Tax Court Addresses Captive Insurance Arrangements

Feb. 6, 2014

In Rent-A-Center, Inc. and Affiliated Subsidiaries v. Commissioner of Internal Revenue, the U.S. Tax Court determined that payments by subsidiaries of Rent-A-Center Inc. (RAC) to a captive insurance company, Legacy Insurance Co. Ltd. (Legacy), for workers’ compensation, automobile, and general liability insurance were deductible as insurance payments. The Tax Court held that the arrangement shifted risk from RAC’s insured subsidiaries to Legacy, which was formed for a valid business purpose; was a separate, independent, and viable entity; was financially capable of meeting its obligations; and reimbursed RAC’s subsidiaries when they suffered an insurable loss.

The Tax Court also addressed whether an RAC guarantee for the benefit of Legacy’s insured would cause the arrangement to fail to qualify as insurance. RAC guaranteed up to $25 million of Legacy’s debt in order to have Bermuda treat deferred tax assets (DTA) as general business assets for purposes of its minimum solvency requirement. The Tax Court held that even with the guarantee, risk shifting did occur because the guarantee was used only to change the category of the DTAs and, therefore, concluded that Legacy was not undercapitalized. Although the Tax Court held that under this narrow set of circumstances a parental guarantee did not result in a failure to shift risk, any captive insurance arrangement with a parental guarantee should expect a challenge from the IRS. As a result, companies should avoid entering into a parental guarantee with their captive insurance company.

The Tax Court also addressed the IRS’s contention that Legacy’s premium-to-surplus ratios for the years in question were higher than those of commercial insurance companies. The court found that the higher premium ratios did not necessarily disqualify the payments to Legacy from constituting insurance. The majority opinion also did not challenge RAC’s method for allocating its actuarially determined premium obligation to Legacy, which allocated premiums paid to Legacy by the subsidiaries in the same manner RAC allocated premium expense to unrelated insurers.

A dissenting opinion argued that Legacy’s lack of employees and netting of certain payment obligations between Legacy and RAC should be viewed as evidence that Legacy should be disregarded as a separate entity. The concurring opinion dismissed these arguments, stating that, “In the real world of large corporations, these practices are commonplace. For ease of operations, including running payroll, companies create a staff leasing subsidiary and lease employees companywide. … And it is unrealistic to expect members of a consolidated group to cut checks to each other.” Although the companies did not cut physical checks for every payment obligation, best practice dictates the movement of cash when transactions involve related parties.

While the Tax Court’s ruling in Rent-A-Center was a taxpayer victory, it nevertheless highlights the issues the IRS and courts will use to scrutinize captive insurance arrangements.
 
 

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