For the last decade, taxpayers have had to demonstrate that tax-related transactions have economic substance. This is the result of Congress's codification of the economic substance doctrine in 2010 26 U.S.C. § 7701(o)(1).
Under this doctrine, all transactions must comply with the following two factors.
The transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position; and
The taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such a transaction.
The first factor focuses on the transaction's objective substance. In the case of captive insurance disputes, the court would ask the question, "Is this an insurance company?" and use the Harper test analysis to find its answer.1
The second factor focuses on the taxpayer's subjective intent, asking why the taxpayer formed the captive. Although the case law contains both positive and negative examples, the analysis is inferential and typically contained in the case's factual recitations. This has, unfortunately, led practitioners to overlook this critical element since the recent taxpayer losses in the micro-captive area contain textbook examples of bad facts.
This article will first look at the Frank Lyon Co. v. U.S., 435 U.S. 561 (1978), case, which is a US Supreme Court decision that clearly explains subjective intent. This will be followed by several fact patterns from earlier captive cases that contain surprisingly good subjective intent justification.2 Next will be an analysis of the recent micro-captive losses that are littered with bad fact patterns.
Frank Lyon and Business Purpose
In the mid-1950s, Worthem Bank was competing with its cross-town rival to build a new headquarters in Little Rock, Arkansas. Federal and state law prevented Worthem from utilizing its preferred financing method. The bank turned to Frank Lyon Co., a local contractor whose president sat on the bank's board of directors, and proposed a sale lease-back transaction. Frank Lyon agreed; it bought the land from the bank, constructed the headquarters, and leased it back to the bank. Frank Lyon next started to deduct various real estate expenses on its tax returns. The Internal Revenue Service (IRS) disallowed these deductions, arguing the bank was the "de facto owner" of the building. Frank Lyon disagreed and took the IRS to court.
The case eventually reached the US Supreme Court, which ruled for Frank Lyon. The decision contains this now famous passage.
In short, we hold that where, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.
Circumstances forced the bank to utilize the sale-leaseback structure. The facts contained nothing even hinting that the bank nor the contractor had any motives aside from building a headquarters for the bank. Finally, there was an actual physical structure that resulted—a tangible "thing" from which the bank conducted its business.
The Frank Lyon case stands for the proposition that a transaction should arise organically from ongoing business operations—that it should be the natural result of ongoing activity. This does not mean that an outside party, such as an investment banker or business consultant, cannot recommend and then implement a transaction. However, it does mean they should do so in a manner that is consistent with the client's ongoing business operations.
Early Captive Cases with Good Subjective Intent Justification
Before the UPS v. Commissioner, 78 T.C.M. (CCH) 262 (1999), decision, most of the captive decisions focused on the transaction's objective content, eventually providing practitioners with a formal definition of an insurance company. They also contain a panoply of great examples of good subjective intent. The summaries below are taken from the court decisions.
Beech Aircraft Corp. v. U.S., 54 A.F.T.R.2d 84-6173 (1971)
In June 1971, a jury verdict was rendered against Beech for $21,700,000, $17,500,000 of which was for punitive damages. An investigation by Beech convinced its officers that the defense to the lawsuit had been poorly developed and that the case was ineffectively tried. Beech sought to obtain, without success, an insurance contract that would permit its own attorneys to conduct the defense of actions or at least participate in such trials. No insurer would consent to such an arrangement.
Here, Beech clearly believed it had an insurance coverage problem (poor trial representation) that resulted in harm to the company. The company tried to find a remedy on the traditional market but could not. To solve this problem, it formed a captive.
Stearns-Roger Corp. Inc. v. U.S., 577 F. Supp. 833 (D. Colo. 1984)
Stearns-Roger was in the worldwide business of designing and manufacturing large mining, petroleum, and power generation plants. These plants and facilities frequently cost between $5 million and $20 million, and substantial liability risks accompanied their design and construction. The bid specifications through which the jobs are obtained usually required Stearns-Roger to insure both itself and the client against many of these risks. If it were unable to obtain such insurance, the taxpayer could not compete in bidding for many major projects.
The insurance typically required includes coverage for errors and omissions, damage to completed operations, and comprehensive general liability. Since the early 1970s, Stearns-Roger found it difficult or impossible to obtain from traditional insurance companies the types and huge amounts of coverage needed. For that reason, Stearns-Roger decided to enter the insurance business, partly as a financial opportunity and partly to provide itself a source for insurance required to keep it in business.
This is a very typical fact pattern for heavy, blue-collar industries such as contractors, trucking companies, and oil and gas concerns. Due to the inherent risk of these businesses, it is not uncommon for insurance companies to simply withdraw from a market.
