CC:WR:PNW:SEA:TL-N-426-00

.

Internal

Revenue Service

memorandum

CC:WR:PNW:SEA:TL-N-426-00

KGMedleau

Date:

JUN 1

2000

To:

Bill Marx, Team Manager, MS W:,lO2

Vince DiGioia, Revenue Agent

From:

District Counsel

Seattle

Subject:

---- - Deductibility of Insurance Premiums; Economic Family

Rationale

This advice constitutes return information subject to I.R.C. 5 6103. This advice

contains confidential information subject to attorney-client

and deliberative process privileges and, if

prepared in contemplation

of litigation, subject to the attorney work product privilege. Accordingly, the

Collection, Criminal Investigations,

Examination, or Appeals recipient of this document may provide it

only to those persons whose official tax administration

duties with respect to this case require such

disclosure. In no event may thls document be provided to Collection, Criminal Investigations,

Examination, Appeals, or other persons beyond those specifically indicated In this statement.

This

advice may not be disclosed to taxpayers or their representatives.

This advice is not binding on Examination or Appeals and is not a final case

determination.

Such advice is advisory and does not resolve Service position on an issue or provide

the basis for closing a case. The determination

of the Service in the case is to be made through the

exercise of the independent judgment of the office with jurisdiction over the case.

You asked that we consider whether the structure of the transaction

between ---- --------- ---------------- -- ----------------- -------- and ------------ ------------------------- ---------------- constitutes a captive arrangement that precludes a section

162 deduction for premiu~ms paid by ---- to ------------- during ----- and ----under the economic family rationale set forth in Rev. Rul. 77-316. For the

reasons I discussed with you, we believe that the deductions cannot be

disallowed solely on the basis of a captive arrangement and the economic family

rationale. We recommend proposing an adjustment only if the payments were

either excessive in amount (section 482 adjustment) and/or extremely excessive

in nature (sham transaction adjustment). However, based on our review of the

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current administrative file, it appears that no proposed adjustment is warranted

primarily because the payments made by ----- to ------------- appear to be for

arms-length amounts and are not sham transactions.

The rationale for our legal conclusions and recommendations, as well as

my understanding of the facts upon which they are based, are set forth below.

Facts

In ------ ------------ was formed following a divisive reorganization that

segregated the --------------- related activities from other activities engaged in by

----- predecessor, -------------- ------------ --- ----------- --------- ---- had employed

captive insurance subsidiaries to provide workman’s compensation insurance and

the Service disallowed the premiums paid by ----- and its subsidiaries to the

captive insurance subsidiaries (and the disallowance was eventually upheld by

both the Tax Court and the ------ Circuit). In partial response, ------------ was

created to provide workman’s compensation insurance for the ---------------activities engaged in by ----- and some of its subsidiaries.

------------ was organized as a captive insurance company under the state

of ------------ Articles of incorporation were filed and a certification of incorporation

was issued by the ----------- Secretary of State. The ---------- Department of

Banking, Insurance and Securities authorized ------------ to transact business as a

captive insurer and write workers’ compensation coverage, and the state also

periodically issued ------------- certificates of good standing.

---- and ------------- are commonly controlled as follows: All of the voting

stock of ---- is owned by a trust. ---- --------------- --- --------st are ----- --- -------and ---- ----------------- children of ------ --- ----- -------- -------- (both deceased). The

beneficial interest in the trust are split evenly between the children of ----- --------- ----- ----- ----------------- Neither ----- ---- -------- nor ----- ---------------- ----beneficiary of the trust. The stock of ------------- is owne-- --- -- -------------- in

which ----- --- -------- and ----- ---------------- ------- hold a 50 percent interest.

During ----- and ------- ---- and some of its subsidiaries paid “premiums”

to ------------- in exchange for ------------ providing workers’ compensation

coverage for its --------------- -------------- in various states, including ---------------2-

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---------- -------------- ------------- --------------- -------------- --------- ----------------------------- ------------ ---------- -------- ----------- ----- -------- ------------ ----- ------------------------ -------- ------------------- ----------------- ----- ----- ------- ------------ charged

---- and its subsidiaries were within the range of third party- ----------- -ates for

similar insurance and/or the published National Council on Compensation

Insurance (NCCI) rates for the Atlantic and Gulf states. ------------ reinsured a

portion (but not all) of its risks with third party insurers. ---------- ------ nor any of its

subsidiaries indemnitied ------------ from losses on its workers’ compensation

coverage for ---- and its---------------s.

