They may not be as delicious as apple pie or enjoyable as baseball, but tax loopholes are just as American. The U.S. Tax Court recently provided a new mechanism for corporations to reduce tax liabilities when, in Rent-A-Center, Inc., et al. v. Commissioner, 142 T.C. 1 (Jan. 14, 2014), it ruled a parent corporation could deduct as a trade or business expense, payments made on behalf of its subsidiaries to a wholly-owned captive insurer that provided coverage for the subsidiaries. Of particular note is the Court’s departure from Humana Inc. v. Commissioner, 88 T.C. 197 (1987), and adoption of the reasoning of the federal appellate court that reversed a portion of Humana in Humana Inc. v. Commissioner, 881 F.2d 247 (6th Cir. 1989).
From 2003 through 2007 (the “Tax Years”), Rent-A-Center, Inc. (“RAC”) was the largest domestic rent-to-own company and filed consolidated federal income tax returns for itself and 15 subsidiaries. For the Tax Years, the Internal Revenue Service (“IRS”) determined total deficiencies against RAC in excess of $40 million attributable to deductions taken by RAC for payments made to its wholly-owned, Bermuda-based captive insurer, Legacy Insurance Co., Ltd. (“Legacy”).
RAC formed Legacy in December 2002 as a way to save costs on insurance premiums. Legacy provided RAC’s primary level coverage for workers’ compensation, automobile and general liability. RAC purchased excess coverage from Discover Re for the same risks. The annual premium Legacy charged RAC was actuarially determined using loss forecasts developed by its broker and was allocated to each RAC subsidiary that owned covered stores. Notably, all of RAC’s stores were owned and operated by its subsidiaries. RAC paid the premiums for each policy and at the end of each year adjusted the allocations attributable to each subsidiary to reflect actual insurance costs. Legacy employed a third-party administrator to evaluate and pay claims.
The Tax Court found that payments to Legacy were deductible because: (1) Legacy was a bona fide insurance company, and not, as the IRS claimed, “a sham entity created primarily to generate Federal income tax savings,” Rent-A-Center, 142 T.C. at 7. and (2) the payments were deductible insurance expenses.
On the question of whether Legacy was a bona fide insurance company, the Tax Court quickly found that RAC considered tax consequences in forming Legacy, but it was not a “tax-driven transaction,” because Legacy “made a business decision premised on a myriad of significant and legitimate considerations.” Id. The Tax Court determined Legacy was a bona fide insurance company because: (i) RAC faced actual and insurable risk, (ii) comparable coverage with other insurance companies would have been more expensive (if available at all), (iii) the contracts between Legacy and RAC’s other subsidiaries were bona fide arm’s-length contracts, (iv) premiums were determined actuarially and (v) because Legacy was subject to Bermuda’s regulatory control and met its minimum statutory requirements, paid claims from its separately maintained account and was capitalized adequately.
The question of whether RAC’s payments to Legacy were deductible as insurance expenses involved more extensive analysis and ultimately led to the Tax Court reversing a portion of its earlier decision in Humana. The Internal Revenue Code does not define insurance, but the U.S. Supreme Court has established two necessary criteria —risk shifting and risk distribution. The Tax Court also considers whether the arrangement involves insurance risk and meets commonly accepted notions of insurance. The IRS conceded the criteria of insurable risk was present because RAC faced insurable risk related to workers’ compensation, automobile and general liability. The Tax Court easily found that Legacy distributed risk by insuring the risks to subsidiaries that collectively owned upwards of 2,600 stores, had 14,300 employees and operated 7,100 vehicles. The Tax Court also ruled that Legacy constituted an insurer in the commonly accepted sense, in that it was adequately capitalized, regulated by Bermuda, issued valid and binding policies, received actuarially determined premiums and paid claims.
Accordingly, the deductibility of RAC’s payments to Legacy turned on the existence of risk shifting from RAC’s subsidiaries to Legacy and the Tax Court’s interpretation of Humana. In Humana, the Tax Court faced two distinct issues: the deductibility of premiums paid by a parent to a captive (parent-subsidiary arrangement) and the deductibility of premiums paid by affiliated subsidiaries to a captive (brother-sister arrangement). In that case, the Tax Court held that neither parent-subsidiary premiums nor brother-sister premiums were deductible because the risk did not shift to the captive insurer.
The Sixth Circuit affirmed the Tax Court’s ruling relating to the parent-subsidiary arrangement, but reversed with respect to the brother-sister arrangement. It ruled that brother-sister premium payments were deductible because risk shifts when a subsidiary that has no ownership interest in the captive insurer pays premium under an insurance contract to the insurer. The court went on to lay out a roadmap for RAC’s later arrangement, refuting the Tax Court’s reasoning that denying deductions in the brother-sister context was necessary to prevent a parent to a captive insurance company from avoiding the non-deductibility of payments in the parent-subsidiary context by paying premiums on behalf of its subsidiaries.
Adopting the portion of the Sixth Circuit’s decision in Humana that approved deductions in the brother-sister context, the Tax Court in Rent-a-Center overruled its prior precedent and ruled that brother-sister arrangements shifted risk because the claims paid by the captive did not affect the net worth of the insured subsidiaries. The Tax Court rightly reversed itself in the case of the arrangement set up by RAC, but, as a concurring opinion aptly noted, the deductibility of captive insurance transactions is based on the facts and circumstances of each case and insurance brokers helping a corporation create a captive insurer would be wise to closely follow those in Rent-a-Center.