however, respondent’s

expert admitted that his analysis of commercial insurance

companies contained erroneous numbers. Furthermore, he

failed to properly explain the profitability data he cited and

did not include relevant data relating to Legacy. Moreover,

his comparison, of Legacy’s premium-to-surplus ratios with

the ratios of commercial insurance companies, was not

instructive. Commercial insurance companies have lower pre-

mium-to-surplus ratios because they face competition and, as

a result, typically price their premiums to have significant

underwriting losses. They compensate for underwriting

losses by retaining sufficient assets (i.e., more assets per

dollar of premium resulting in lower premium-to-surplus

ratios) to earn ample amounts of investment income. Cap-

tives in Bermuda, however, have fewer assets per dollar of

premium (i.e., higher premium-to-surplus ratios) but gen-

erate significant underwriting profits because their pre-

miums reflect the full dollar value, rather than the present

value, of expected losses. Simply put, the premium-to-surplus

ratios do not indicate that Legacy was a sham.

D. Legacy Was a Bona Fide Insurance Company.

Petitioner presented convincing, and essentially uncontra-

dicted, evidence that Legacy was a bona fide insurance com-

pany. As respondent concedes, petitioner faced actual and

16 A class 4 insurance company may carry on insurance business, includ-

ing excess liability business or property catastrophe reinsurance business.

See Insurance Act, 1978, sec. 4E.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 13

insurable risk. Comparable coverage with other insurance

companies would have been more expensive, and some insur-

ance companies (e.g., Discover Re) would not underwrite the

coverage provided by Legacy. In addition, RAC established

Legacy for legitimate business reasons, including: increasing

the accountability and transparency of its insurance oper-

ations, accessing new insurance markets, and reducing risk

management costs. Furthermore, Legacy entered into bona

fide arm’s-length contracts with petitioner; charged actuari-

ally determined premiums; was subject to the BMA’s regu-

latory control; met Bermuda’s minimum statutory require-

ments; paid claims from its separately maintained account;

and, as respondent’s expert readily admitted, was adequately

capitalized. See Humana Inc. & Subs. v. Commissioner, 881

F.2d 247, 253 (6th Cir. 1989), aff ’g in part, rev’g in part and

remanding 88 T.C. 197, 206 (1987); Harper Grp. v. Commis-

sioner, 96 T.C. at 59. Moreover, the validity of claims Legacy

paid was established by SRS, an independent third-party

administrator, which also determined the validity of claims

pursuant to the Discover Re policies. See Harper Grp. v.

Commissioner, 96 T.C. at 59. Finally, RAC’s subsidiaries did

not own stock in, or contribute capital to, Legacy.

II. The Payments to Legacy Were Deductible Insurance

Expenses.

The Code does not define insurance. The Supreme Court,

however, has established two necessary criteria: risk shifting

and risk distribution. See Helvering v. Le Gierse, 312 U.S.

531, 539 (1941). In addition, the arrangement must involve

insurance risk and meet commonly accepted notions of insur-

ance. See Harper Grp. v. Commissioner, 96 T.C. at 58;

AMERCO v. Commissioner, 96 T.C. at 38. These four criteria

are not independent or exclusive, but establish a framework

for determining ‘‘the existence of insurance for Federal tax

purposes.’’ See AMERCO v. Commissioner, 96 T.C. at 38.

Insurance premiums may be deductible. A taxpayer may not,

however, deduct amounts set aside in its own possession to

compensate itself for perils which are generally the subject

of insurance. See Clougherty Packing Co. v. Commissioner, 84

T.C. 948, 958 (1985), aff ’d, 811 F.2d 1297 (9th Cir. 1987). We

consider all of the facts and circumstances to determine

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14 142 UNITED STATES TAX COURT REPORTS (1)

whether an arrangement qualifies as insurance. See Harper

Grp. v. Commissioner, 96 T.C. at 57. Respondent contends

that payments to Legacy represent amounts petitioner set

aside to self-insure its risks.

A. The Policies at Issue Involved Insurance Risk.

Respondent concedes that petitioner faced insurable risk

relating to all three types of risk: workers’ compensation,

automobile, and general liability. Petitioner entered into con-

tracts with Legacy and Discover Re to address these three

types of risk. Thus, insurance risk was present in the

arrangement between petitioner and Legacy.

B. Risk Shifting

We must now determine whether the policies at issue

shifted risk between RAC’s subsidiaries and Legacy. This

requires a review of our cases relating to captive insurance

arrangements.

1. Precedent Relating to Parent-Subsidiary Arrangements

In 1978, we analyzed parent-subsidiary captive arrange-

ments for the first time. See Carnation Co. v. Commissioner,

71 T.C. 400 (1978), aff ’d, 640 F.2d 1010 (9th Cir. 1981). In

Carnation, the parties entered into two insurance contracts:

an agreement between Carnation and an unrelated insurer,

and a reinsurance agreement between the captive and the

unrelated insurer. Id. at 402–404. The unrelated insurer

expressed concern to Carnation about the captive’s financial

stability and requested a letter of credit or other guaranty.

Id. at 404. Carnation refused to issue a letter of credit or

other guaranty but did execute an agreement to provide,

upon demand, $2,880,000 of additional capital to the captive.

Id. at 402–404. We held, relying on Le Gierse, that the

parent-subsidiary arrangement was not insurance because

the three agreements (i.e., the two insurance contracts and

the agreement to further capitalize the captive), when consid-

ered together, were void of insurance risk. Id. at 409. The

Court of Appeals for the Ninth Circuit affirmed and con-

cluded that our application of Le Gierse was appropriate

given the interdependence of the three agreements. See

Carnation Co. v. Commissioner, 640 F.2d at 1013. Further-

more, the Court of Appeals held that ‘‘[t]he key was that

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 15

* * * [the unrelated insurer] refused to enter into the

reinsurance contract with * * * [the captive] unless Carna-

tion’’ executed the capitalization agreement. See id.

In Clougherty, our next opportunity to analyze a parent-

subsidiary captive arrangement, the parties entered into two

insurance contracts: an agreement between Clougherty and

an unrelated insurer, and a reinsurance agreement between

the captive and the unrelated insurer. Clougherty Packing

Co. v. Commissioner, 84 T.C. at 952. We concluded that ‘‘the

operative facts [17] in the instant case * * * [were] indistin-

guishable from the facts in Carnation’’, analyzed Clougherty’s

balance sheet, and held that risk did not shift to the captive:

We found in Carnation, as we find here, that to the extent the risk

was not shifted, insurance does not exist and the payments to that

extent are not insurance premiums. The measure of the risk shifted is

the percentage of the premium not ceded. This is nothing more than a

recharacterization of the payments which petitioner seeks to deduct as

insurance premiums. [Id. at 956, 958–959.]

The Commissioner urged us to adopt his economic family

theory, which posits that

the insuring parent corporation and its domestic subsidiaries, and the

wholly owned ‘‘insurance’’ subsidiary, though separate corporate entities,

represent one economic family with the result that those who bear the

ultimate economic burden of loss are the same persons who suffer the

loss. To the extent that the risks of loss are not retained in their entirety

by * * * or reinsured with * * * insurance companies that are unre-

lated to the economic family of insureds, there is no risk-shifting or risk-

distributing, and no insurance, the premiums for which are deductible

under section 162 of the Code. [Rev. Rul. 77–316, 1977–2 C.B. 53, 54.]

In rejecting the Commissioner’s economic family theory, we

emphasized that ‘‘[w]e have done nothing more in Carnation

and here but to reclassify, as nondeductible, portions of the

payments which the taxpayers deducted as insurance pre-

miums but which were received by the taxpayer’s captive

insurance subsidiaries.’’ See Clougherty Packing Co. v.

