Clougherty Packing Co. v. C.I.R.

• Decision Date: 03 March 1987
• Docket Number: No. 85-7707,85-7707
• Citation: 811 F.2d 1297
• Parties: -668, 55 USLW 2489, 87-1 USTC P 9204 CLOUGHERTY PACKING COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1297

811 F.2d 1297

59 A.F.T.R.2d 87-668, 55 USLW 2489, 87-1

USTC P 9204

CLOUGHERTY PACKING COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 85-7707.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Aug. 6, 1986.

Decided March 3, 1987.

Brian J. Seery, Los Angeles, California, for petitioner-appellant.

Gayle P. Miller, Gary R. Allen, Washington, D.C., for respondent-appellee.

Appeal from the United States Tax Court for the Central District of California.

Before ANDERSON, PREGERSON and REINHARDT, Circuit Judges.

REINHARDT, Circuit Judge:

We are presented with another version of a not so novel question: Are amounts paid as "insurance premiums" by a parent corporation to its "captive insurance company" ¹ subsidiary deductible for purposes of federal income taxation? This latest twist, like the previous case we considered, Carnation Co. v. Commissioner, 640 F.2d 1010 (9th Cir.), cert. denied, 454 U.S. 965, 102 S.Ct. 506, 70 L.Ed.2d 381 (1981), aff'g 71 T.C. 400 (1978), involves the purchase by a parent of insurance from an unrelated insurance company and the reinsurance by the unrelated company of the principal portion of that liability with the parent's captive subsidiary; however, in the case now before us there is no agreement between the parties providing for additional capitalization of the captive by the parent or otherwise ensuring that the captive will be able to perform its obligations under the reinsurance agreement.

Differing fact patterns of the captive insurer issue have appeared before several courts, all of which have held that insurance payments from a parent to its wholly-owned captive are not deductible. ² Yet the issue seems not to have been addressed with finality, or, perhaps, as Clougherty asserts, we and other courts have not explained our decisions adequately. We affirm the United States Tax Court's finding of non-deductibility and attempt to provide a more complete explanation of the reasoning underlying our conclusion.

I. Facts

The parties have stipulated fully to the facts. Clougherty Packing Company is a California corporation whose principal business is slaughtering and meat processing. It employs over 1,000 workers, for whom California requires Clougherty either to maintain workers' compensation coverage through an authorized insurer or to self-insure after obtaining consent from the California Director of Industrial Relations. Cal.Lab.Code Sec. 3700 (West 1971). Clougherty faced numerous claims, and from 1971 to 1977, it self-insured a portion of its risk and obtained excess liability coverage for the balance from authorized insurers. As a partial self-insurer, Clougherty was required to deposit securities with the state treasurer as collateral for potential claims; the collateral totaled $857,110 in 1977.

In 1976, an outside consultant recommended that Clougherty form a captive insurance company to insure its workers' compensation liability. Clougherty incorporated two wholly-owned subsidiaries, Lombardy Insurance Corporation in Colorado and Clougherty Packing Company of Arizona, the latter eventually becoming the sole holder of Lombardy stock. ³ Colorado permits the incorporation of captive insurers pursuant to the Colorado Captive Insurance Company Act, Colo.Rev.Stat. Secs. 10-6-101 to -130 (1973). Clougherty capitalized Lombardy for $1 million, and the Colorado Division of Insurance thereafter issued Lombardy a certificate of authority to conduct business as a captive insurance company in Colorado.

Clougherty then negotiated and reached an agreement for a captive insurance program with Fremont Indemnity Company, an authorized insurance carrier in California unrelated to Clougherty. As of January 1, 1978, Clougherty terminated the self-insurance portion of its insurance coverage and purchased all of its workers' compensation insurance from Fremont. Fremont reinsured with Lombardy the first $100,000 of each claim against Clougherty and ceded to Lombardy 92% of its annual premium. Fremont also charged Clougherty an additional amount equal to five percent of the premium as a fee for providing the captive insurer program. There was no agreement requiring Clougherty to indemnify Fremont, to capitalize Lombardy further, or otherwise to guarantee Lombardy's obligations. Lombardy engaged in no business other than the reinsuring of Clougherty. The premium charged by Fremont and the reinsurance rate charged by Lombardy were approved by the appropriate state agencies. Fremont remained liable for the payment of insurance claims in the event Lombardy became insolvent or defaulted for any other reason. However, under California law, because Clougherty had purchased an insurance policy from an authorized insurer, Clougherty could not be held liable for covered workers' compensation claims in the event that Fremont failed to make the required payments. Cal.Lab.Code Secs. 3755, 3757 (West 1971).