Law and Analysis

Generally, premiums paid for insurance are deductible under section

162(a) if directly connected with the taxpayer’s trade or business. Treas. Reg.

§ 1.162-1 (a). Although the Internal Revenue Code does not define the term

“insurance,” the Supreme Court has stated that to constitute “insurance,” a

transaction must involve “risk shifting” (from the insured to the insurer) and “risk

distribution” by the insurer. Helverina v. Le Gierse, 312 U.S. 531, 539 (1941). In

this regard, amounts set aside by a taxpayer as a “self-insurance” rese?;e for

anticipated losses are not insurance expenses because risk is not shifted from

the taxpayer; therefore, such amounts are not deductible until the taxpayer

actually pays or accrues the anticipated loss. United States v. General Dvnamics

m,

481 U.S. 239, 243-244 (1987).

In instances where the taxpayer enters into an “insurance” arrangement

with a related “insurance” company, both the Service and the courts have

attempted to address whether sufficient risk shifting is present in order for the

transaction to be considered insurance. In Rev. Rul. 77-316, 1977-2 C.B. 53, the

Service addressed three situations whereby a taxpayer attempted to seek

insurance coverage for itself and its operating subsidiaries through the taxpayer’s

wholly-owned captive insurer subsidiary. The Service concluded that the

transactions were not insurance to the extent that risk was retained by the captive

insurance subsidiary. The Service reasoned that the taxpayer, its non-insurance

subsidiaries, and its captive insurance subsidiary, represented one “economic

family” for purposes of the risk shifting analysis. Consequently, although risk

shifted among separate entities within the economic family, the transaction did

not result in sufficient risk shifting to constitute “insurance” because the economic

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burden of losses remained within that family. Therefore, the premiums pair! by

the taxpayer and its non-insurance subsidiaries were not deductible.

Courts have uniformly held that transactions between a parent and its

captive insurance subsidiary do not constitute “insurance” where the captive

“insures” only entities to which its is related. E.q., Stearns-Rooer Corp. v. Untied

States, 774 F.2d 414 (lOth Cir. 1985); Carnation Comoanv v. Commissioner, 640

F.2d 1010 (9” Cir. 1981) affq. 71 T.C. 400 (1978); Mobil Oil Corp. v. United

States, 8 Cl. Ct. 555 (1985). Nevertheless, no court so holding has totally

accepted the economic family theory as set forth in Rev. Rul. 77-316. Although

some of the earlier cases involving parent-subsidiary transactions appear to

endorse the essence of the economic family theory, those cases do not expressly

rely upon the theory due to apprehension that it will be invoked outside of the

context of captive insurance and run afoul of the doctrine of separate corporate

existence set forth in Moline Prooerties. Inc. v. Commissioner, 319 U.S. 436, 439

(1943).’ See AMERCO. Inc. v. Commissioner, 979 F.2d 162, 166 (9th Cir. 1992)

(explaining reluctance of courts to accept the economic family theory). In

Clouahertv Packina Co. v. Commissioner, 811 F.2d 1297 (9th Cir. 1987) the

Ninth Circuit attempted to reconcile its refusal to characterize a parent-subsidiary

transaction as insurance with Moline Prooerties by fashioning the “balance sheet

test.” Under this approach, the court in Clouahertv Packinq reasoned that a

parent-subsidiary transaction is not insurance because a loss covered by the

captive subsidiary will reduce, dollar for dollar, the value of the insurer’s stock

reflected on the parent’s balance sheet. The court reasoned that such an

approach is consistent with Moline Prooerties because the parent’s assets are

viewed apart from the captive insurance subsidiary’s assets. Clouahertv Packing,

811 F.2d at 305.

Employing the balance sheet test set forth in Clouahertv Packing, both the

Sixth Circuit and the Federal Claims Court have held that payments to a captive

In Moline Prooerties, the Court held that absent an exception, ~JJ.,

where the corporation is a sham, a corporation should be viewed as a separate

taxable entity. Accordingly, in contexts other than insurance, such as sales,

leases or loans, both the Service and the courts have recognized for tax

purposes the validity of transactions between related entities if the essential

elements of the transaction are present and the entities acted at arm’s length.