Commissioner, 84 T.C. at 960.

17 Our

Opinion emphasized that the ‘‘operative’’ facts related to the

‘‘interdependence of all of the agreements’’ as confirmed by the ‘‘execution

dates’’. See Clougherty Packing Co. v. Commissioner, 84 T.C. 948, 957

(1985), aff ’d, 811 F.2d 1297 (9th Cir. 1987).

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16 142 UNITED STATES TAX COURT REPORTS (1)

The Court of Appeals for the Ninth Circuit affirmed our

decision in Clougherty and applied a balance sheet and net

worth analysis, pursuant to which a determination of

whether risk has shifted depends on whether a covered loss

affects the balance sheet and net worth of the insured. See

Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305.

In defining insurance, the Court of Appeals stated that ‘‘a

true insurance agreement must remove the risk of loss from

the insured party.’’ Id. at 1306. The Court of Appeals elabo-

rated:

[W]e examine the economic consequences of the captive insurance

arrangement to the ‘‘insured’’ party to see if that party has, in fact,

shifted the risk. In doing so, we look only to the insured’s assets, i.e.,

those of Clougherty, to determine whether it has divested itself of the

adverse economic consequences of a covered workers’ compensation

claim. Viewing only Clougherty’s assets and considering only the effect

of a claim on those assets, it is clear that the risk of loss has not been

shifted from Clougherty. [Id. at 1305.]

Furthermore, the Court of Appeals explained that the bal-

ance sheet and net worth analysis does not ignore separate

corporate existence:

Moline Properties requires that related corporate entities be afforded

separate tax status and treatment. It does not require that the Commis-

sioner, in determining whether a corporation has shifted its risk of loss,

ignore the effect of a loss upon one of the corporation’s assets merely

because that asset happens to be stock in a subsidiary. Because we only

consider the effect of a covered claim on Clougherty’s assets, our analysis

in no way contravenes Moline Properties. [Id. at 1307.]

Finally, the Court of Appeals concluded that ‘‘[t]he parent of

a captive insurer retains an economic stake in whether a cov-

ered loss occurs. Accordingly, an insurance agreement

between parent and captive does not shift the parent’s risk

of loss and is not an agreement for ‘insurance.’ ’’ Id.

2. Precedent Relating to Brother-Sister Arrangements,

In Humana Inc. & Subs. v. Commissioner, 88 T.C. at 206,

we were faced with two distinct issues: the deductibility of

premiums paid by a parent to a captive (parent-subsidiary

arrangement) and the deductibility of premiums paid by

affiliated subsidiaries to a captive (brother-sister arrange-

ment). Humana, Inc. (Humana), operated a hospital network

and, in 1976, was unable to renew its existing policies

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 17

relating to workers’ compensation, malpractice, and general

liability. Id. at 200. Humana’s insurance broker could not

obtain comparable coverage and recommended that Humana

establish a captive insurance company. Id. Humana subse-

quently incorporated, and capitalized with $1 million, a Colo-

rado captive. Id. at 201–202. The captive provided coverage

relating to Humana and its subsidiaries’ workers’ compensa-

tion, malpractice, and general liability. Id. at 202–204.

Humana paid the captive a monthly premium which was

allocated among itself and each operating subsidiary. Id. at

203.

We held that the parent-subsidiary premiums were not

deductible because Humana did not shift risk to the captive.

See id. at 206–207. The brother-sister arrangement, however,

presented an issue of first impression. See id. at 208. We

rejected the Commissioner’s economic family theory and held

‘‘that it is more appropriate to examine all of the facts to

decide whether or to what extent there has been a shifting

of the risk from one entity to the captive insurance com-

pany.’’ See id. at 214. We extended our rationale from Carna-

tion and Clougherty (i.e., recharacterizing a captive insurance

arrangement as self-insurance) to brother-sister arrange-

ments and stated that declining to do so ‘‘would exalt form

over substance and permit a taxpayer to circumvent our

holdings by simple corporate structural changes.’’ See id. at

213. The report on which we relied, prepared by Irving

Plotkin, stated: ‘‘ ‘A firm placing its risks in a captive insur-

ance company in which it holds a sole or predominant owner-

ship position, is not relieving itself of financial uncertainty.’ ’’

Id. at 210 (fn. ref. omitted). In addition, the report stated:

‘‘True insurance relieves the firm’s balance sheet of any potential

impact of the financial consequences of the insured peril. For the price

of the premiums, the insured rids itself of any economic stake in

whether or not the loss occurs. * * * [However] as long as the firm deals

with its captive, its balance sheet cannot be protected from the financial

vicissitudes of the insured peril.’’ [Id. at 211–212; alteration in original;

fn. ref. omitted.]

After quoting extensively from the report and analyzing the

facts, ‘‘[w]e conclude[d] that there was not the necessary

shifting of risk from the operating subsidiaries of Humana

Inc. to * * * [the captive] and, therefore, the amounts

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18 142 UNITED STATES TAX COURT REPORTS (1)

charged by Humana Inc. to its subsidiaries did not constitute

insurance.’’ See id. at 214.

Seven Judges concurred with the opinion of the Court’s

parent-subsidiary holding but disagreed with the brother-

sister holding. See Humana Inc. & Subs. v. Commissioner, 88

T.C. at 219 (Ko¨rner, J., concurring and dissenting). They

found the opinion of the Court’s rationale ‘‘disingenuous and

entirely unconvincing’’ and asserted that the opinion of the

Court had implicitly adopted the Commissioner’s ‘‘economic

family’’ theory. Id. at 223. After emphasizing that the

subsidiaries had no ownership interest in the captive, paid

premiums for their own insurance, and would not be affected

(i.e., their balance sheets and net worth) by the payment of

an insured claim, the dissent further stated:

The theory of Helvering v. Le Gierse, 312 U.S. 531 (1941), may have been

adequate to sustain the holdings in Carnation and Clougherty, where

only a parent and its insurance subsidiary were involved. It cannot be

stretched to cover the instant brother-sister situation, where there was

nothing—equity ownership or otherwise—to offset the shifting of risk

from the hospital subsidiaries to * * * [the captive]. If the majority is

to accomplish the fell deed here, ‘‘a decent respect to the opinions of

mankind requires that they should declare the causes which impel them’’

to such a result. [Id. at 224; fn. ref. omitted.]

The Court of Appeals for the Sixth Circuit affirmed our

decision relating to the parent-subsidiary arrangement, but

reversed our decision relating to the brother-sister arrange-

ment. 18 See Humana Inc. & Subs. v. Commissioner, 881 F.2d

at 251–252. The Court of Appeals for the Sixth Circuit

adopted the Court of Appeals for the Ninth Circuit’s balance

sheet and net worth analysis and held that the subsidiaries’

payments to the captive were deductible. Id. at 252 (‘‘[W]e

look solely to the insured’s assets, * * * and consider only

the effect of a claim on those assets[.]’’ (citing Clougherty

Packing Co. v. Commissioner, 811 F.2d at 1305)). In rejecting

our holding relating to the brother-sister arrangement, the

Court of Appeals stated that ‘‘the tax court incorrectly

extended the rationale of Carnation and Clougherty in

holding that the premiums paid by the subsidiaries of

18 We

need not defer to the Court of Appeals for the Sixth Circuit’s hold-

ing because this matter is appealable to the Court of Appeals for the Fifth

Circuit, which has not addressed this issue. See Golsen v. Commissioner,

54 T.C. 742, 757 (1970), aff ’d, 445 F.2d 985 (10th Cir. 1971).

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 19

Humana Inc. to * * * [the captive], as charged to them by

Humana Inc., did not constitute valid insurance agreements’’

and concluded that ‘‘[n]either Carnation nor Clougherty

* * * provide[s] a basis for denying the deductions in the

brother-sister * * * [arrangement].’’ Id. at 252–253. In

response to our rationalization that ‘‘[i]f we decline to extend

our holdings in Carnation and Clougherty to the brother-

sister factual pattern, we would exalt form over substance

and permit a taxpayer to circumvent our holdings by simple

corporate structural changes’’, the Court of Appeals stated:

