United States: Tax Court Rules In Favor Of Taxpayer In Historic Captive Insurance Case

The Tax Court has held in favor of the taxpayer in Rent-A-Center v. Commissioner (142 TC 1), allowing Rent-A-Center to claim a Section 162 deduction for payments to a Bermuda captive insurance company. The decision has been highly anticipated because it addresses many of the current areas of uncertainty for captive insurance. The controversial decision was issued en banc, with one concurrence and two dissents.

Rent-A-Center had previously been insuring its worker's compensation, directors and officers liability, and other liabilities through third-party insurance. After a feasibility study, Rent-A-Center set up a Bermuda captive insurance company, which issued insurance policies for such risks. The IRS challenged the arrangement by arguing that the Bermuda entity was a sham and that there was no risk shifting or risk distribution.

The majority decision held that the entity was not a sham, notwithstanding that the assets used to meet Bermuda minimum capital requirements included "hook stock" of the common parent and deferred tax assets related to the insurance arrangement due to certain timing differences. The majority further held that there was risk shifting, notwithstanding that all the insured companies were brother-sister related entities.

The Tax Court adopted the Sixth Circuit's standards of risk shifting as articulated in Humana Inc. & Subs. v. Commissioner (881 F.2d 247), which focuses on the balance sheet approach and rejects the notion that risk shifting cannot occur when there are related parties or an "economic family." Finally, the majority held that there was risk distribution based on the number of insured risks to satisfy statistical concepts of the law of large numbers, and did not address or focus on the actual number of insured companies, which has historically been the focus of the IRS (see the safe harbors under Rev. Rul. 2002-90, for example).

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