1

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insurer by a sibling subsidiary were deductible as insurance premiums. Humana,

Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989); Kidde Industries. Inc. vi

United States, 40 Fed.CI. 42 (1997). In both Humana and Kidde_,the captive in

question insured risks only within its related group. Both courts reasoned that,

unlike parent-subsidiary transactions, sufficient risk shifting existed with respect

to the brother-sister transactions because a loss incurred by the insured

subsidiary did not diminish the assets reflected on that subsidiary’s balance sheet

when the captive paid the claim. Relying upon Moline Properties, each court

explained that brother-sister transactions should be considered insurance for

Federal income tax purposes unless either the captive entity or the transaction

itself is a sham. Humana, 881 F.2d at 255.I-1Kidde 40 Fed.CI. at 47.

Similar to the relationship of ---- and ------------- in Crawford Fittina Co. v.

United States, 606 F.Supp. 136 (N.--- --hio 1------ ----- Crawford Companies were

not a separate parent-subsidiary group but were a group of separate corporations

that were owned and controlled by a group of related individuals. The district

court held that insurance premiums paid to a captive insurance company were

deductible as ordinary and necessary business expenses because the taxpayer

and the other shareholders of the captive were not so economically related that

their separate financial transactions had to be aggregated and treated as the

transactions of a single taxpayer.2

Based on the above, it is clear that whether the transaction between ---and ------------- is insurance is not determined solely by the economic familytheo---- ----------sister transactions, as well as the more attenuated arrangement

present in the instant case, are subject to the same standards as those applied to

unrelated parties who enter into purported “insurance” transactions. Thus,

*

In addition, ------------ can only be a ---- captive insurer by

application of the.section- ----- ------ution rules. T-- ------, we are not aware of any

court that has considered a captive insurance case in which the relationship

between the corporations is based on the application of the attribution rules and

we doubt a court would apply section 318 attribution in this context. This is

because section 318(a) provides that the section applies only where they “are

expressly made applicable” and section 162 does not make expressly make

section 328 applicable to the determination of ordinary and necessary business

expenses.

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whether the transaction constitutes insurance is a facts and circumstances

question that includes a determination of whether (among other things): (1) the

insurer was organized and operated as an insurance company; (2) the insurer

was regulated by insurance law; (3) the insurer is adequately capitalized; (4) the

premiums charged were based on arms-length transactions; and (5) the unpaid

losses held by the insurer bear a rationale relationship to claim experience.

The current information contained in the administrative file indicates that

the transactions between ---- and ------------ appear to be valid insurance

transactions.

------------ was organi----- ----- -perated as a ----------- insurance

company and------- --------ted by ----------- insurance law. More importantly, the

premiums ---- and its subsidiaries paid to ------------ were within the range of

third party ------ers rates for similar insuran--- --------- NCCI published rates for the

Atlantic and Gulf states. While ------------ reinsured a portion of its risks with third

party insurers, it remained liabl-- ---- -- -----on of the risks. Neither ---- nor any of

its subsidiaries indemnified ------------ from losses on its workers’ -------ensation

coverage for ----- and its su-------------- Because the payments made by ----- to

------------ ap------ to be for arms-length amounts and are not sham trans--------s,

--------------ent under section 482 or a sham transaction theory seems warranted.

See footnote 1, a.

Conclusion

We believe that the deductions ---- and its subsidiaries claimed for

premiums paid to ------------- cannot b-- -----llowed solely on the basis of a captive

arrangement and ----- ----------ic family rationale. Furthermore, because the

payments made by ----- to ------------- appear to be for arms-length amounts and

are not sham transa-------, ---- ----------ent under section 482 or a sham

transaction theory seems warranted

If you have any questions, or if we could be of any more assistance, please

do not hesitate to call the undersigned at 220-5951.

KEITH G. MEDLEAU

Attorney