MALONE & HYDE INC. v. Commissioner

• Decision Date: 02 November 1989
• Docket Number: Docket No. 5901-85.
• Parties: Malone & Hyde Inc. and Subsidiaries v. Commissioner.
• Court: U.S. Tax Court

58 T.C.M. (CCH) 631 (1989)

T.C. Memo. 1989-604.

Malone & Hyde Inc. and Subsidiaries v. Commissioner.

Docket No. 5901-85.

United States Tax Court.

Filed November 2, 1989.

John M. Bixler, Frederick H. Robinson, 655 Fifteenth St., N.W., Washington, D.C., and Keith D. Lawson, for the petitioner. Vallie C. Brooks, for the respondent.

Memorandum Findings of Fact and Opinion

PARKER, Judge:

Respondent determined deficiencies in petitioner's Federal income tax as follows:

                Fiscal Year
                Ended Deficiency
                  6/24/78 .....................  $ 50,247.97
                  6/30/79 .....................   766,064.83
                  6/28/80 .....................   949,061.05
                

After concessions,¹ the issues for decision are:

(1) Whether Malone & Hyde, Inc. may deduct as ordinary and necessary business expenses the amounts it paid to Northwestern National Insurance Company as insurance premiums, which were in turn paid by Northwestern National Insurance Company to Malone & Hyde's wholly owned subsidiary, Eastland Insurance, Ltd., as reinsurance premiums.

(2) Alternatively, if these amounts paid over to Eastland Insurance, Ltd. are not deductible as insurance premiums, whether the net additions to Eastland's case reserves for reported, uncontested worker's compensation claims may be allowed as deductions. This depends on whether or not the "all events" test for accrual of these expenses has been satisfied.

(3) Alternatively, if the amounts paid over to Eastland Insurance, Ltd. are not deductible as insurance premiums, and if the net additions to the case reserves for reported, uncontested worker's compensation claims are not deductible, whether the amounts paid by Eastland to General Adjustment Bureau (GAB) to finance the contested claims in the Loss Impress Fund are deductible. This depends on whether or not the requirements of section 461(f)² have been satisfied.

Findings of Fact

Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.

Petitioner (Malone & Hyde, Inc., and Subsidiaries) had its principal place of business at 3030 Poplar Avenue, Memphis, Tennessee at the time of the filing of the petition. Malone & Hyde, Inc. (hereinafter referred to as Malone & Hyde) is the common parent of petitioner, an affiliated group of corporations within the meaning of section 1504(a), which filed consolidated Federal income tax returns for each of the taxable years ending June 30, 1978, 1979, and 1980 (hereinafter referred to as fiscal year or FY 1978, 1979, and 1980) with the Internal Revenue Service Center at Memphis, Tennessee. During each of the years involved, Malone & Hyde maintained its books and records on the basis of the accrual method of accounting and used that method for purposes of computing its income for Federal income tax purposes.

Malone & Hyde is incorporated under the laws of the State of Tennessee and has been in the wholesale food distribution business since 1907. During each of its fiscal years 1978, 1979, and 1980, Malone & Hyde stock was publicly traded on the New York Stock Exchange. During the years in issue, subsidiaries and divisions of Malone & Hyde operated in the retail food industry, the insurance industry, the financial services industry, the retail drugstore industry, the retail auto parts industry, and the retail sporting goods industry. Malone & Hyde was primarily a wholesale food distributor, distributing all food products and all of the services that its customers (independent retail grocery store owners) needed to compete against the chains. It operated 10 distribution centers, primarily in the southeast, servicing approximately 2,500 independent retail grocers. It also provided its customers the other services mentioned above.

Since the early 1960's, Hyde Insurance Agency, Inc., a wholly owned subsidiary of Malone & Hyde, has been in business as an insurance agency, serving purely as a broker to provide Malone & Hyde and its subsidiaries and its customers with insurance written by the various major insurance companies. Hyde Insurance Agency acted as a full-service insurance agency obtaining for its clients all types of insurance coverage, including property, casualty, general liability, auto liability, and worker's compensation.³ The Hyde Insurance Agency's clients included Malone & Hyde, Malone & Hyde's subsidiaries, Malone & Hyde's wholesale customers who operated independent retail grocery stores, and some third parties unrelated to Malone & Hyde or its subsidiaries or its customers. The Hyde Insurance Agency never wrote any insurance but merely obtained insurance coverage from the various major insurance companies.