During the 1960s, Ocean Drilling faced difficulties insuring its drilling rigs. At that time, the drilling rig business was written predominately by the Lloyd Syndicate ("Lloyd's"), with the London Market serving as an ancillary market to Lloyd's. As the technology of drilling rigs developed rapidly, Lloyd's adjusted its insurance rates in an attempt to cover itself against potential losses from the new drilling rigs. Because of the limited experience in insuring the new rigs and a number of substantial losses on these rigs, insurance rates increased sharply.
By the end of the 1960s, rates were as high as 10 percent of the value of insured vessels, and Ocean Drilling was unable to obtain full coverage of its rigs through the existing insurance market. In response to this dilemma, the plaintiff analyzed its history of premiums and losses and determined that the establishment of a captive insurer could alleviate the problems that the plaintiff faced in the insurance market. In 1968, Ocean Drilling established Mentor as a wholly owned subsidiary incorporated in Bermuda.
The Lloyd's market is typically the market of last result for procuring insurance. It is also not uncommon for companies that utilize this market to eventually form a captive for the same reason as Ocean Drilling: it's simply more economical.
Humana Inc. & Subsidiaries v. Commissioner of Internal Revenue,
88 US Tax Ct. 197 (1987)
Through the services of its insurance broker, Marsh & McLennan, Inc. (Marsh & McLennan), Humana, Inc., attempted to obtain general and professional liability insurance from third-party insurers but was unsuccessful. On June 1, 1976, Marsh & McLennan recommended that the petitioner immediately take steps to establish a captive insurance company.
At the time that the Marsh & McLennan letter was received, the petitioner was considering the following options.
Creating a trust fund or reserve for self-insurance;
Combining with other hospital companies in a 5-year insurance pooling arrangement; or
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 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 was likely derived from board meeting minutes for a meeting specifically devoted to the topic of insurance. The company methodically considered and rejected three options before settling on a captive.
Summary of Early Captive Cases
All the above cases have a clear pattern: the company had a problem with significant insurance coverage, adequate legal representation provided by the insurer was lacking, coverage was unavailable, and the cost was too high. The Humana fact pattern not only illustrated a clear problem with coverage, it also showed that, after analysis, a captive offered the best solution. Moreover, all these facts clearly show that the need for the captive rose organically from the taxpayer's ongoing business operations as required by Frank Lyon—that the transaction was "compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features."
Recent Micro-Captive Cases
The above examples compare negatively with the formation fact-patterns in the recent micro-captive cases.
Avrahami v. Comm'r, 149 T.C. No. 7 (U.S.T.C. Aug. 21, 2017)
The taxpayer, in this case, first learned about captives from their certified public accountant (CPA), who recommended an estate-planning attorney, who then recommended a second estate-planning lawyer who helped the Avrahamis form a captive. The inclusion of the CPAs and estate-planning lawyers, and the exclusion of insurance professionals, inferred that the taxpayer's motivation was tax savings and estate planning and not insurance.
Caylor Land & Development, Inc. v. Comm'r
, T.C. Memo 2021-30 (2021)
The facts in Caylor first note that the taxpayer had the "broadest policies available," covering property, general liability, umbrella, cyber, equipment, installation, auto, and terrorism. On the plus side, the business had $500,000 of noninsured losses between 1997–2007 (or about $50,000/year). Unfortunately, there was no mention of the captive covering these previously uninsured losses. To make matters worse, the insured learned about the captives at a presentation that focused on their "potential tax benefits." This was followed by a discussion with the taxpayer's CPA and attorney. Conspicuously absent from this discussion was the insurance agent, which the court noted.
Reserve Mechanical Corp. v. Comm'r of Internal Revenue, T.C. Memo. 2018-86 (U.S.T.C. June 18, 2018)
In this case, the taxpayer was engaged in the high-risk business of "distributing, servicing, repairing, and manufacturing equipment for underground mining and construction." But save for a recommendation from a business mentor about needing more insurance, there was no mention of any significant problems with current insurance coverage.
Summary of Later Captive Cases
In comparison to the earlier cases mentioned above, the facts in the micro-captive cases exhibit relatively few problems with insurance coverage. And none of the captives that had potential coverages underwrote those problem areas in their respective captives.
In closing, subjective intent—the reasons why a taxpayer forms a captive—is just as important as objective substance. Make sure that you thoroughly investigate the reasons why the company is forming the captive to ensure (no pun intended) that it's to underwrite risk—and thoroughly document the reasons. It could come in handy at some later date.
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1Harper Group and Includible Subsidiaries c. Comm'r, 96 T.C. 45 (1991). (In determining the propriety of claimed insurance deductions by a parent or affiliated company to a captive insurance company, the following three-prong test must be applied, and each part must be satisfied: (1) whether the arrangement involves the existence of an "insurance risk," (2) whether there was both risk shifting and risk distribution, and (3) whether the arrangement was for "insurance" in its commonly accepted sense.)
2 The earlier captive insurance cases centered on the transaction's objective substance.