Rent-A-Center: the good, the bad and the ugly

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06 August 2014

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Rent-A-Center: the good, the bad and the ugly

In January, the US Tax Court ruled in favour of Rent-A-Center, allowing its captive insurance company subsidiary Legacy Insurance to currently deduct ‘premiums’ when paid (for tax years 2003 through 2007). The general consensus seems to be that the Internal Revenue Service (IRS) and, in particular, the commissioner of internal revenue, suffered a defeat. This decision should further empower captive owners and those that are considering captives as a risk management tool, particularly as the IRS has encountered a less than stellar record of success in challenging captive structures through the courts.

While we at JLT Insurance Management applaud the ruling that Rent-A-Center’s captive was not a sham, as the IRS claimed, we also believe that this was just one more round of many challenges to come for captives.

The good

If we look at the case without taking into account the dissent, it reads like a typical captive’s wish list of best possible results:

The court, once again paying homage to Humana, Moline Properties and other cases, confirmed that a captive could achieve risk shifting and risk distribution in a multiple subsidiary taxpayer setting. Captives can rely on independent actuarial analysis to determine ‘arm’s-length’ premiums.

Applying a sound, consistent formula for allocating total premium, instead of determining premium by entity, is an acceptable methodology for charging out premiums;

Bookkeeping entries in lieu of individual cash transfers between entities is sufficient to support transactional status and to demonstrate risk transfer.

Providing a parental guarantee to maintain minimum capital and surplus requirements of the domicile (Bermuda in this case) does not necessarily neutralise risk transfer.

Investing premiums and accumulated surplus in lockstep with commercial insurers is not required.

The bad

Although the case offered positive takeaways, Rent-A-Center had technical issues relating to its operation of Legacy. Any of these technicalities could have been fatal to Rent-A-Center’s contention:

For a very short period of time, Legacy violated Bermuda law by writing insurance without the benefit of its certificate of registration. Either the commissioner did not take issue with this or it was considered a minor issue.

Legacy failed to maintain adequate levels of capital and surplus (2003 to 2005) to meet the minimum requirements of Bermuda law. Bermuda does not normally permit recognition of deferred tax assets (DTAs) in considering surplus adequacy, but accepted them from Rent-A-Center along with a parental guarantee.

Legacy kept minimal funds, only enough to pay yearly claims. All other funds were used to purchase non-dividend-paying Rent-A-Center treasury stock. Purchases of treasury stock returned cash directly to Rent-A-Center, but experts declared that there was no circular cash flow.

The ugly

In addition to technicalities, the dissenting judges chose to focus more on equating the business of captive insurance with that of commercial insurance companies. These judges lamented and then reluctantly moved on from the failed ‘single economic family’ theory espoused (and subsequently discarded) by the IRS some years ago. Dissenting judges cited these points:

In totality, transactions involving Legacy amount to nothing more than an elaborate strategy devised by insurance and tax advisers to circumvent the prohibition on deducting contributions to a self-insured reserve.

The principles of judicial restraint counsel that courts should decide cases on the narrowest possible ground, yet the technicalities previously noted didn’t trip up Rent-A-Center.

Parental guarantees neutralise risk shifting. Dissenting judges cited Internal Revenue Ruling 2002-90, 2002-2 CB at 985, which states in part that “(t)here are no parental (or other related party) guarantees of any kind made in favour of” the captive. Indeed, multiple courts have all held that the existence of a parental guarantee may negate the existence of insurance within an affiliated group. While the $25 million guarantee allowed Legacy to meet minimum capitalisation and surplus requirements, the guarantee could (and would) be called upon to satisfy shortfalls in surplus if adverse losses developed. That the guarantee was never actually needed is irrelevant.

While Legacy technically met the solvency rules under the Bermuda Act, when compared with commercial insurers there would be no way that surpluses could absorb the impact of significantly worse than expected loss development.

Legacy’s investment in Rent-A-Center treasury stock was counterintuitive. If Legacy had severe losses, the value of company treasury stock would have fallen in lockstep. Not only would worsening losses worsen the economic stability of the captive, but the drop in value of its investment portfolio would compound the situation.

Documentation is crucial

The Rent-A-Center case identified the need for a vehicle to help manage enterprise risk in a more efficient way than simply taking what the market had to offer, and took the initiative to engage qualified risk management experts and proper tax counsel.

Nowhere is it written that any business strategy has to be tax inefficient. Rent-A-Center made the right decision to take more active control of its risk management costs.

The extra step Rent-A-Center took by carefully documenting its pre- and post-captive creation by way of a feasibility study provides conclusive (and we believe persuasive) evidence against the IRS contention that the captive was a sham perpetrated simply to accelerate deductions for loss reserves.

Intent matters

The court obviously looked at the overall intent of Rent-A-Center when establishing Legacy and gave specific weight to those facts that supported a positive outcome. We wonder about the possible alternative outcome if Rent-A-Center had not taken the right steps from the start.

Despite technical glitches, it appears that the overall intent of the utilisation of Legacy carried the day.

This, to us, means the IRS may not find playing ‘gotcha’ with captives for minor filing mistakes very useful, as long as captives can prove intent in written documentation.

Operating your captive by following the rules, making decisions at arm’s length and paying attention to details is essential. After the fact, however, the only way to prove intent is by adequate documentation.

This is often neglected by captive owners, which can be caught short should a situation like this arise. This case illustrates the importance of proper documentation of purpose, structure and procedures in supporting the overall intent of a captive.

A final word

It will be a long time before we have any kind of textbook definition of what constitutes a captive insurance company in the eyes of the IRS. Because captives are flexible, adaptable risk management structures, it will always be difficult to shoehorn them into any set definition. In the meantime, captive owners and those considering captives should do what is right for their businesses.

Use captives to reduce the cost of managing enterprise risk to help stay competitive in an increasingly competitive world. Plan for the good, be prepared for the bad and minimise the ugly.