By the mid-1970's, the Hyde Insurance Agency found that insurance premiums were increasing each year and certain insurance was not obtainable for some of its clients. Its parent corporation, Malone & Hyde, began to investigate other means of obtaining adequate insurance coverages, including creating its own insurance subsidiary. Malone & Hyde was dissatisfied with the premiums it paid to its insurer, CNA, under CNA's "divisor plan." CNA's "divisor plan" was based on a fixed percentage of the amount of paid claims and reserves. Under that "divisor plan," the higher the claims the more CNA was paid, thus resulting in little incentive to control claims costs. As a result, both the Hyde Insurance Agency and Malone & Hyde considered other cheaper cost alternatives in insurance coverage.

Since Malone & Hyde's only experience in the insurance business was limited to running an insurance agency, it retained an independent consultant, Risk Management, Inc. (RMI), of Los Angeles, California, to advise it on setting up its own insurance subsidiary. In March 1977, Malone & Hyde executed a written agreement with RMI for the development of a captive insurance program.⁴ RMI was in the business of developing and managing such captive insurance programs. The agreement was made with the understanding that Malone & Hyde would enter into a management contract with RMI for the implementation and management of the program developed. RMI prepared a Proposed Insurance Subsidiary Feasibility Report for Malone & Hyde dated May 27, 1977.⁵

RMI recommended a two-phase development plan for entering the insurance business. In phase I, the insurance subsidiary would only insure the risks of Malone & Hyde and its subsidiaries. In phase II, if the insurance subsidiary had proved that it could operate as a financially sound enterprise, Malone & Hyde could decide whether to expand so that third-party risks (Malone & Hyde's customers and unrelated outside parties) would be insured. RMI also recommended that the insurance subsidiary reinsure risks originally placed with another insurance company, rather than to insure risks directly. RMI believed that providing reinsurance was preferable to providing direct insurance because reinsurers need not, as direct insurers must, qualify to conduct business under the insurance laws of each state in which a policy holder resides. RMI further recommended that the company be incorporated outside the United States because the insurance laws of some foreign countries are less restrictive than those of Colorado, the only state that had a captive insurance company statute in 1977. RMI suggested Bermuda as a possible place of incorporation because of the relative simplicity of its insurance regulations. Malone & Hyde adopted RMI's recommendations and decided to create an insurance company subsidiary to reinsure selected risks.

Subsequently, Eastland Insurance, Ltd. (hereinafter referred to as Eastland) was incorporated in Bermuda on June 21, 1977, to carry on the business of insurance, reinsurance, and coinsurance. Eastland was authorized to issue 120,000 shares at $1 par value. Malone & Hyde purchased all of these shares on June 21, 1977, for $120,000. Under Bermuda's insurance law, Eastland was adequately capitalized.

On May 10, 1978, Eastland executed a management agreement with RMI's subsidiary, Pinehurst Management Company, Ltd. (hereinafter referred to as Pinehurst Management), effective July 1, 1978, to perform services in Bermuda on behalf of Eastland. Eastland's officers and directors were the same individuals as Malone & Hyde's officers and directors, and were based in Memphis, Tennessee. The board of directors of Eastland determined that the initial activity of the company would include only reinsurance of the risks of Malone & Hyde and its subsidiaries, but that Eastland would investigate avenues of obtaining participation in risks of unrelated entities. The board further determined that Eastland would reinsure only the first $150,000 of each claim of worker's compensation, auto liability, and general liability. Malone & Hyde had good historical loss information as to those types of claims, and those were the predictable, less volatile claims. Since Eastland acted only as a reinsurer, Malone & Hyde had to choose an insurer who qualified to sell insurance in each state where Malone & Hyde and its subsidiaries (and later possibly its customers) operated and who would be willing to act as a primary insurer and reinsure the risks with Eastland. Malone & Hyde talked to several insurance companies before deciding upon the company most suitable to function as the primary insurer of risks to be reinsured with Eastland.

Northwestern National Insurance Company (hereinafter referred to as Northwestern), a large, highly regarded casualty insurance company in Milwaukee, Wisconsin, became the insurer and Eastland was the reinsurer for those claims. Eastland began reinsuring risks on July 1, 1978, covering only worker's compensation, auto liability, and general liability. In other words, Malone & Hyde and its subsidiaries would insure their risks with Northwestern and Northwestern would reinsure those risks up to $150,000 with Eastland. Northwestern could act as either the primary insurer of such risks...