All transactions occur against the backdrop of antiavoidance law—five common-law doctrines used by the courts and the Treasury Department to determine if a transaction is legitimate or a tax shelter: substance over form, the sham transaction doctrine, the business purpose test, the economic substance doctrine, and the step transaction doctrine. The analysis is, at best, difficult.
There is a large amount of overlap between the five, causing a great deal of confusion even among experienced jurists. The final determination is based on the totality of the circumstances that align more with Potter Stewart's famous definition of pornography—"I know it when I see it"—rather than with organizing analysis of a specific legal issue.
The 2010 incorporation of the Economic Substance Doctrine into the tax code helped somewhat. The taxpayer must demonstrate the following.
(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.
26 U.S.C. 7701(o)
Although the doctrine gave us general parameters, it is still sufficiently murky to make clear answers difficult. The accompanying case law only adds to the confusion.
On the plus side, the codification does give practitioners two prongs: an objective and subjective. The objective component (Section A) analyzes the transaction's minutia. Here, courts engage in a very detailed analysis of the transaction components to determine if it is, in fact, what the taxpayer claims it is. The subjective prong (Section B) focuses on the taxpayer's motivation when they performed the transaction, asking the question, "Did he intend to do 'X' legitimately, or did he instead want the benefits (usually in the form of a deduction) without the possibility of a loss?" 1
A previous article, "Elements of Insurance," explained the basic elements of insurance, which would be used to determine if the taxpayer complied with the objective component of the economic substance doctrine. That analysis is more in line with standard legal writing, where a lawyer will weave factors and facts together to determine if the transaction passes a particular test.
The subjective test is more nuanced and complex. Rather than use factors, it focuses on the transaction's history to determine if events pushed a taxpayer in a particular transactional direction. The Frank Lyon Co. v. United States, 435 U.S. 561 (1978), case provides the most famous example. In Lyon, an Arkansas bank named Worthen wanted to build its new headquarter in downtown Little Rock. Banking regulations prevented the company from self-funding the transaction and placing the bank on its balance sheet.
They contacted the Frank Lyon Company, an Arkansas contractor whose president sat on the board of Worthen Bank, and proposed the parties engage in a standard sale leaseback transaction. Lyon agreed. It purchased the land, built the new headquarters, and then leased it back to Worthen. But when Lyon started to take tax deductions related to its new building, the Internal Revenue Service (IRS) denied the deductions, arguing that Worthen was the true owner of the bank.
The case wound its way through the courts and was eventually tried before the US Supreme Court in Gregory v. Helvering, 293 U.S. 465 (1935), which ruled in Lyon's favor. The Supreme Court decision contains this key paragraph.
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-avoidance features to which meaningless labels are attached, the government should honor the allocation of rights and duties effectuated by the parties; so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.
The taxpayer in Lyon didn't want to use a sale-leaseback, instead preferring to simply own the building outright. The law prevented this structure, meaning the final sale-leaseback transaction was "compelled or encouraged by business or regulatory realities." The parties had separate lawyers who negotiated the terms and conditions of the final contract, meaning the transaction was "imbued with tax-independent considerations." There is no mention of taxes in the factual recitation, which means the transaction was "not shaped solely by tax-avoidance features."
Note that the court does not state "the taxpayer had a specific subjective intent" to engage in the transaction. Instead, the judges inferred from the facts and circumstances that the taxpayer's intent was not tax motivated.
At this point, savvy tax practitioners will quote the following passage from Gregory v. Helvering: "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted." They will then argue this allows—in fact, encourages—discussion of taxes and tax benefits. These same practitioners will fail to note that Gregory is also the legal wellspring from which all modern antiavoidance law springs. While granting taxpayers the right to minimize taxes, it also requires all transactions have sufficient substance, preventing courts from exalting "artifice above reality." Id.
How does a taxpayer prove suggestive intent in the captive insurance arena? There are a number of ways. First off, who recommended the transaction? In the 2017 list of abusive tax shelters, the IRS specifically mentioned captive insurance transactions recommended by "promoters, accountants or wealth planners."
