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On January 14, the United States Tax Court issued a reviewed opinion in Rent-A-Center Inc. v. Commissioner, 142 T.C. 1 (2014), which held that subsidiaries of Rent-A-Center Inc. (RAC) were entitled to claim deductions for insurance premiums paid to a Bermuda captive insurance company – Legacy Insurance Co. (Legacy) – that (i) was wholly owned by RAC and (ii) had made an election under IRC § 953(d) to be treated as a U.S. corporation for federal tax purposes. In so holding, the Tax Court’s majority opinion concluded that:
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Legacy was created for significant and legitimate non-federal-tax reasons; specifically, to provide otherwise unavailable insurance to the subsidiaries at a reduced cost.
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There was no impermissible circular flow of funds between RAC and Legacy, even though Legacy used a significant portion of the premiums that it received to invest in treasury shares of RAC, i.e., hook stock of its parent company.
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Legacy’s premium-to-surplus ratios during the years in issue (2003-2007) did not indicate that it was a sham, and a comparison of such ratios to those of commercial property and casualty insurance companies in the United States or Bermuda was “not instructive.”
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Legacy was a bona fide insurance company for federal tax purposes even though it was capitalized in part with a parent guaranty. Notably, the parent guaranty was for a fixed amount that was small in comparison to the amount of annual premiums paid to Legacy.
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The premiums paid to Legacy were deductible under IRC § 162 by the insured subsidiaries based on an analysis demonstrating the existence of (i) insurance risk, (ii) risk shifting, (iii) risk distribution, and (iv) insurance in the commonly accepted sense. In this analysis, the Tax Court focused on the independence of the risks assumed, i.e., that the risks were unaffected by the same event, not on the number of subsidiaries insured.
Of note, seven judges agreed with the conclusions reached in the majority opinion, and another four concurred with the majority in a separate opinion, while five judges dissented from the conclusions reached in the majority opinion, and a sixth judge dissented on the grounds that there was “insufficient depth” in the majority opinion to join in its findings.
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Sutherland Observations
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Overall, the Rent-A-Center opinion is a favorable development for companies with captive insurance arrangements that fall outside of the “safe harbor” parameters described by the IRS in authorities such as Rev. Rul. 2002-90, 2002-2 C.B. 985, and Rev. Rul. 2005-40, 2005-2 C.B. 4. Although the case could be appealed (presumably to the U.S. Court of Appeals for the Fifth Circuit), the Rent-A-Center opinion nonetheless could have an immediate impact on current IRS examinations and appeals involving captive insurance programs.
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The case involved the interesting side issue of whether the Tax Court should revisit its opinion in Humana Inc. v. Commissioner, 88 T.C. 197 (1987), aff’d in part, rev’d in part, and remanded, 881 F.2d 247 (6th Cir. 1989), even though the IRS abandoned its “economic family theory” with respect to brother-sister captive insurance arrangements more than a decade ago in Rev. Rul. 2001-31, 2001-1 C.B. 1348. Ultimately, the majority opinion concluded that the “Court of Appeals for the Sixth Circuit’s critique of our analysis of the brother-sister arrangement in Humana” was “persuasive,” thus signaling its agreement with the Sixth Circuit’s reversal of its analysis on that issue.
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