Sears, Roebuck and Co. v. C.I.R.

• Citation: 972 F.2d 858
• Decision Date: 14 October 1992
• Docket Number: Nos. 91-3038,91-3688,s. 91-3038
• Parties: -5540, 92-2 USTC P 50,426 SEARS, ROEBUCK AND CO. and Affiliated Corporations, Petitioner-Appellant, Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee, Cross-Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 858

972 F.2d 858

70 A.F.T.R.2d 92-5540, 92-2 USTC P 50,426

SEARS, ROEBUCK AND CO. and Affiliated Corporations Petitioner-Appellant, Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee Cross-Appellant.

Nos. 91-3038, 91-3688.

United States Court of Appeals Seventh Circuit.

Argued April 3, 1992.

Decided Aug. 18, 1992.

As Amended on Denial of Rehearing

Oct. 14, 1992.

Michael M. Conway (argued), Frederic W. Hickman, Michael R. Schlessinger, Patrick A. Heffernan, Bradford L. Ferguson, Burton H. Litwin, Hopkins & Sutter, Chicago, Ill., petitioner-appellant, cross-appellee.

Abraham N.M. Shashy, Jr., I.R.S., Gary R. Allen, David I. Pincus (argued), John A. Dudeck, Jr., Mary F. Clark (argued), Dept. of Justice, Tax Div., Appellate Section, Washington, D.C., for respondent-appellee, cross-appellant.

George R. Abramowitz, Francis M. Gregory, Jr., Dennis L. Allen, Sutherland, Asbill & Brennan, Washington, D.C., amicus curiae Mortgage Ins. Companies of America.

Carolyn J. Johnson, National Ass'n of Ins. Com'rs, Kansas City, Mo., amicus curiae National Ass'n of Ins. Com'rs.

Frederic W. Hickman, Richard Bromley, Hopkins & Sutter, Chicago, Ill., Robert L. Zeman, Patrick J. McNally, National Ass'n of Independent Insurers, Des Plaines, Ill., amicus curiae National Ass'n of Independent Insurers.

Before BAUER, Chief Judge, EASTERBROOK, Circuit Judge, and NOLAND, Senior District Judge. ^*

EASTERBROOK, Circuit Judge.

Several subsidiaries of Sears, Roebuck & Co. sell insurance. One, Allstate Insurance Co., underwrote some of the risks of the parent corporation. Two others wrote mortgage insurance, promising to pay lenders if borrowers defaulted. Because Sears and all other members of the corporate group file a consolidated tax return, disputes about the tax consequences of these transactions affect the taxes of the entire group. The Commissioner of Internal Revenue assessed the group with deficiencies exceeding $2.5 million for the tax years 1980-82. Whether the group owes this money depends on the proper characterization of the two kinds of transaction.

An insurer may deduct from its gross income an amount established as a reserve for losses. 26 U.S.C. § 832. Until 1986 it could deduct the entire reserve; today it must discount this reserve in recognition of the fact that a dollar payable tomorrow is worth less than a dollar today. Tax Reform Act of 1986 § 1023, 100 Stat. 2085, 2399 (1986). These transactions occurred before 1986, and in any event we deal with the existence rather than the size of the deduction. Allstate created and deducted reserves to cover casualties on policies it issued to Sears. The Commissioner disallowed these deductions (and made some related adjustments), reasoning that the shuffling of money from one corporate pocket to another cannot be "insurance." The Tax Court disagreed. It distinguished captive subsidiaries (which write policies for the parent corporation but few or no others) from bona fide insurance companies that deal with their corporate parents or siblings at market terms. 96 T.C. 61 (1991).

The two subsidiaries underwriting mortgage insurance estimated losses as of the time the underlying loans went into default. The Commissioner contended that these insurers could not establish deductible loss reserves until the lenders obtained good title to the mortgaged property, because the insurance policies made a tender of title a condition precedent to the insurers' obligation to pay. The Tax Court agreed with this conclusion, rejecting the insurers' argument that the Internal Revenue Code permits them to deduct loss reserves required by state law, as these reserves were.

The judges of the Tax Court split four ways. Judges Korner, Shields, Hamblen, Swift, Gerber, Wright, Parr, Colvin, and Halpern joined Judge Cohen's opinion for the majority. Judges Chabot and Parker would have ruled for the Commissioner on both issues; Chief Judge Nims and Judge Jacobs would have ruled for Sears on both issues. Judge Whalen concluded that the majority had things backward: that Sears should have prevailed on the mortgage insurance issue but lost on the subsidiary issue. We join Chief Judge Nims and Judge Jacobs.