While this may seem an odd cast of characters, the assumption is that each does not have an insurance purpose in recommending the transaction. A "promoter" is obviously trying to encourage a course of behavior for personal gain; an accountant's primary motive is likely tax reduction; wealth planners are attempting to increase assets under management. Insurance producers are conspicuously absent from this list because their recommendations are focused on risk management and insurance. This does not mean that noninsurance professions can't recommend a captive insurance transaction to their clients. But it does mean they need to be exceedingly careful in how they first broach the topic and later discuss it with their clients.
Captive insurance case law is replete with examples of legitimate factual pretexts for forming captive insurance companies. The most obvious example is a situation where insurance coverage does not exist. This occurred in two cases: Trenton v. United States, 166 F. Supp. 796, 797–798 (New Jersey 1960) and United States v. Weber Paper Co., 320 F.2d 199, 201 (8th Cir. 1963). In both, the insureds owned property adjacent to a waterway that had recently flooded. Insurers stopped writing coverage as a result.
The companies were faced with three "solutions:" (1) moving their operations—which was not possible as both business models were based on waterway transport, (2) closing—which was obviously possible but extremely unattractive, which left, (3)developing some type of self-insurance facility.
Hard markets are another excellent factual precursor. This happened in Stearns-Rogers Corp., Inc. v. United States, 577 F. Supp. 833, 834 (Colo. 1984). Stearns Rogers, a company that designed and manufactured "large mining, petroleum and power generation plants." To bid on projects, the company had to obtain insurance for its own contractors as well as its clients. Starting in the early 1970s, the company "found it difficult or impossible to obtain from traditional companies the types and huge amounts of coverage needed." Therefore, the company formed a captive insurance company under the Colorado Captive Insurance Company Act.
Gaining more control of an insurance program is another valid reason; this occurred in Carnation Co. v. C.I.R., 71 T.C. 400, 402 (1978), where the parent company had extensive workers compensation exposure. Carnation's board of directors resolved to "organize an insurance company in Bermuda to carry on the business of insurance and reinsurance of various multiple line risks," including those of petitioner and its subsidiaries. This placed the burden of risk management squarely on the company, incentivizing them to be more proactive in containing costs.
Mobil Oil Corp. v. United States, 8 Cl. Ct. 555, 557 (1985), involved a large multinational company that was concerned it was purchasing insurance inefficiently and that the purchased policies were inadequate for the risks it was covering. Beech Aircraft had a similar goal, but it manifested itself in a different way. In that case, Beech Aircraft v. United States, 1984 WL 988, 1984 U.S. Dist. LEXIS 15251 (D. Kan. July 3, 1984), the plaintiff lost a jury verdict of $21.7 million in 1971. The old insurance policy did not allow Beech to investigate claims against the company or participate meaningfully in their legal defense. Forming a captive allowed Beech to control the drafting of policy language and meaningfully participate in its defense.
So, how can practitioners establish subjective intent? A 3- to 5-year history of insurance coverage is a good place to start as it can demonstrate a hardening market, the exit of insurers, heightened claims activity, difficult policy language, and the like. All transactions should demonstrate that the company considered a number of options and then rationally choose a captive insurer.
This is what happened in the Humana decision, where the company considered four options.
The final option was accepted because of the following.
… 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, [establishing a captive] would provide access to world reinsurance and excess insurance markets.
These facts were included in the minutes of a board meeting devoted to this topic.
How should practitioners approach the topic of taxes? After all, C-suite executives who don't analyze the tax ramifications of their decisions are likely derelict in their fiduciary duty to the company. My recommendation is that all sales literature should be completely stripped of any discussion of taxes. Don't mention them until the client is deep in the process of considering a captive program—perhaps the fourth or fifth discussion. Then, relegate it to the "added bonus" category: "Mr. Client, I'm glad you see the benefit of underwriting some of this risk. The most efficient means to do so is through a captive insurer, which is a more financially efficient structure."
Under the economic substance doctrine, all taxpayers must have a "substantial" purpose in entering into a specific transaction, which means the nontax components should be "of considerable size, importance, or worth." 2 If you take all of the transactions' individual facts, place each on a separate piece of paper, put them in a large bag, and then remove all of the tax facts, you should still have most of the slips of paper you started with. If that's not the case, you've exalted "artifice above reality" and likely have a problem transaction.
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