Such an argument provides no legal justification for denying the deduc-

tion in the brother-sister context. The legal test is whether there has

been risk distribution and risk shifting, not whether Humana Inc. is a

common parent or whether its affiliates are in a brother-sister relation-

ship to * * * [the captive]. We do not focus on the relationship of the

parties per se or the particular structure of the corporation involved. We

look to the assets of the insured. * * * If Humana changes its corporate

structure and that change involves risk shifting and risk distribution,

and that change is for a legitimate business purpose and is not a sham

to avoid the payment of taxes, then it is irrelevant whether the changed

corporate structure has the side effect of also permitting Humana Inc.’s

affiliates to take advantage of the Internal Revenue Code § 162(a) (1954)

and deduct payments to a captive insurance company under the control

of the Humana parent as insurance premiums. [Id. at 255–256.]

The Court of Appeals held that ‘‘[t]he test to determine

whether a transaction under the Internal Revenue Code

§ 162(a) * * * is legitimate or illegitimate is not a vague and

broad ‘economic reality’ test. The test is whether there is risk

shifting and risk distribution.’’ Id. at 255. The Court of

Appeals further addressed our analysis and stated:

The tax court cannot avoid direct confrontation with the separate cor-

porate existence doctrine of Moline Properties by claiming that its deci-

sion does not rest on ‘‘economic family’’ principles because it is merely

reclassifying or recharacterizing the transaction as nondeductible addi-

tions to a reserve for losses. The tax court argues in its opinion that such

‘‘recharacterization’’ does not disregard the separate corporate status of

the entities involved, but merely disregards the particular transactions

between the entities in order to take into account substance over form

and the ‘‘economic reality’’ of the transaction that no risk has shifted.

The tax court misapplies this substance over form argument. The sub-

stance over form or economic reality argument is not a broad legal doc-

trine designed to distinguish between legitimate and illegitimate trans-

actions and employed at the discretion of the tax court whenever it feels

that a taxpayer is taking advantage of the tax laws to produce a favor-

able result for the taxpayer. * * * The substance over form analysis,

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20 142 UNITED STATES TAX COURT REPORTS (1)

rather, is a distinct and limited exception to the general rule under

Moline Properties that separate entities must be respected as such for

tax purposes. The substance over form doctrine applies to disregard the

separate corporate entity where ‘‘Congress has evinced an intent to the

contrary’’ * * *

[Humana Inc. & Subs v. Commissioner, 881 F.2d at 254.]

In short, we do not look to the parent to determine whether

premiums paid by the subsidiaries to the captive are deduct-

ible. Id. at 252. The policies shifted risk because claims paid

by the captive did not affect the net worth of Humana’s

subsidiaries. See id. at 252–253.

3. Brother-Sister Arrangements May Shift Risk.

We find persuasive the Court of Appeals for the Sixth Cir-

cuit’s critique of our analysis of the brother-sister arrange-

ment in Humana. First, our extension of Carnation and

Clougherty to brother-sister arrangements was improper. As

the Court of Appeals correctly concluded: ‘‘Carnation dealt

solely with the parent-subsidiary issue, not the brother-sister

issue. Likewise, Clougherty dealt only with the parent-sub-

sidiary issue and not the brother-sister issue. Nothing in

either Carnation or Clougherty lends support for denying the

deductibility of the payments in the brother-sister context.’’

Id. at 253–254.

Second, the opinion of the Court’s extensive reliance on

Plotkin’s report to analyze the brother-sister arrangement

was inappropriate. The report in Humana addressed parent-

subsidiary, rather than brother-sister, arrangements. See

Humana Inc. & Subs. v. Commissioner, 88 T.C. at 209; see

also supra pp. 16–20. In the instant cases, Plotkin explicitly

addressed brother-sister arrangements and stated:

Even though the brother, the captive, and the parent are in the same

economic family, to the extent that a brother has no ownership interest

in the captive, the results of the parent-captive analysis do not apply.

It is not the presence or absence of unrelated business, nor the number

of other insureds (be they affiliates or non-affiliates), but it is the

absence of ownership, the captive’s capital, and the number of statis-

tically independent risks (regardless of who owns them) that enables the

captive to provide the brother with true insurance as a matter of

economics and finance.

We agree. Humana’s subsidiaries had no ownership interest

in the captive. See Humana Inc. & Subs. v. Commissioner, 88

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 21

T.C. at 201–202. Thus, the parent-subsidiary analysis

employed by the opinion of the Court was incorrect.

Third, we did not properly analyze the facts and cir-

cumstances. See id. at 214. The balance sheet and net worth

analysis provides the proper analytical framework to deter-

mine risk shifting in brother-sister arrangements. See

Humana Inc. & Subs. v. Commissioner, 881 F.2d at 252;

Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305.

Instead, we implicitly employed a substance-over-form

rationale to recharacterize Humana’s subsidiaries’ payments

as amounts set aside for self-insurance and referenced, but

did not apply, the balance sheet and net worth analysis.

Indeed, we did not ‘‘examine the economic consequences of

the captive insurance arrangement to the ‘insured’ party to

see if that party * * * [had], in fact, shifted the risk.’’ See

Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305.

4. The Legacy Policies Shifted Risk.

In determining whether Legacy’s policies shifted risk, we

narrow our scrutiny to the arrangement’s economic impact on

RAC’s subsidiaries (i.e., the insured entities). See Humana

Inc. & Subs. v. Commissioner, 881 F.2d at 252–253;

Clougherty Packing Co. v. Commissioner, 811 F.2d at 1305

(‘‘[W]e examine the economic consequences of the captive

insurance arrangement to the ‘insured’ party to see if that

party has, in fact, shifted the risk. In doing so, we look only

to the insured’s assets[.]’’). In direct testimony respondent’s

expert, however, emphasized that petitioner’s ‘‘captive pro-

gram * * * [did] not involve risk shifting that * * * [was]

comparable to that provided by a commercial insurance pro-

gram.’’ We decline his invitation to premise our holding on

a specious comparability analysis. Simply put, the risk either

was, or was not, shifted.

The policies at issue shifted risk from RAC’s insured

subsidiaries to Legacy, which was formed for a valid business

purpose; was a separate, independent, and viable entity; was

financially capable of meeting its obligations; and reimbursed

RAC’s subsidiaries when they suffered an insurable loss. See

Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61, 100–101

(1991), aff ’d in part, rev’d in part, 972 F.2d 858 (7th Cir.

1992); AMERCO v. Commissioner, 96 T.C. at 41. Moreover,

a payment from Legacy to RAC’s subsidiaries did not reduce

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22 142 UNITED STATES TAX COURT REPORTS (1)

the net worth of RAC’s subsidiaries because, unlike RAC, the

subsidiaries did not own stock in Legacy. Indeed, on cross-

examination, respondent’s expert conceded that the balance

sheets and net worth of RAC’s subsidiaries were not affected

by a covered loss and that the policies shifted risk:

[Petitioner’s counsel]: But if the loss gets paid, whose balance sheet

gets affected in that case?

[Respondent’s expert]: What’s hanging me up is that I don’t know

whether—I guess you’re right, because * * * [RAC’s subsidiary] will

treat the payment from—the payment that it expects from Legacy as an

asset, so the loss would hit Legacy’s [balance sheet].