I

Allstate is a substantial underwriter, collecting more than $5 billion in premiums annually and possessing more than $2 billion in capital surplus. During the years at issue, Allstate charged Sears approximately $14 million per year for several kinds of insurance. Some 99.75% of Allstate's premiums came from customers other than Sears, which places 10% to 15% of its insurance with Allstate. The Commissioner's brief concedes that "[p]olicies issued to Sears by Allstate were comparable to policies issued to unrelated insureds. With respect to the execution, modification, performance and renewal of all of the policies in issue, Allstate and Sears observed formalities similar to those followed with respect to the insurance policies issued by Allstate to unrelated insureds. In addition, the premium rates charged by Allstate to Sears were determined by means of the same underwriting principles and procedures that were used in determining the premium rates charged to unrelated insureds, and were the equivalent of arm's-length rates." The Tax Court made similar findings, although not nearly so concisely.

Allstate, founded in 1931, has been selling insurance to Sears since 1945. Everyone, including the Commissioner, has taken Allstate as the prototypical non-captive insurance subsidiary. Until 1977 the Internal Revenue Service respected transactions between non-captive insurers and their parents. In that year the Commissioner decided that a wholly owned subsidiary cannot "insure" its parent's operations, even if the subsidiary's policies are identical in terms and price to those available from third parties. Rev.Rul. 77-316, 1977-2 C.B. 53. Examples given in this revenue ruling all dealt with captives that had no customers outside the corporate family. After issuing the ruling the Service continued to believe that subsidiaries engaged in "solicitation and acceptance of substantial outside risks" could provide insurance to their parents. G.C.M. 38136 (Oct. 12, 1979). But in 1984 the General Counsel reversed course, G.C.M. 39247 (June 27, 1984), and the Commissioner later announced that all wholly owned insurance subsidiaries should be treated alike. Rev.Rul. 88-72, 1988-2 C.B. 31, clarified, Rev.Rul. 89-61, 1989-1 C.B. 75. Our task is to decide whether this is correct. We therefore disregard details, which may be found in the Tax Court's opinion. Like the Commissioner, we deem immaterial the nature of the risks Allstate accepted, the terms the parties negotiated, and the precise deductions taken.

If Sears did no more than set up a reserve for losses, it could not deduct this reserve from income. United States v. General Dynamics Corp., 481 U.S. 239, 107 S.Ct. 1732, 95 L.Ed.2d 226 (1987). Firms other than insurance companies may deduct business expenses only when paid or accrued; a reserve is deductible under § 832 only if the taxpayer issued "insurance." "Self-insurance" is just a name for the lack of insurance--for bearing risks oneself. According to the Commissioner, "insurance" from a subsidiary is self-insurance by another name. Moving funds from one pocket to another does nothing, even if the pocket is separately incorporated. If Subsidiary pays out a dollar, Parent loses the same dollar. Nothing depends on whether Subsidiary has other customers; there is still a one-to-one correspondence between its payments and Parent's wealth. So although Allstate may engage in the pooling of risks, and thus write insurance, Sears did not purchase the shifting of risks, and thus did not buy insurance. Unless the transaction is insurance from both sides--unless it "involves risk-shifting [from the client's perspective] and risk-distributing [from the underwriter's]", Helvering v. Le Gierse, 312 U.S. 531, 539, 61 S.Ct. 646, 649, 85 L.Ed. 996 (1941)--it is not insurance for purposes of the Internal Revenue Code. The Commissioner asks us to pool the corporate family's assets to decide whether risk has been shifted. This is the "economic family" approach of Rev.Rul. 77-316, which the Service sometimes supplements with a "balance sheet" inquiry under which a transaction is not insurance if it shows up on both sides of a corporation's balance sheet.

No judge of the Tax Court has ever embraced the IRS's "economic family" approach, which is hard to reconcile with the doctrine that tax law respects corporate forms. Molien Properties, Inc. v. CIR, 319 U.S. 436, 63 S.Ct. 1132, 87 L.Ed. 1499 (1943). Although the Commissioner may recharacterize intra-corporate transactions that lack substance independent of their tax effects, cf. Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935); Yosha v. CIR, 861 F.2d 494 (7th Cir.1988)--which supports disregarding captive insurance subsidiaries--the "economic family" approach asserts that all transactions among members of a corporate group must be disregarded. Even the ninth circuit, which in citing Rev.Rul. 77-316 favorably has come the closest to the Commissioner's position, has drawn back by implying that subsidiaries doing substantial outside business cannot be lumped with true captives into a single pot. Carnation Co. v. CIR, 640 F.2d 1010 (9th Cir.1981); Clougherty Packing Co. v. CIR, 811 F.2d 1297, 1298 n. 1 (9th Cir.1987).

What is "insurance" for tax purposes? The Code lacks a definition. Le Gierse mentions the combination of risk shifting and risk distribution, but it is a blunder to treat a phrase in an opinion as if it were statutory language. Zenith Radio Corp. v. United States, 437 U.S. 443, 460-62, 98 S.Ct. 2441, 2450-51, 57 L.Ed.2d 337 (1978). Cf. United States v. Consumer Life Insurance Co., 430 U.S. 725, 740-41, 97 S.Ct. 1440, 1448-49, 52 L.Ed.2d 4 (1977). The Court was not writing a definition for all seasons and...