Stearns-Roger Corp., Inc. v. United States

• Decision Date: 10 January 1984
• Docket Number: Civ. A. No. 81-C-2046.
• Parties: STEARNS-ROGER CORP., INC., Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of Colorado

577 F. Supp. 833

STEARNS-ROGER CORP., INC., Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. No. 81-C-2046.

United States District Court, D. Colorado.

January 10, 1984.

Robert E. Benson, Holland & Hart, Denver, Colo., for plaintiff.

Robert N. Miller, U.S. Atty., Denver, Colo., Robert Horwitz, Trial Atty., Tax Div., Dept. of Justice, Washington, D.C., for defendant.

AMENDED MEMORANDUM OPINION AND ORDER

CARRIGAN, District Judge.

In November 1974, the plaintiff, Stearns-Roger Corporation (Stearns-Roger), incorporated a captive insurance company, Glendale Insurance Company (Glendale). For the tax years 1974 through 1978, Stearns-Roger deducted, as business expenses for federal income tax purposes, $6,042,515.80 in insurance premiums it paid to Glendale. The Internal Revenue Service (IRS) subsequently audited Stearns-Roger and disallowed the deductions. Plaintiff paid the asserted taxes attributable to the disallowed deductions, then filed this suit seeking refund.

This amended memorandum opinion¹ constitutes my findings of fact and conclusions of law required by Fed.R.Civ.P. 52(a). Jurisdiction is founded on 28 U.S.C. § 1346(a)(1).

I. GENERAL BACKGROUND.

Stearns-Roger is in the business, world-wide, of designing and manufacturing large mining, petroleum, and power generation plants. These plants and facilities frequently cost between $5,000,000 and $20,000,000, and substantial liability risks accompany their design and construction. The bid specifications through which the jobs are obtained usually require Stearns-Roger to insure both itself and the client against many of these risks. If it were unable to obtain such insurance, the tax-payer could not compete in bidding for many major projects.

The insurance typically required includes coverage for errors and omissions, damage to completed operations, and comprehensive general liability. Since the early 1970's, Stearns-Roger has found it difficult or impossible to obtain from traditional insurance companies the types and huge amounts of coverage needed. For that reason, Stearns-Roger decided to enter the insurance business, partly as a financial opportunity and partly to provide itself a source for insurance required to keep it in business.

Stearns-Roger formed its captive insurance company pursuant to the Colorado Captive Insurance Company Act, Colo.Rev. Stat. Section 10-6-101 et seq. (1973). In order to obtain state authorization to incorporate the company, Stearns-Roger first had to prove to the Colorado Insurance Commissioner that adequate alternative insurance sources did not exist. The commissioner so found.

Glendale Insurance Company then was incorporated as a captive insurance company capitalized with $1,000,000. To ensure sufficient protection for third-party insureds, Stearns-Roger executed an indemnification agreement by which it agreed to indemnify Glendale for losses and damages up to $3,000,000.² In November 1974, the Commission issued Glendale a certificate of authority to operate as a captive insurance company.

Glendale issued insurance policies covering Stearns-Roger, its fifteen subsidiaries, and its project customers. The policies covered errors and omissions, damage to completed operations, comprehensive general liability, and workmen's compensation. For its 1974-78 tax years, Stearns-Roger deducted as business expenses for insurance the premiums paid to Glendale.³ The IRS disallowed these deductions and Stearns-Roger, after paying the deficiencies, commenced this refund action.

Prior to trial, the parties stipulated to the following facts:

(1) Glendale was a bona fide insurance company;

(2) Stearns-Roger would have found it difficult or impossible to obtain the required insurance from unrelated third-party insurors;

(3) Premiums paid by Stearns-Roger to Glendale for "insurance" were reasonable in amounts;

(4) Glendale is not Stearns-Roger's alter ego; the two corporations are different entities; and,

(5) Glendale never made any demands of Stearns-Roger under the indemnity agreement, and that agreement was terminated on November 24, 1981.

II. FINDINGS OF FACT AND CONCLUSIONS OF LAW.

The issue is whether the sums Stearns-Roger paid Glendale are deductible "insurance" payments under the 1954 Internal Revenue Code, 26 U.S.C. § 162(a). Deductible business expenses include insurance premiums against fire, storm, theft, accident, and other similar losses. 26 C.F.R. § 1.162-1(a).

I find from the evidence that since the early 1970's it has been difficult or impossible for Stearns-Roger to obtain on the open market from commercial insurance companies, the insurance required for itself, its subsidiaries, and its customers. I further find that Stearns-Roger incorporated Glendale to fill this business need. Glendale was not a sham, but a legitimate insurance subsidiary, which operated as a corporate entity distinct from Stearns-Roger. Compare Roubik v. Commissioner, 53 T.C. 365 (1969); Noonan v. Commissioner, 52 T.C. 907 (1969).

