CAPTIVE INSURANCE COMPANIES & THE BUSINESS PURPOSE DOCTRINE

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1 CAPTIVE INSURANCE COMPANIES & THE BUSINESS PURPOSE DOCTRINE Beckett G. Cantley 1 Atlanta Law Group F. Hale Stewart, Esq. 2 The Law Office of Hale Stewart The 70% marginal tax rate of the 1970s encouraged the use of tax shelters. One of the more popular tax shelter structures involved promoters selling limited partnership interests to high net worth individuals for small sums of money. The partnership would purchase assets of questionable worth at highly inflated values, funding the purchase with non-recourse debt. The limited partners would then deduct their proportionate share of depreciation against their gross income. The IRS successfully fought these shelters using the business purpose doctrine, which exclusively focuses on the taxpayer s state of mind in performing the transaction. 3 The Frank Lyon 4 case provides an excellent set of illustrative facts along with a clear explanation of the doctrine. In that case, an Arkansas bank wanted to build their headquarters in downtown Little Rock, but Arkansas banking law prevented them from using their preferred method of financing. The bank approached the Frank Lyon Company, which was also a bank board member, about setting up a standard sale-leaseback financing arrangement. The Frank Lyon Company agreed, and after building the headquarters and leasing the building back to the bank, the Frank Lyon Company deducted expenses related to the building. The IRS disallowed the deductions, arguing the bank was the de facto building owner. The case went to the Supreme Court, which sided with the taxpayer. The Supreme Court based their decision on the business purpose doctrine, which they defined in the following manner: Where, as here, there is a genuine multiple-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax- 1 Beckett G. Cantley is a partner with the Atlanta Law Group ( He can be reached for comment at bgcantley@atllawgroup.com and (404) F. Hale Stewart, Esq. is a partner at The Law Office of Hale Stewart ( He can be reached at (832) or at hale@hscaptivemanagement.com. 3 While potentially still a stand-alone anti-avoidance doctrine, the business purpose doctrine has largely been subsumed as the subjective prong of the economic substance doctrine, which was codified in 2010 in 26 U.S.C. 7701(o): (o) Clarification of economic substance doctrine (1) Application of doctrine: In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A)the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer s economic position, and (B)the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. 4 Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

2 avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties. The Frank Lyon fact pattern clearly complied with these factors. Arkansas law (a business or regulatory reality ) prevented the bank from using their preferred structure. The bank and the Frank Lyon Company came to an arms-length bargain using a standard real estate structure (the transaction was imbued with tax independent considerations ) and there was no mention of any tax considerations (the deal wasn t shaped solely by tax-avoidance features ). The Business Purpose Doctrine & Initial Captive Cases The Service did not use the business purpose argument during the initial round of captive insurance cases because the taxpayer s subjective business purpose intent was never really in question. Captives began, and then flourished, because of market failure. Starting in the 1950s, companies were either unable to find insurance or could only find very expensive coverage. In either case, this forced them to seek more viable options to obtain coverage. For example, two companies in the earliest captive cases, Consumer s Oil 5 and Weber Paper 6, owned property in a flood plain, where they could find no flood related coverage because recent flooding made insurance companies decide not to offer flood coverage for that area. 7 Companies in later cases also formed captives because they could not find insurance, or could only find cost prohibitive policies. The company in the Ocean Drilling 8 case originally purchased flood insurance from Lloyd s of London, but due to a large rate increase, the company instead chose to form its own insurance subsidiary. The taxpayer in Stearns Rogers 9 formed a captive because they failed to find any coverage for their large-scale construction business line. The Humana 10 case provides the best example of how a company demonstrates a decisionmaking process that illustrates a clear, non-tax related business purpose for forming a captive. From that case: At the time that the Marsh McLennan letter was received, petitioner was considering the following options: (1) going uninsured; (2) creating a trust fund or reserve for self-insurance; (3) combining with other hospital companies in a 5-year insurance pooling arrangement; or (4) establishing a captive insurance company. Petitioner rejected option (1) because it concluded that it was not strong enough to sustain the burden of catastrophic risk if it went uninsured. It rejected option (2) because, first, it felt that this option would not allow it access to commercial insurance markets for certain excess protection which it regarded as essential; second, some 40 percent of its business was under Medicare and Medicaid, and at least the former would not permit reimbursement for additions to the reserves; and third, it was clear that payments into such a reserve fund would not be deductible 5 Consumers Oil Corp. of Trenton v. United States, 188 F. Supp. 796 (D.N.J. 1960) 6 U.S. v. Weber Paper Co. United States, 320 F.2d 199 (8 th Cir. 1963) 7 F. Hale Stewart and Beckett G. Cantley, U.S. Captive Insurance Law 2 nd Edition, pg F. Hale Stewart and Beckett G. Cantley 8 Ocean Drilling and Exploration Co. v. United States, 988 F. 2d 1135 (Fed. Cir. 1993) 9 Stearns Rogers Corp. Inc. v. United States, 577 F. Supp. 833 (D. Col. 1984) 10 Humana v. Comm r, 88 T.C. 197 (1987) 2