[Petitioner’s counsel]: But it wouldn’t hit * * * [RAC’s subsidiary’s]

balance sheet.

[Respondent’s expert]: I would think that’s right. * * *

[Petitioner’s counsel]: Why is that not risk-shifting?

[Respondent’s expert]: That’s an—why is that not risk-shifting?

[Petitioner’s counsel]: Yes. Why is that not risk-shifting? Why hasn’t

[RAC’s subsidiary] shifted its risk to Legacy? Its insurance risk—why

hasn’t it shifted to Legacy in that scenario?

[Respondent’s expert]: I mean, I would say from an accounting

perspective, it has managed to have—is it—if we’re going to respect all

these [corporate] forms, then it will have shifted that risk.

5. The Parental Guaranty Did Not Vitiate Risk Shifting.

Legacy, in March 2003, petitioned the BMA and received

approval, through December 31, 2003, to treat DTAs as gen-

eral business assets. On September 17, 2003, RAC issued the

parental guaranty to Legacy, which petitioned, and received

permission from, the BMA to treat DTAs as general business

assets through December 31, 2006. Respondent contends that

the parental guaranty abrogated risk shifting between

Legacy and RAC’s subsidiaries. We disagree. First, and most

importantly, the parental guaranty did not affect the balance

sheets or net worth of the subsidiaries insured by Legacy.

Petitioner’s expert, in response to a question the Court posed

during cross-examination, convincingly countered respond-

ent’s contention:

[The Court]: * * * [W]hat impact does the corporate structure have on

the effect of the parental guarantee?

[Petitioner’s expert]: I think it has a great impact on it. None of the

subs, as I understand it, are entering in or [are] a part of that guar-

antee. Only the subs are effectively insureds under the policy. They are

the only ones who produce risks that could be covered. The guarantee

in no way vitiates the completeness of the transfer of their uncertainty,

their risk, to the insuring subsidiary.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 23

Even if one assumes that the guarantee increases the capital that the

captive could use to pay losses, none of those payments would go to the

detriment of the sub as a separate legal entity.

Second, the cases upon which respondent relies are distin-

guishable. Respondent cites Malone & Hyde, Inc. v. Commis-

sioner, 62 F.3d 835, 841 (6th Cir. 1995) (holding that a

reinsurance arrangement was not bona fide because the cap-

tive was undercapitalized and the parent guaranteed the

captive’s obligations to an unrelated insurer), rev’g T.C.

Memo. 1993–585; Carnation Co. v. Commissioner, 71 T.C. at

404, 409 (holding that a reinsurance arrangement lacked

insurance risk where the captive was undercapitalized and,

at the insistence of an unrelated primary insurer, the parent

agreed to provide additional capital); and Kidde Indus., Inc.

v. United States, 40 Fed. Cl. 42, 49–50 (1997) (holding that

a reinsurance arrangement lacked risk shifting because the

parent indemnified the captive’s obligation to pay an unre-

lated primary insurer). Unlike the agreements in these cases,

the parental guaranty did not shift the ultimate risk of loss;

did not involve an undercapitalized captive; and was not

issued to, or requested by, an unrelated insurer. Cf. Malone

& Hyde, Inc. v. Commissioner, 62 F.3d at 841–843; Carnation

Co. v. Commissioner, 71 T.C. at 404, 409; Kidde Indus., Inc.,

40 Fed. Cl. at 49–50.

Third, RAC guaranteed Legacy’s ‘‘liabilities under the Act

[i.e., the Bermuda Insurance Act and related regulations]’’,

pursuant to which Legacy was required to maintain ‘‘certain

solvency and liquidity margins’’. RAC did not pay any money

pursuant to the parental guaranty and Legacy’s ‘‘liabilities

under the Act’’ did not include Legacy’s contractual obliga-

tions to RAC’s affiliates or obligations to unrelated insurers.

For purposes of calculating the minimum solvency margin,

Legacy treated a portion of the parental guaranty as a gen-

eral business asset. See supra pp. 9–10. In sum, by providing

the parental guaranty to the BMA, Legacy received permis-

sion to treat DTAs as general business assets and ensured its

continued compliance with the BMA’s solvency require-

ments. 19 The parental guaranty served no other purpose and

19 Legacy

used a portion of the parental guaranty as a general business

asset. See supra pp. 9–10. Legacy’s DTAs always exceeded the amount of

Continued

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24 142 UNITED STATES TAX COURT REPORTS (1)

was unilaterally revoked by RAC, in 2006, when Legacy met

the BMA’s solvency requirements without reference to DTAs.

C. The Legacy Policies Distributed Risk.

Risk distribution occurs when an insurer pools a large

enough collection of unrelated risks (i.e., risks that are gen-

erally unaffected by the same event or circumstance). See

Humana Inc. & Subs. v. Commissioner, 881 F.2d at 257. ‘‘By

assuming numerous relatively small, independent risks that

occur randomly over time, the insurer smoothes out losses to

match more closely its receipt of premiums.’’ Clougherty

Packing Co. v. Commissioner, 811 F.2d at 1300. This dis-

tribution also allows the insurer to more accurately predict

expected future losses. In analyzing risk distribution, we look

at the actions of the insurer because it is the insurer’s, not

the insured’s, risk that is reduced by risk distribution. See

Harper Grp. v. Commissioner, 96 T.C. at 57. A captive may

achieve adequate risk distribution by insuring only subsidi-

aries within its affiliated group. See Humana Inc. & Subs. v.

Commissioner, 881 F.2d at 257; Rev. Rul. 2002–90, 2002–2

C.B. 985.

Legacy insured three types of risk: workers’ compensation,

automobile, and general liability. During the years in issue,

RAC’s subsidiaries owned between 2,623 and 3,081 stores;

had between 14,300 and 19,740 employees; and operated

between 7,143 and 8,027 insured vehicles. RAC’s subsidiaries

operated stores in all 50 States, the District of Columbia,

Puerto Rico, and Canada. RAC’s subsidiaries had a sufficient

number of statistically independent risks. Thus, by insuring

RAC’s subsidiaries, Legacy achieved adequate risk distribu-

tion. See Humana Inc. & Subs. v. Commissioner, 881 F.2d at

257.

D. The Arrangement Constituted Insurance in the Com-

monly Accepted Sense.

Legacy was adequately capitalized, regulated by the BMA,

and organized and operated as an insurance company. Fur-

thermore, Legacy issued valid and binding policies, charged

and received actuarially determined premiums, and paid

the parental guaranty treated as a general business asset. See supra pp.

9–10.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 25

claims. In short, the arrangement between RAC’s subsidi-

aries and Legacy constituted insurance in the commonly

accepted sense. See Harper Grp. v. Commissioner, 96 T.C. at

60.

Conclusion

The payments by RAC’s subsidiaries to Legacy are, pursu-

ant to section 162, deductible as insurance expenses.

Contentions we have not addressed are irrelevant, moot, or

meritless.

To reflect the foregoing,

Decisions will be entered under Rule 155.

Reviewed by the Court.

THORNTON, VASQUEZ, WHERRY, HOLMES, BUCH, and NEGA,

JJ., agree with this opinion of the Court.

GOEKE, J., did not participate in the consideration of this

opinion.