The IRS held that Stearns-Roger's premium payments were not deductible as "insurance" payments.

The Supreme Court has defined insurance as requiring "risk-shifting and risk-distribution." Helvering v. Le Gierse, 312 U.S. 531, 539, 61 S.Ct. 646, 649, 85 L.Ed. 996 (1941). Within that framework the government contends that the premiums paid here were to a self-insurance reserve, and such self-insurance, since it does not shift or distribute risk, cannot be relied upon to establish premium deductibility. The government relies on Spring Canyon Coal v. Commissioner, 43 F.2d 78 (10th Cir.1931), cert. denied, 284 U.S. 654, 52 S.Ct. 33, 76 L.Ed. 555 (1931).

The government's expert witness, Dr. Irving Plotkin, testified that in economic terms the taxpayer's payments failed to shift or distribute risk. When Stearns-Roger suffered an "insured" loss, Glendale paid Stearns-Roger for the loss. Plotkin reasoned that because Glendale is a wholly-owned Stearns-Roger subsidiary, the premiums and losses paid were simply transfers of funds within the Stearns-Roger "economic family." Plotkin concluded that risk had not been shifted or distributed out of the economic family, and in the absence of this shifting or distributing there could not be insurance.

Stearns-Roger, on the other hand, contends that its payments to Glendale were ordinary and necessary insurance payments within 26 U.S.C. § 162(a). It points out that the regulations, in 26 C.F.R. § 162-1(a), expressly provide that insurance payments are deductible. Stearns-Roger argues that its agreement with Glendale shifted the risk of loss to Glendale and that Glendale, not Stearns-Roger, paid losses. Further, Stearns-Roger posits that its transactions with Glendale were conducted, for tax purposes, between two distinct corporate entities.

The initial inquiry is whether Glendale, a wholly-owned⁴ Stearns-Roger subsidiary, should be treated as a corporate entity distinct from the plaintiff. As stated above, the parties have stipulated that "the two corporations are different entities...." The Code generally treats separate corporations as distinct tax entities; i.e., their financial transactions are not usually aggregated for federal tax purposes. National Carbide Corporation v. Commissioner, 336 U.S. 422, 69 S.Ct. 726, 93 L.Ed. 779 (1949). Further, the Code normally recognizes the income tax consequences of transactions between distinct corporations.

The courts consistently have recognized that "for tax purposes, where the purpose for the creation of a corporation is a business one or the creation is followed by business activity, the corporate entity will not be disregarded." Skarda v. Commissioner, 250 F.2d 429, 433-34 (10th Cir. 1957); see also Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 63 S.Ct. 1132, 87 L.Ed. 1499 (1943). Moreover, case law establishes that a parent corporation and its wholly-owned subsidiary may be separate tax entities. National Carbide Corporation v. Commissioner, 336 U.S. 422, 69 S.Ct. 726, 93 L.Ed. 779 (1949); Coca-Cola Bottling Co. v. United States, 443 F.2d 1253 (10th Cir.1971); B. Bittker and J. Eustice, Federal Income Taxation of Corporations and Shareholders, paragraph 15.08 at 15-47 (4th ed. 1979).

There are, however, specific situations in which the financial transactions of separate but related corporations may be aggregated and treated as the transactions of a single taxpayer for certain purposes. Congress, realizing that corporations might abuse the separate corporate entity doctrine, has enacted specific statutes enabling the IRS to void transactions whose principal purpose is income tax avoidance or evasion. See e.g., 26 U.S.C. §§ 267, 269 and 482. While tax considerations no doubt played some part in choosing the ultimate form in which the transactions here were cast, the government has not demonstrated that Stearns-Roger's principal purpose for forming or doing business with Glendale was tax avoidance or evasion. Compare Bobsee Corp. v. United States, 411 F.2d 231, 235 (5th Cir.1969); House Beautiful Homes, Inc. v. Commissioner, 405 F.2d 61, 65 (10th Cir.1968). Rather, the principal impelling motive was business necessity. I find and conclude, therefore, that these attribution sections do not apply.

Next the government argues that the plaintiff and Glendale are both in a single "economic family" and thus there can be no "insurance" risk shifting or risk distribution between them. In essence, the defendant asserts that for purposes of determining whether there has been risk shifting, Stearns-Roger and Glendale should be treated as one economic entity even though it has been stipulated that they are two distinct corporate entities. In support of its "economic family" argument, the government relies on Carnation Company v. Commissioner, 640 F.2d 1010 (9th Cir. 1981), cert. denied, 454 U.S. 965, 102 S.Ct. 506, 70 L.Ed.2d 381 (1981).

In Carnation, the Ninth Circuit dealt with a domestic corporation (Carnation)...