In calculating its federal income tax liability in its fiscal years ending July 29, 1978, and July 28, 1979, Clougherty deducted as necessary business expenses the amounts it paid to Fremont as insurance premiums--$840,000 and $1,457,000 respectively. Of these sums, Lombardy received $772,900 and $1,340,000. In reviewing Clougherty's tax returns, the Commissioner of Internal Revenue disallowed the portions of premiums received by Lombardy from Fremont and determined income tax deficiencies for Clougherty of $370,944 and $628,202.

Clougherty appealed the Commissioner's disallowance, and a divided panel of the United States Tax Court sitting en banc affirmed. Clougherty Packing Co. v. Commissioner, 84 T.C. 948 (1985). Eight judges subscribed to the plurality opinion, three wrote separate concurrences, and seven joined in dissent. Clougherty's timely filing brings the matter before this court.

II. Legal Discussion

A. Standard of Review

Our court has jurisdiction to review decisions of the United States Tax Court. 26 U.S.C. Sec. 7482(a) (1982). We review its decisions on the same basis as decisions following civil bench trials in federal district court. 26 U.S.C. Sec. 7482(a) (1982); Mayors v. Commissioner, 785 F.2d 757, 759 (9th Cir.1986). The parties here have at all times stipulated to the relevant facts; the only questions are those of law. Our review of the Tax Court's decision is thus de novo. Vukasovich v. Commissioner, 790 F.2d 1409, 1413 (9th Cir.1986). Although the Tax Court's judgments in its field of expertise are accorded a presumption that they correctly apply the law, we do not apply a rule of special deference to its decisions. Id.

B. The Definition of Insurance

In calculating taxable income, section 162(a) of the Internal Revenue Code, 26 U.S.C. Sec. 162 (1954), permits the deduction from gross income of all ordinary and necessary expenses incurred in carrying on a business. Premiums for insurance, including those for workers' compensation coverage, are deductible business expenses. 26 C.F.R. Sec. 1.162-1(a) (1986). The insuring taxpayer deducts the amounts paid as premiums but, of course, cannot deduct covered claims because the source of the payments is the insurance carrier. In lieu of purchasing insurance, one may elect to self-insure, paying off claims as they arise or setting aside fixed sums into a reserve account to pay off intermittent losses. While insurance premiums are deductible, amounts placed into self-insurance reserves are not. Steere Tank Lines, Inc. v. United States, 577 F.2d 279, 280 (5th Cir.1978), cert. denied, 440 U.S. 946, 99 S.Ct. 1424, 59 L.Ed.2d 634 (1979); Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78, 80 (10th Cir.1930), cert. denied, 284 U.S. 654, 52 S.Ct. 33, 76 L.Ed. 555 (1931); Pan-American Hide Co., 1 B.T.A. 1249 (1925). Instead, the self-insuring taxpayer must wait until losses actually occur, at which time the reserve funds actually paid out may be expensed and deducted from gross income. In between the extremes of ordinary insurance and direct self-insurance lies the captive insurer transaction. We must decide whether to treat this transaction as one or the other. If the former, then the amounts paid by Clougherty to its captive Lombardy through Fremont are deductible insurance premiums; if the latter, no deduction is permitted. We hold that the captive insurer arrangement used by Clougherty falls on the self-insurance side of the line.

The appropriate starting point of our analysis is the meaning of "insurance." Neither the Internal Revenue Code nor tax regulations provide a definition of insurance. The accepted definition for purposes of federal income taxation dates back to Helvering v. Le Gierse, 312 U.S. 531, 61 S.Ct. 646, 85 L.Ed. 996 (1941), in which the Supreme Court stated that "[h]istorically and commonly insurance involves risk-shifting and risk-distributing." Id. at 539, 61 S.Ct. at 649; see Commissioner v. Treganowan, 183 F.2d 288, 291 (2d Cir.), cert. denied, 340 U.S. 853, 71 S.Ct. 82, 95 L.Ed. 625 (1950); B. Bittker, 5 Federal Taxation of Income, Estates & Gifts p 127.2 at 127-7 (1984) ("under Le Gierse the shifting and distribution of the risk of death are indispensable elements of life insurance"). ⁴ Shifting risk entails the transfer of the impact of a potential loss from the insured to the insurer. If the insured has shifted its risk to the insurer, then a loss by or a claim against the insured does not affect it because the loss is offset by the proceeds of an insurance payment. See Beech Aircraft, 797 F.2d at 922; Treganowan, 183 F.2d at 291; O'Brien & Tung, Captive Off-Shore Insurance Corporations, 31 N.Y.U. Inst. 665, 683-84 (1973). Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as a premium and set aside for the payment of such a claim. Insuring many independent risks in return for numerous premiums serves to distribute risk. By assuming numerous relatively small,...