BUCH, J., concurring: To the extent respondent is arguing

that a captive insurance arrangement between brother-sister

corporations cannot be insurance as a matter of law, we need

not reach that issue. In Rev. Rul. 2001–31, 2001–1 C.B. 1348,

1348, the Internal Revenue Service stated that it would ‘‘no

longer invoke the economic family theory with respect to cap-

tive insurance transactions.’’ And in Rauenhorst v. Commis-

sioner, 119 T.C. 157, 173 (2002), we held that we may treat

as a concession a position taken by the IRS in a revenue

ruling that has not been revoked. Because Rev. Rul. 2001–

31 has not been revoked, we could treat the economic family

argument as conceded.

At the same time the IRS abandoned the economic family

theory, it made clear that it would ‘‘continue to challenge cer-

tain captive insurance transactions based on the facts and

circumstances of each case.’’ Rev. Rul. 2001–31, 2001–1 C.B.

at 1348. Then, in a series of revenue rulings, the IRS shed

light on the facts and circumstances it deemed relevant. See

Rev. Rul. 2005–40, 2005–2 C.B. 4; Rev. Rul. 2002–91, 2002–

2 C.B. 991; Rev. Rul. 2002–90, 2002–2 C.B. 985; Rev. Rul.

2002–89, 2002–2 C.B. 984.

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26 142 UNITED STATES TAX COURT REPORTS (1)

The concise opinion of the Court sets forth facts and cir-

cumstances supporting its conclusion. I write separately to

respond to points made in Judge Lauber’s dissent.

I. Legacy’s Policies

Taking into account the nature of risks that Legacy

insured, Legacy was sufficiently capitalized.

A. Long-Tail Coverage

During each of the years in issue Legacy insured three

types of risk: workers’ compensation, automobile, and general

liability. Policies relating to these risks are generally referred

to as long-tail coverage because ‘‘claims may involve damages

that are not readily observable or injuries that are difficult

to ascertain.’’ See Acuity v. Commissioner, T.C. Memo. 2013–

209, at *8–*9. Workers’ compensation insurance, which gen-

erated between 66% and 73% of Legacy’s premiums 1 during

the years in issue, ‘‘is generally long tail coverage because of

the inherent uncertainty in determining the extent of an

injured worker’s need for medical treatment and loss of

wages for time off work.’’ Id. An insurer pays out claims

relating to long-tail coverage over an extended period.

B. Rent-A-Center’s Insurance Program

Rent-A-Center did not obtain insurance solely from Legacy;

Rent-A-Center also obtained insurance from multiple unre-

lated third parties. Legacy was responsible for only a portion

of each claim (e.g., the first $350,000 of each workers’ com-

pensation claim during 2003). To the extent that a claim

exceeded Legacy’s coverage, a third-party insurer was

responsible for paying the excess amount. Rent-A-Center

obtained coverage from unrelated third-party insurers for

claims of up to approximately $75 million. Therefore, extraor-

dinary losses would not affect Legacy’s ability to pay claims

because they would be covered by unrelated third parties.

1 Legacy’s premiums attributable to workers’ compensation liability were

$28,586,597 in 2003; $35,392,000 in 2004; $36,463,579 in 2005;

$39,086,374 in 2006; and $45,425,032 in 2007.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 27

C. Allocation Formula

Premiums were actuarially determined. At trial respondent

conceded that Aon ‘‘produced reliable and professionally pro-

duced and competent actuarial studies.’’ Legacy relied on

these studies to set premiums. Once Legacy determined the

premium, Rent-A-Center allocated it to each operating sub-

sidiary in the same manner that it allocated premiums

relating to unrelated insurers. In a captive arrangement, a

parent may allocate a premium among its subsidiaries. See

Humana Inc. & Subs. v. Commissioner, 881 F.2d 247, 248

(6th Cir. 1989) (‘‘Humana Inc. allocated and charged to the

subsidiaries portions of the amounts paid representing the

share each bore for the hospitals each operated.’’), aff ’g in

part, rev’g in part and remanding 88 T.C. 197 (1987); Kidde

Indus., Inc. v. United States, 40 Fed. Cl. 42, 45 (1997)

(‘‘National determined the premiums that it charged Kidde

based in part on underwriting data supplied by Kidde’s divi-

sions and subsidiaries * * * Kidde used these same data to

allocate the total premiums among its divisions and subsidi-

aries.’’).

II. The Parental Guaranty

Citing a footnote in Humana, see Lauber op. p. 39, Judge

Lauber’s dissenting opinion asserts that the existence of a

parental guaranty is enough to justify disregarding the cap-

tive insurance arrangement. That footnote, however,

addresses only situations in which there is both inadequate

capitalization and a parental guaranty, concluding: ‘‘These

weaknesses alone provided a sufficient basis from which to

find no risk shifting and to decide the cases in favor of the

Commissioner.’’ Humana Inc. & Subs. v. Commissioner, 881

F.2d at 254 n.2 (emphasis added). Here, the fact finder did

not find inadequate capitalization. And the mere existence of

a parental guaranty is not enough for us to disregard the

captive insurer; we must look to the substance of that guar-

anty.

As the opinion of the Court finds, the parental guaranty

was created to convert deferred tax assets into general busi-

ness assets for regulatory purposes. See op. Ct. p. 22. The cir-

cumstances relating to its issuance, including that the

parental guaranty was issued to Legacy and that it was lim-

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28 142 UNITED STATES TAX COURT REPORTS (1)

ited to $25 million—or, less than 10% of the total premiums

paid to Legacy—support the conclusion that it was created

solely to encourage the Bermuda Monetary Authority to

allow Legacy to treat DTAs as general business assets.

In contrast, the cases that have found that a parental

guaranty eliminates any risk shifting involved either a

blanket indemnity or a capitalization agreement that

resulted in a capital infusion in excess of premiums received.

And even then, the indemnity or capitalization agreement

was coupled with an undercapitalized captive. Accordingly,

those cases are distinguishable from the situation presented

here.

Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th

Cir. 1995), rev’g T.C. Memo. 1993–585, involved an insurance

subsidiary established to provide reinsurance for the parent

and its subsidiaries. After incorporating the captive, Malone

& Hyde entered into an agreement with a third-party insurer

to insure both its own and its subsidiaries’ risks. Id. at 836.

The third-party insurer then reinsured the first $150,000 of

coverage per claim with the captive. Id. Because the captive

was thinly capitalized—it had no assets other than $120,000

of paid-in capital—Malone & Hyde executed ‘‘hold harmless’’

agreements in favor of the third-party insurer. Id. These

agreements provided that if the captive defaulted on its

obligations as reinsurer, then Malone & Hyde would com-

pletely shield the third-party insurer from liability. Id. In

deciding whether the risk had shifted, the court held that

‘‘[w]hen the entire scheme involves either undercapitalization

or indemnification of the primary insurer by the taxpayer

claiming the deduction, or both, these facts alone disqualify

the premium payments from being treated as ordinary and

necessary business expenses to the extent such payments are

ceded by the primary insurer to the captive insurance sub-

sidiary.’’ Id. at 842–843. In short, Malone & Hyde, Inc. had

a thinly capitalized captive insurer and a blanket indemnity.

Here, neither of those facts is present.

The facts in Kidde Indus., Inc. are quite similar to those

in Malone & Hyde, Inc. Kidde incorporated a captive and

entered into an insurance agreement with a third-party

insurer who in turn entered into a reinsurance agreement

with the captive. Kidde Indus., Inc., 40 Fed. Cl. at 45. As in

Malone & Hyde, Inc., the captive was significantly under-

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 29

capitalized, and Kidde executed an indemnification agree-

ment to provide the third-party insurer with the ‘‘level of

comfort’’ needed before it would issue the policies. Id. at 48.

Again, the court held that Kidde retained the risk of loss and

could not deduct the premiums. Id.

Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff ’d,

640 F.2d 1010 (9th Cir. 1981), involved slightly different

facts. A captive reinsured 90% of the third-party insurer’s

liabilities under Carnation’s policy. Id. at 403. As part of this

arrangement, the third-party insurer ceded 90% of the pre-

miums to the captive and the captive paid the third-party

insurer a 5% commission based on the net premiums ceded.

Id. Carnation provided $3 million of capital to the captive—

an amount that was well in excess of the total annual pre-

miums paid to the captive—because the third-party insurer

had concerns about the captive’s capitalization. Id. at 404.

The Court held that the reinsurance agreement and the

agreement to provide additional capital counteracted each

other and voided any insurance risk. Id. at 409. In affirming

the Tax Court, the Court of Appeals for the Ninth Circuit

held that, in considering whether the risk had shifted, the

key was that the third-party insurer would not have issued

the policies without the capitalization agreement. Carnation

Co. v. Commissioner, 640 F.2d at 1013.

Those cases are distinguishable because they all involved

undercapitalized captives. As explained previously, the

opinion of the Court found that Legacy was adequately

capitalized. Further, in each of the three cases above, the

parent provided either indemnification or additional capital-

ization in order to persuade a third-policy insurer to issue

insurance policies. Here, Discover Re provided insurance

before Legacy’s inception and continued providing coverage

after Legacy was formed. The parental guaranty was issued

to Legacy for the singular purpose of allowing Legacy to treat

the DTAs as general business assets. Additionally, the guar-

anty amounted to only $25 million. This small fraction of the

$264 million in premiums for policies written by Legacy

during the years in issue does not rise to the level of protec-

tion provided by the total indemnities in Malone & Hyde,

Inc. and Kidde Indus., Inc.

When we consider the totality of the facts, the parental

guaranty appears to have been immaterial. This conclusion

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30 142 UNITED STATES TAX COURT REPORTS (1)

is bolstered by the facts that the parental guaranty was uni-

laterally withdrawn by Rent-A-Center in 2006 and that Rent-

A-Center never contributed any funds to Legacy pursuant to

that parental guaranty.

III. Consolidated Groups

Judge Lauber’s dissent refers to a hodgepodge of facts

about how Rent-A-Center operated its consolidated group as

evidence that Legacy’s status as a separate entity should be

disregarded. Examples of the facts cited in that dissent are

that Legacy had no employees and that payments between it

and other members of the Rent-A-Center consolidated group

were handled through journal entries. See Lauber op. p. 44.

In the real world of large corporations, these practices are

commonplace. For ease of operations, including running pay-

roll, companies create a staff leasing subsidiary and lease

employees companywide. Or they hire outside consultants to

handle the operations of a specialty business such as a cap-

tive insurer. Legacy, like Humana, hired an outside manage-

ment company to handle its business operations. Compare

op. Ct. note 6 (Legacy engaged Aon to provide management

services) with Humana Inc. & Subs. v. Commissioner, 88

T.C. at 205 (Humana engaged Marsh & McLennan to provide

management services). And it is unrealistic to expect mem-

bers of a consolidated group to cut checks to each other.

Rent-A-Center and Legacy did what is commonplace—they

kept track of the flow of funds through journal entries. So

long as complete and accurate records are maintained, the

commingling of funds is not enough to require the dis-

regarding of a separate business. See, e.g., Kahle v. Commis-

sioner, T.C. Memo. 1991–203 (finding that the taxpayer

‘‘maintained complete and accurate records’’ notwithstanding

the commingling of business and personal funds).

Corporations filing consolidated returns are to be treated

as separate entities, unless otherwise mandated. Gottesman

& Co. v. Commissioner, 77 T.C. 1149, 1156 (1981). It may be

advantageous for a corporation to operate through various

subsidiaries for a multitude of reasons. These reasons may

include State law implications, creditor demands, or simply

convenience, but ‘‘so long as that purpose is the equivalent

of business activity or is followed by the carrying on of busi-

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 31

ness by the corporation, the corporation remains a separate

taxable entity.’’ Moline Props., Inc. v. Commissioner, 319 U.S.

436, 438–439 (1943). Even the consolidated return regula-

tions make clear that an insurance company that is part of

a consolidated group is treated separately. See sec. 1.1502–

13(e)(2)(ii)(A), Income Tax Regs. (‘‘If a member provides

insurance to another member in an intercompany trans-

action, the transaction is taken into account by both mem-

bers on a separate entity basis.’’). Thus, if a corporation gives

due regard to the separate corporate structure, we should do

the same.

IV. Conclusion

The issue presented in these cases is ultimately a matter

of when, not whether, Rent-A-Center is entitled to a deduc-

tion relating to workers’ compensation, automobile, and gen-

eral liability losses. 2 Because the IRS has conceded in its

rulings that insurance premiums paid between brother-sister

corporations may be insurance and the Court determined

that, under the facts and circumstances of these cases as

found by the Judge who presided at trial, the policies at issue

are insurance, Rent-A-Center is entitled to deduct the pre-

miums as reported on its returns. See op. Ct. pp. 13–25.

FOLEY, GUSTAFSON, PARIS, and KERRIGAN, JJ., agree with

this concurring opinion.

HALPERN, J., dissenting:

‘‘‘The principle of judicial parsimony’ (L. Hand, J., in

Pressed Steel Car Co. v. Union Pacific Railroad Co., * * *

[240 F. 135, 137 (S.D.N.Y. 1917)]), if nothing more, condemns

a useless remedy.’’ Sinclair Ref. Co. v. Jenkins Petroleum

Process Co., 289 U.S. 689, 694 (1933). While usually invoked

by a court to justify a stay in discovery on other issues when

one issue is dispositive of a case, 8A Charles Allen Wright,

2 If the Court had determined that the policies were not insurance, then

Rent-A-Center would nevertheless have been entitled to deduct the losses

as they were paid or incurred. See sec. 162. By forming Legacy and giving

due regard to its separate structure, Rent-A-Center achieved some accel-

eration of deductions relating to losses that would otherwise be deductible,

along with other nontax benefits. See op. Ct. p. 11.

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32 142 UNITED STATES TAX COURT REPORTS (1)

Arthur R. Miller & Richard L. Marcus, Federal Practice and

Procedure, sec. 2040, at 198 n.7 (3d ed. 2010), I think the

principle should guide us in declining to overrule Humana

Inc. & Subs. v. Commissioner, 88 T.C. 197 (1987), aff ’d in

part, rev’d in part and remanded, 881 F.2d 247 (6th Cir.

1989), to the extent that it holds that a captive insurance

arrangement between brother-sister corporations cannot be

insurance as a matter of law.

These cases are before the Court Conference for review, see

sec. 7460(b), because we perceive that Judge Foley’s report is

in part overruling Humana, although Judge Foley does not

in so many words say so. He says: ‘‘We find persuasive the

Court of Appeals for the Sixth Circuit’s critique of our anal-

ysis the brother-sister arrangement in Humana.’’ See op. Ct.

p. 20. The Court of Appeals said: ‘‘We reverse the tax court

on * * * the brother-sister issue.’’ Humana Inc. & Subs. v.

