Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

three pronged test for determining whether amounts paid to a captive insurance company are
deductible as premium expenses. See Amerco v. Commissioner, 96 T.C. 18 (1991), aff’d, 979
F.2d 162 (9th Cir. 1992); Harper Group v. Commissioner, 96 T.C. 45 (1991), aff’d, 979 F.2d
1341 (9th Cir. 1992), and Sears v. Commissioner, 96 T.C. 61 (1991), modified, 96 T.C. 671
(1991), aff’d in part and rev’d in part, 972 F.2d 858 (7th Cir. 1992).
In order for a payment between related entities to be considered a deductible insurance premium
the payment must involve: (1) an insurance risk; (2) risk shifting and risk distribution and (3) it
must be insurance in the commonly accepted sense. See Amerco v. Commissioner, 96 T.C. 18
(1991).
The first prong of the test, the presence of an insurance risk, was summarized by the Tax Court in
Amerco as a situation in which "* * * an insured faces some hazard; an insurer accepts a premium
and agrees to perform some act if or when the loss event occurs. * * *" Amerco v.
Commissioner, 96 T.C. at 38-39. Factors which may indicate the lack of an insurance risk include
an obligation on the part of the related corporations to pay the claims filed with the captive or to
make additional contributions to the captive based on loss experience. See Gulf Oil Corporation
v. Commissioner, 89 T.C. 1010 (1987).
The second prong, the requirement of risk shifting and risk distribution, has engendered a great
deal of debate and confusion. The Tax Court and several appellate courts have found risk shifting
to exist where the captive insures substantial amounts of unrelated business. The Tax Court’s
rationale for using the amount of unrelated business as the litmus test for risk shifting was
expressed in Gulf Oil Corporation, in which the court stated, "If all of the insured are related, the
insurance is merely self-insurance because the group’s premium pool is used only to cover the
group’s losses. By adding unrelated insured, the pool from which losses are paid no longer is
made up of only the affiliated group’s premiums." Gulf Oil Corporation v. Commissioner, 89
T.C. 1010, 1026-27. The Tax Court thus concludes that risk shifting cannot occur between
related parties without the presence of unrelated business. The Service’s view, as expressed in
Rev. Rul. 88-72, is that the absence or presence of third party insured is immaterial to whether the
risk has been shifted. The critical inquiry is whether the economic risk of loss has actually shifted
from the insured to the insurer. However, because the Tax Court and several appellate courts
have placed significant weight on the amount of unrelated business, we recommend that cases
raising this issue be coordinated with the Captive Issue Specialist.
Although the concept of risk shifting has been discussed by the courts, the risk distribution
requirement remains unclear. As expressed in Rev. Rul. 88-72, the Service’s position is that risk
distribution requires the underwriting of statistically unrelated risks so that there is a reduced
possibility that a single costly claim will exceed the amount taken in as a premium and set aside
for payment of such a claim. The Ninth Circuit adopted the Service’s view of risk distribution in
Clougherty Packing Company. However, the Tax Court appears to have blended the concepts of
risk shifting and risk distribution, assuming that when an insured shifts its own risk to an insurance
company, it agrees to receive some of the risk of other insured. See Amerco v. Commissioner, 96
T.C. 18 (1991), aff’d, 979 F.2d 162 (9th Cir. 1992); Harper Group v. Commissioner, 96 T.C. 45
(1991), aff’d, 979 F.2d 1341 (9th Cir. 1992), and Sears, Roebuck and Co. v. Commissioner, 96
T.C. 61 (1991), modified, 96 T.C. 671 (1991), aff’d in part and rev’d in part, 972 F.2d 858 (7th
Cir. 1992).
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