|February 27, 2014|
Previously published on February 26, 2014
Rent-A-Center, Inc. v. Commissioner, 142 T.C. No. 1 (2014)
A great business opportunity that may provide significant tax advantages is for a company to form its own wholly-owned captive insurance company to insure the risks of affiliated companies. Captive insurance companies provide numerous economic and business benefits, including reduced insurance costs, coverage for risks that might otherwise be uninsurable, and enhanced loss prevention and claims management. In addition to such nontax benefits, premiums paid to captives may be deductible from Federal income taxes as insurance expenses. Captives can also offer significant asset protection and estate and gift tax benefits for their owners.
In a recent opinion involving captives, a majority of the U.S. Tax Court in Rent-A-Center, Inc. v. Commissioner held that payments by a parent company’s wholly-owned subsidiaries to a wholly-owned captive insurance company were fully deductible under section 162 of the Internal Revenue Code of 1986, as amended, as insurance expenses. The decision reverses the Tax Court’s prior analysis regarding the deductibility of premiums paid by affiliated subsidiaries to a captive (referred to as a brother-sister captive insurance arrangement) and agrees with the Sixth Circuit that there can be sufficient shifting of risk in such an arrangement for insurance to exist and premiums paid to the captive to constitute deductible insurance expenses. This opinion is favorable for taxpayers because it demonstrates that captive insurance companies are legitimate business arrangements entitled to special tax treatment if structured and managed properly.
There is no statutory definition of the term “insurance.” The issue of whether arrangements involving captive insurance companies qualify as “insurance” for Federal tax purposes has been a source of considerable contention between the Internal Revenue Service and taxpayers. The U.S. Supreme Court, however, has established two necessary criteria for an arrangement to be considered insurance: risk shifting and risk distribution. Also, the arrangement must involve insurance risk and meet commonly accepted notions of insurance.
In Rent-A-Center, Inc., Rent-A-Center (“RAC”) became increasingly concerned about its growing risk management costs following a period of rapid expansion from 1993 to 2002. Aon Risk Consultants, Inc. analyzed RAC’s insurance program and advised the company to create a wholly-owned insurance subsidiary (i.e., a captive). RAC incorporated its captive, Legacy Insurance Co. Ltd. (“Legacy”), in Bermuda in 2002. Legacy wrote insurance policies that covered RAC’s workers’ compensation, automobile, and general liability claims. The annual premiums Legacy charged were allocated to each RAC subsidiary. Beginning in January, 2008, the IRS sent RAC notices of deficiencies for tax years 2003 through 2007, determining that the subsidiaries’ payments to Legacy were not deductible insurance expenses. The IRS had argued that RAC’s captive was a sham entity created primarily to generate Federal income tax savings.
In deciding whether the subsidiaries’ payments were deductible, the Tax Court first determined whether Legacy was a bona fide insurance company. Although Federal income tax consequences were considered during the formation of Legacy, the court ruled that the formation of Legacy was not a tax-driven transaction. Specifically, the court concluded that Legacy was not a sham because RAC created the captive for significant and legitimate nontax considerations, including increasing the accountability and transparency of RAC’s insurance operations, accessing new insurance markets, and reducing risk management costs. Further supporting the court’s holding were its findings that Legacy entered into arm’s-length insurance contracts for workers’ compensation, automobile, and general liability claims; charged actuarially determined premiums; was subject to regulatory control; paid claims from its separately maintained account; and was adequately capitalized. In the Kilpatrick Townsend Tax Team’s experience defending captives, the IRS focuses on the types of coverage the captive insures and the extent to which the captive operates as a business with maintenance of books and records, a claim processing procedure, and other operational systems a business would employ. The fact that Legacy covered workers compensation and other common business risks of loss weighed in Legacy’s favor and should have deterred the IRS from litigating the case.
Turning to the issue of whether the payments to Legacy were deductible insurance expenses, the court analyzed the four criteria mentioned above: risk shifting, risk distribution, whether the captive arrangement involved insurance risk, and whether the arrangement met commonly accepted notions of insurance. The Tax Court held that all four requirements were satisfied. In its analysis, the court focused on risk shifting; in particular, whether the insurance policies at issue shifted risk between RAC’s subsidiaries, as the insured entities, and Legacy. In doing so, the court examined the arrangement’s economic impact on RAC’s subsidiaries to determine if the subsidiaries had, in fact, shifted the risk. It concluded that the policies shifted risk, acknowledging the Sixth Circuit’s ruling in Humana v. Commissioner that brother-sister captive insurance arrangements may shift risk. Based on the specific facts presented to the court, it found that Legacy 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. Moreover, a payment from Legacy to RAC’s subsidiaries did not reduce the net worth of the subsidiaries.
As noted, Rent-A-Center, Inc. is a favorable opinion for companies that have captive insurance companies or are considering establishing them. Again, businesses of all sizes should consider whether a captive insurance company could be a very economical way to handle insurance costs. Please contact the author of this legal alert, Antoinette Ellison, or any other member of the Kilpatrick Townsend Tax Team for additional information on the benefits a captive insurance company may offer you and other similar matters.