Commissioner, 881 F.2d at 257. Under our Conference proce-

dures, the Conference may not adopt a report overruling a

prior report of the Court absent the affirmative vote of a

majority of the Judges entitled to vote on the case. Six of the

sixteen Judges entitled to vote on these cases join Judge

Foley, for a total of seven clearly affirmative votes. Six

Judges voted ‘‘no’’. Three Judges voted ‘‘concur in result’’, and

those votes, under our procedures, are counted as affirmative

votes. Whether the Court has in fact overruled a portion of

Humana undoubtedly will be unclear to many readers of this

report. The resulting confusion is unnecessary. Moreover, by

putting his report overruling Humana before the Conference,

Judge Foley has put before the Conference his subsidiary

findings of fact and his ultimate finding that the brother-

sister payments were correctly characterized as insurance

premiums. That has attracted two side opinions, one

characterizing Judge Foley’s opinion as ‘‘concise’’ (Judge

Buch), see concurring op. p. 26, and emphasizing evidence in

the record that supports his findings and the other character-

izing his ultimate findings as ‘‘conclusory’’ (Judge Lauber) see

Lauber op. p. 38, and contending ‘‘the undisputed facts of the

entire record warrant the opposite conclusion * * *, [that]

the Rent-A-Center arrangements do not constitute ‘insurance’

for Federal income tax purposes.’’ Whether I describe Judge

Foley’s analysis as concise or as conclusory, simply put, there

is insufficient depth to it to persuade me to join his findings

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 33

(i.e., that there is risk shifting, that there is risk distribution,

and, in general, that there is a bona fide insurance arrange-

ment). I do agree with Judge Lauber that ‘‘[w]hether the

facts and circumstances, evaluated in the aggregate, give rise

to ‘insurance’ presents a question of proper characterization.

It is thus a mixed question of fact and law.’’ See Lauber op.

p. 38. Nevertheless, had Judge Foley steered clear of

Humana, I believe that we could have avoided Conference

consideration and have left it to the appellate process (if

invoked) to determine whether Judge Foley’s findings are

persuasive.

And I believe that Judge Foley could have steered clear of

Humana. As both Judges Buch and Lauber point out, the

Commissioner has given up on arguing that captive insur-

ance arrangement between brother-sister corporations cannot

be insurance as a matter of law. See, e.g., Rev. Rul. 2001–

31, 2001–C.B. 1348. Judge Foley ignores that ruling and its

progeny when, pursuant to Rauenhorst v. Commissioner, 119

T.C. 157, 173 (2002), he could have relied on the Commis-

sioner’s concessions to steer clear of revisiting Humana. I

agree with Judge Foley that Humana is not dispositive of the

brother-sister insurance question in these cases, but not

because I would overrule Humana on that issue; rather, I see

no reason to address Humana in the light of the Commis-

sioner’s present administrative position. While I agree with

Judge Foley that the facts and circumstances test provides

the proper analytical framework, I otherwise dissent from his

opinion.

LAUBER, J., agrees with this dissent.

LAUBER, J., dissenting: These cases, like Humana Inc. &

Subs. v. Commissioner, 88 T.C. 197 (1987), aff ’d in part,

rev’d in part and remanded, 881 F.2d 247 (6th Cir. 1989),

involve what I will refer to as a ‘‘classic’’ captive insurance

company. In these cases, as in Humana, the captive has no

outside owners and insures no outside risks. Rather, it is

wholly owned by the parent of the affiliated group and it

‘‘insures’’ risks only of the parent and the operating subsidi-

aries, which stand in a brother-sister relationship to it.

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34 142 UNITED STATES TAX COURT REPORTS (1)

In Humana we held that purported ‘‘insurance’’ premiums

paid to a captive by other members of its affiliated group—

whether by the parent or by the sister corporations—were

not deductible for Federal income tax purposes. An essential

requirement of ‘‘insurance’’ is the shifting of risk from

insured to insurer. Helvering v. Le Gierse, 312 U.S. 531, 539

(1941). We held in Humana that ‘‘there was not the nec-

essary shifting of risk’’ from the operating subsidiaries to the

captive, and hence that none of the purported ‘‘premiums’’

constituted amounts paid for ‘‘insurance.’’ 88 T.C. at 214. The

Court of Appeals for the Sixth Circuit affirmed as to amounts

paid to the captive by the parent, but reversed as to amounts

paid to the captive by the sister corporations. 881 F.2d at

257.

The opinion of the Court (majority) adopts the reasoning

and result of the Sixth Circuit, overrules Humana in part,

and holds that amounts charged to the captive’s sister cor-

porations constitute deductible ‘‘insurance premiums.’’ I dis-

sent both from the majority’s decision to overrule Humana

and from its holding that amounts charged to the sister cor-

porations constituted payments for ‘‘insurance’’ under the

totality of the facts and circumstances.

I. Background

The captive insurance issue has a rich history to which the

majority refers only episodically. It has been clear from the

outset of our tax law that taxpayers (other than insurance

companies) cannot deduct contributions to an insurance

reserve. Steere Tank Lines, Inc. v. United States, 577 F.2d

279, 280 (5th Cir. 1978); Spring Canyon Coal Co. v. Commis-

sioner, 43 F.2d 78, 80 (10th Cir. 1930). Thus, if a unitary

operating company maintains a reserve for self-insurance,

amounts it places in that reserve are not deductible as

‘‘insurance premiums.’’

One strategy by which taxpayers sought to avoid this non-

deductibility rule was to place their self-insurance reserve

into a captive insurance company. In cases involving ‘‘classic’’

captives—i.e., captives that have no outside owners and

insure no outside risks—the courts have uniformly held that

this strategy does not work. Employing various legal theo-

ries, every court to consider the question has held that

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 35

amounts paid by a parent to a classic captive do not con-

stitute ‘‘insurance premiums.’’ 1

Insurance and tax advisers soon devised an alternative

strategy for avoiding the bar against deduction of contribu-

tions to a self-insurance reserve—namely, adoption of or

conversion to a holding company structure. In essence, an

operating company would drop its self-insurance reserve into

a captive; drop its operations into one or more operating

subsidiaries; and have the purported ‘‘premiums’’ paid to the

captive by the sister companies instead of by the parent. In

Humana, we held that this strategy did not work either, rea-

soning that ‘‘we would exalt form over substance and permit

a taxpayer to circumvent our holdings [involving parent-cap-

tive payments] by simple corporate structural changes.’’ 88

T.C. at 213. In effect, we concluded in Humana that conver-

sion to a holding-company structure—without more—should

not enable a taxpayer to accomplish indirectly what it cannot

accomplish directly, achieving a radically different and more

beneficial tax result when there has been absolutely no

change in the underlying economic reality.

While the Commissioner had success litigating the parent-

captive pattern, he had surprisingly poor luck litigating the

brother-sister scenario. The Tenth Circuit, like our Court,

agreed that brother-sister payments to a classic captive are

not deductible as ‘‘insurance premiums.’’ 2 By contrast, the

1 See

Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir.

1986); Stearns-Roger Corp. v. United States, 774 F.2d 414, 415–416 (10th

Cir. 1985); Humana Inc. & Subs. v. Commissioner, 88 T.C. 197, 207 (1987),

aff ’d in part, rev’d in part and remanded, 881 F.2d 247 (6th Cir. 1989);

Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985), aff ’d, 811

F.2d 1297, 1307 (9th Cir. 1987); Carnation Co. v. Commissioner, 71 T.C.

400 (1978), aff ’d, 640 F.2d 1010, 1013 (9th Cir. 1981). On the other hand,

the courts have held that parent-captive payments may constitute ‘‘insur-

ance premiums’’ where the captive has a sufficient percentage of outside

owners or insures a sufficient percentage of outside risks. See, e.g., Sears,

Roebuck & Co. v. Commissioner, 96 T.C. 61 (1991) (approximately 99.75%

of insured risks were outside risks), supplemented by 96 T.C. 671 (1991),

aff ’d in part and rev’d in part, 972 F.2d 858 (7th Cir. 1992); Harper Grp.

v. Commissioner, 96 T.C. 45 (1991) (approximately 30% of insured risks

were outside risks), aff ’d, 979 F.2d 1341 (9th Cir. 1992); AMERCO v. Com-

missioner, 96 T.C. 18 (1991) (between 52% and 74% of insured risks were

outside risks), aff ’d, 979 F.2d 162 (9th Cir. 1992).

