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

While not all captive situations involve sham corporations or sham transactions, certain fact
patterns do lend themselves to this analysis. In Malone & Hyde Inc. v. Commissioner, 62 F.3d
835 (6th Cir. 1995), rev’g T.C. Memo. 1993-585, CCH 49,463(M), the Sixth Circuit concluded
that the captive was a sham and thus the payments made by the related corporation were
nondeductible. The appellate court stated that the Tax Court should have determined whether the
captive was a sham corporation before considering whether risk shifting and risk distribution were
present. According to the Sixth Circuit, a taxpayer does not have a bona fide insurance
transaction if it uses as its insurer "* * * an undercapitalized foreign insurance captive that is
propped-up by guarantees of the parent corporation. The captive in such a case is essentially a
sham corporation, and the payments to such a captive that are designated as insurance premiums
do not constitute bona fide business expenses, entitling the taxpayer to a deduction under [IRC
section] 162(a)." See Malone & Hyde Inc. v. Commissioner, 62 F.3d 835, 839.
In reaching its conclusion that a valid insurance arrangement did not exist, the appellate court
distinguished the facts of Malone & Hyde from its decision in Humana, Inc. v. Commissioner,
881 F.2d 247 (6th Cir. 1989), aff’g in part, rev’g in part and rem. in part 88 T.C. 197 (1987). In
Humana, the taxpayer’s previous insurance had been canceled and the immediate need for
alternative insurance led to the creation of the captive insurance company. In Malone & Hyde,
however, the taxpayer had no problem obtaining comparable insurance from an unrelated party
but instead organized the captive insurance company despite the ready availability of more
conventional alternatives. See Malone & Hyde, 62 F.3d 835. In Humana, the captive was a fully
capitalized domestic insurance company organized in Colorado and subject to the regulatory
control of that state’s insurance commission. In contrast, the taxpayer in Malone & Hyde
organized the captive insurance company with only the thin capitalization required under Bermuda
law. The Malone & Hyde court recognized that the Humana decision specifically characterized
insurance schemes that involve undercapitalized captive offshore insurance companies to be
without the requisite risk shifting element. See Malone & Hyde Inc., 62 F.3d at 840.
It is important to note that the sham analysis is a limited concept. Therefore, cases which present
fact patterns similar to Malone & Hyde, Inc. should be coordinated with the Captive Issue
Specialist.
Insurance companies offer retrospective compensation (“retro") as a means of attracting more and
better quality business. This form of c compensation is commonly accepted by auto dealers and
may be associated with either credit life and disability insurance premiums and/or extended service
contracts. In this context, retrospective compensation is an agreement with the insurer for the
dealership to share in a portion of the underwriting profit, based on claim experience of the
business placed by the dealership. This is a one sided arrangement in which the dealers shares no
risk of loss. The retro is generally found in an addendum to the original agreement with the
dealership.
Agents should take note of two very important elements of a retro. The first is the formula used
to calculate the retro and the second is the timing of the payment.
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