3 for Federal income tax purposes. Petitioner rejected option (3) because, first, it had doubts about the financial viability of its potential affiliates in such a pooling arrangement; second, one such potential affiliate owned hospitals in what were regarded as the worst States for malpractice claims; and third, it was reluctant to bind itself to such an arrangement for a 5-year period. Option (4) was considered the most attractive because it possessed none of the perceived disadvantages associated with the other options and it would provide a regulated method of insuring risks which would both isolate funds for the settlement of claims and satisfy interested lenders, mortgagees, and securities analysts. In addition, option (4) would provide access to world reinsurance and excess insurance markets. The above case excerpt depicts a logical discussion of four options and also shows a sound reason for rejecting the first three, thereby making the captive the logical option to solve a very legitimate problem. Notice how the above excerpt clearly demonstrated a subjective intent focused exclusively on underwriting risk rather than lowering taxes. At no point in any of the 11 major captive insurance cases from the 1950s Flood Plain decision to UPS in 2002 did the Service allege the captive was a tax shelter. The litigation instead focused on the substance of the transaction. The much over-touted Securitas 11 and Rent-A-Center 12 cases follow in this tradition. Both companies formed their respective captives to provide insurance for specific coverages that became cost prohibitive in the open market. Another reason taxpayers subjective intent in forming the original captives wasn t attacked is that insurance firms formed and managed these entities. It is highly probable that if an insurance consultancy is forming a company, it will be deemed an insurer. The Business Purpose Doctrine & Modern Captive Practice This stands in stark contrast to the post-2002 Revenue Ruling captive market, where a host of non-insurance professionals are recommending, forming, and managing captives for taxpayers. This influx of non-insurance professionals has potentially opened taxpayers up to allegations that they are not forming a captive with the commensurate subjective intent to form and run an insurance company. Consider the following common fact patterns when taxpayers are typically introduced to the idea of a captive. Let us begin with a CPA who is intimately involved with a client. He maintains the client s daily records and advises the client throughout the fiscal year on larger, more complex tax matters. During his regular third quarter client meeting, he notes, Mr. Client, after taking all appropriate deductions and projecting your receipts through the end of the fiscal year, it appears you will have final net income of $500,000. His next statement is potentially problematic, when he notes, Have you considered forming a captive insurance company? The CPA is not intentionally placing the client in legal jeopardy. However, should the client form a captive based on this recommendation, the Service could argue the taxpayer s subjective intent was to lower taxes, not mitigate risk. Now consider a client visiting an estate-planning lawyer for the first time. The attorney first asks the potential client about his family and then broadly discusses probate and non-probate transfers. He mentions trusts and discusses various charitable planning options. Then, the attorney 11 Securitas v. Comm r, T.C. Memo (October 29, 2014) 12 Rent-A-Center, Inc. and Affiliated Subsidiaries v. Comm r, 142 T.C. No. 1(2014) 3

4 asks, have you ever heard of a captive insurance company? Like the CPA, the attorney doesn t intend to place the client in jeopardy. However, the Service could potentially argue that a captive formed on this fact pattern wasn t incorporated to underwrite risk, but instead to pass wealth to the owner s children. Finally, consider a financial adviser who discusses the possibility of forming a captive with a client, but a large percentage of the presentation focuses on the captive s potential investment return using several generic portfolio structures. In addition, the financial projections assume a very large premium of $1,200,000 and zero or minimal losses. A captive formed under this fact pattern looks much like a virtual IRA, which we discussed in an earlier article. Here the Service has plenty of evidentiary ammunition to argue the taxpayer didn t form the captive to underwrite risk, but instead to use as an investment account. The difference between the Humana citation above and the three hypothetical fact patterns just outlined is clear. In Humana, the board of directors Minutes focused exclusively on finding a viable alternative to third party insurance. In contrast, the CPA, lawyer and financial adviser were focused on a matter not related to underwriting risk. Thus, since the three conversations weren t based initially on insurance (much less exclusively as in Humana), the Service can potentially challenge the transaction, arguing the taxpayer s subjective intent was something other than forming a viable third party insurance company. At this point, it s very important to note a successful challenge by the Service in the three situations is far from guaranteed. But, at minimum, each transaction is beginning on very suspect grounds enough, from the Service s perspective, to at least dig a little further and put the client through an in-depth audit. Discussing Captives Without Muddled Subject Intent With a little prior planning, the CPA, estate lawyer and financial adviser above can still discuss captives with their client without creating a muddied subjective intent fact pattern. For example, rather than discussing the captive in the initial conversation, they could have said, Mr. Client; I have a potential idea for you, but I d like to perform some professional due diligence to make sure it s an appropriate option. Could you please send me all your current insurance policies? After receiving them, the professional sends them to a captive specialist, who documents policy gaps and exclusions. Then, at a second meeting, the professional can say to the potential client, The reason I asked to see your insurance policies was to determine if a captive insurance company was a viable option. A review of your policies shows you have large gaps and exclusions that a captive could cover. Or, consider this possibility: suppose the CPA listed above read about a large malpractice award. He then contacted a physician client and mentions the award to him. Dr. Smith, did you see the news story about the large malpractice award? In that situation, a captive might be a better option. Have I discussed that possibility with you? A third option is to ask an existing client the following open ended question: what events, should they happen, would seriously jeopardize or completely threaten the viability of your business within an month period? Every entrepreneur has a list of potential fatal events. For example, smaller technology companies often sell a large percentage of their product to a single, larger tech company. If the larger company stops buying their products, the smaller company will experience a potentially devastating loss in income. Another example is a manufacturer who knows that recalling a product will cost a tremendous amount of money. A 4

5 third example is a commercial real estate company that owns properties along the coast or in an earthquake zone. In either situation a natural disaster could wipe out the company. In summation, there are numerous ways of beginning a captive insurance discussion with clients without potentially triggering a business purpose subjective intent problem. We have suggested three such ways, but we are certain there are countless others. As stated above, we suggest: (1) reviewing their insurance policies, identifying gaps and then presenting these findings to the client; (2) using recent events to begin a discussion about risks; and/or, (3) asking business owners what risks, should they occur, could bankrupt their companies. With a little forethought, captive professionals can successfully introduce potential clients to the idea of forming a captive without later jeopardizing the transaction by creating a muddy subjective intent fact pattern. 5