IRS Repulsed in Rent-A-Center Captive Case

We’ve seen this movie before.

Tax Man, The IRS Loses Its Challenge Against A Captive.

Tax Man 2 – The Sequel – The IRS Loses Again In A Captive Challenge.

Tax Man 3, The IRS Strikes Back… And Loses Again.

Tax Man 4, This Time It’s For Keeps But The Captive Owner Wins Yet Again.

On January 14, 2014 the Internal Revenue Service took another beating as the U.S. Tax Court handed down its ruling which upheld that payments by Rent-A-Center to its Bermuda-domiciled captive insurance company, Legacy Insurance Co. Ltd., were deductible as an insurance expense.   Legacy essentially insured three types of risk: worker’s compensation, automobile, and general liability.  Rent-A-Center operates retail locations in all fifty states and had approximately 3,000 stores, 19,000 employees and 8,000 vehicles during the period in question.

The I.R.S. claimed that Legacy was created primarily as a tax shelter for Rent-A-Center, and that Rent-A-Center owed $43 million in back taxes.  The court ruled in favor of Rent-A-Center, finding that policies issued by Legacy Insurance Co. Ltd. were genuine insurance policies and shifted risk between the company’s numerous retail locations.

Specific arguments made by the IRS were as follows:

–          Legacy was not a bona fide insurance company

–          Legacy was a sham entity created primarily to generate tax savings

–          There was an impermissible circular flow of funds

–          The premium-to-surplus ratio indicated Legacy was a sham

–          There was not adequate risk shifting and risk distribution

The court noted that the expert witness put forward by the I.R.S. contradicted many of the Service’s assertions, including undercutting the “circular flow of funds” argument.   On cross-examination, the Service’s expert witness also admitted that his analysis of commercial companies contained erroneous numbers, further undercutting the “premium-to-surplus ratio” argument.    The court also noted:

“…his comparison of Legacy’s premium-to-surplus ratios with the ratios of commercial insurance companies, was not instructive. Commercial insurance companies have lower premium-to-surplus ratios because they face competition and, as a result, typically price their premiums to have significant underwriting losses by retaining sufficient assets (i.e., more assets per dollar of premium resulting in lower premium-to-surplus ratios) to earn ample amounts of investment income. Captives in Bermuda, however, have fewer assets per dollar of premium (i.e., higher premium-to-surplus ratios) but generate significant underwriting profits because their premiums reflect the full dollar value, rather than the present value, of expected losses. Simply put, the premium-to-surplus ratios do not indicate that Legacy was a sham.”

The court also noted that Rent-A-Center “presented convincing, and essentially uncontradicted, evidence that Legacy was a bona fide insurance company.  As respondent (I.R.S) concedes, [Rent-A-Center] faced actual and insurable risk. Comparable coverage with other insurance companies would have been more expensive, and some insurance companies would not underwrite the coverage provided by Legacy.”

The court ruled that “The policies at issue 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 court also ruled that proper risk distribution occurred, noting that “In analyzing risk distribution, we look at the actions of the insurer because it is the insurer’s, not the insured’s, risk that is reduced by risk distribution.”

This ruling is another in a long string of losses by the I.R.S. in its challenges against captive insurance companies.  This case further proves that a well-structured captive insurance company with a legitimate business purpose that also employs risk-shifting and risk-distribution is extremely difficult for the I.R.S. to challenge and defeat.  A plain reading of captive insurance law and captive case law further reinforces this point.