2 See Beech Aircraft Corp., 797 F.2d at 922; Stearns-Roger Corp., 774

Continued

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36 142 UNITED STATES TAX COURT REPORTS (1)

Sixth Circuit in Humana reversed our holding to this effect.

And after some initial ambivalence, the Court of Federal

Claims appears to have concluded that brother-sister ‘‘pre-

mium’’ payments are deductible. 3

The Commissioner had even less success persuading courts

to adopt the ‘‘single economic family’’ theory enunciated in

Rev. Rul. 77–316, 1977–2 C.B. 53, upon which his litigating

position was initially based. That theory was approved by the

Tenth Circuit 4 and found some favor in the Ninth Circuit. 5

But it was rejected by our Court 6 as well as by the Sixth and

Federal Circuits. 7

Assessing this track record, the Commissioner made a

strategic retreat. In 2001 the IRS announced that it ‘‘will no

longer invoke the economic family theory with respect to cap-

tive insurance transactions.’’ Rev. Rul. 2001–31, 2001–1 C.B.

1348, 1348. In 2002 the IRS likewise abandoned its position

that there is a per se rule against the deductibility of

F.2d at 415–416.

3 Compare Mobil Oil Corp. v. United States, 8 Cl. Ct. 555, 566 (1985)

(‘‘[B]y deducting the premiums on its tax returns, * * * [the affiliated

group] achieved indirectly that which it could not do directly. It is well set-

tled that tax consequences must turn upon the economic substance of a

transaction[.]’’), with Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42

(1997) (brother-sister payments deductible for years for which parent did

not provide indemnity agreement). See generally Ocean Drilling & Explo-

ration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993) (brother-

sister payments deductible where captive insured significant outside risks).

4 See Beech Aircraft Corp., 797 F.2d 920; Stearns-Roger Corp., 774 F.2d

at 415–416. See generally Humana, 881 F.2d at 251 (‘‘Stearns-Roger, Mobil

Oil, and Beech Aircraft * * * each explicitly or implicitly adopted the eco-

nomic family concept.’’).

5 See Clougherty Packing, 811 F.2d at 1304 (‘‘[W]e seriously doubt that

the use of an economic family concept in defining insurance runs afoul of

the Supreme Court’s holding in Moline Properties.’’); id. at 1305 (finding

‘‘considerable merit in the Commissioner’s [economic family] argument’’

but finding it unnecessary to rely on that theory); Carnation Co., 640 F.2d

at 1013.

6 See Humana, 88 T.C. at 214 (rejecting the Commissioner’s ‘‘economic

family’’ concept); Clougherty Packing, 84 T.C. at 956 (same); Carnation Co.,

71 T.C. at 413 (same).

7 See Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir. 1995)

(rejecting ‘‘economic family’’ theory but ruling against deductibility of pay-

ments to captive based on facts and circumstances), rev’g T.C. Memo.

1993–585; Ocean Drilling & Exploration Co., 988 F.2d at 1150–1151;

Humana, 881 F.2d at 251.

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 37

brother-sister ‘‘premiums,’’ concluding that the characteriza-

tion of such payments as ‘‘insurance premiums’’ should be

governed, not by a per se rule, but by the facts and cir-

cumstances of the particular case. Rev. Rul. 2002–90, 2002–

2 C.B. 985; accord Rev. Rul. 2001–31, 2001–1 C.B. at 1348

(‘‘The Service may * * * continue to challenge certain cap-

tive insurance transactions based on the facts and cir-

cumstances of each case.’’).

II. Overruling Humana

We decided Humana against a legal backdrop very dif-

ferent from that which we confront today. The Commissioner

in Humana urged a per se rule, predicated on his ‘‘single eco-

nomic family’’ theory, against the deductibility of brother-

sister ‘‘insurance premiums.’’ The Commissioner has long

since abandoned both that per se rule and the theory on

which it was based. Given this change in the legal environ-

ment, I see no need for the Court to reconsider Humana,

which in a practical sense may be water under the bridge.

Respondent’s position in the instant cases is consistent

with the ruling position the IRS has maintained for the past

12 years—namely, that characterization of intragroup pay-

ments as ‘‘insurance premiums’’ should be determined on the

basis of the facts and circumstances of the particular case.

See Rev. Rul. 2001–31, 2001–1 C.B. at 1348. The majority

adopts this approach as the framework for its legal analysis.

See op. Ct. pp. 13-14 (‘‘We consider all of the facts and cir-

cumstances to determine whether an arrangement qualifies

as insurance.’’). The Court need not overrule Humana to

decide (erroneously in my view) that respondent should lose

under the facts-and-circumstances approach that respondent

is now advancing. In Humana, ‘‘we emphasize[d] that our

holding * * * [was] based upon the factual pattern presented

in * * * [that] case,’’ noting that in other cases ‘‘factual pat-

terns may differ.’’ 88 T.C. at 208. That being so, the Court

today could rule for petitioners on the basis of what the

majority believes to be the controlling ‘‘facts and cir-

cumstances,’’ distinguishing Humana rather than overruling

it. Principles of judicial restraint counsel that courts should

decide cases on the narrowest possible ground.

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38 142 UNITED STATES TAX COURT REPORTS (1)

III. The ‘‘Facts and Circumstances’’ Approach

Although I do not believe it necessary or proper to overrule

Humana, the continuing vitality of that precedent does not

control the outcome. These cases can and should be decided

in respondent’s favor under the ‘‘facts and circumstances’’

approach that he is currently advancing. In Rev. Rul. 2002–

90, 2002–2 C.B. at 985, the IRS concluded that brother-sister

payments were correctly characterized as ‘‘insurance pre-

miums’’ where the assumed facts included the following (P =

parent and S = captive):

P provides S adequate capital * * *. S charges the 12 [operating]

subsidiaries arms-length premiums, which are established according to

customary industry rating formulas. * * * There are no parental (or

other related party) guarantees of any kind made in favor of S. * * *

In all respects, the parties conduct themselves in a manner consistent

with the standards applicable to an insurance arrangement between

unrelated parties.

The facts of the instant cases, concerning both ‘‘risk

shifting’’ and conformity to arm’s-length insurance standards,

differ substantially from the facts assumed in Rev. Rul.

2002–90, supra. The instant facts also differ substantially

from the facts determined in judicial precedents that have

characterized intragroup payments as ‘‘insurance premiums.’’

Whether the facts and circumstances, evaluated in the aggre-

gate, give rise to ‘‘insurance’’ presents a question of proper

characterization. It is thus a mixed question of fact and law.

The majority makes certain findings of basic fact, which I

accept for purposes of this dissenting opinion. In many

instances, however, the majority makes no findings of basic

fact to support its conclusory findings of ultimate fact. In

other instances, the majority does not mention facts that

tend to undermine its ultimate conclusions. In my view, the

undisputed facts of the entire record warrant the opposite

conclusion from that reached by the majority and justify a

ruling that the Rent-A-Center arrangements do not con-

stitute ‘‘insurance’’ for Federal income tax purposes.

A. Risk Shifting

1. Parental Guaranty

Rent-A-Center, the parent, issued two types of guaranties

to Legacy, its captive. First, it guaranteed the multi-million-

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(1) RENT-A-CENTER, INC. v. COMMISSIONER 39

dollar ‘‘deferred tax asset’’ (DTA) on Legacy’s balance sheet,

which arose from timing differences between the captive’s

fiscal year and the parent’s calendar year. Normally, a DTA

This text is long and has been trimmed here. Open the source document for the complete record.