Captive insurance arrangements, in New York and in certain other states, are often dependent on the federal treatment of the relationship as insurance for federal income tax purposes.
A recent New York state administrative law judge (ALJ) decision addressed the deductibility of insurance premiums paid by a taxpayer to its captive insurance subsidiary,1 and denied the deductions.
Stewart’s Shops Corporation is headquartered in Saratoga Springs, New York. It is a family- and employee-owned company that started as a dairy and ice cream business, but changed over time to the current business model — a gas station and convenience store business. It has approximately 300 gas stations and stores located in New York and Vermont. Black Ridge Insurance Corporation (BRIC) was a subsidiary of Stewart’s licensed as a captive insurance company by the New York Insurance Department. During tax years 2006–2009, Stewart’s filed a combined New York state franchise tax return with its subsidiaries; however, BRIC was not included in this combined filing (although BRIC was included in Stewart’s federal consolidated income tax return). During these tax years, Stewart’s paid between $10 million and $11 million per annum in premiums to BRIC and deducted most of these premiums (less amounts representing reimbursed losses) in computing its combined New York state franchise tax liability.
New York’s audit of Stewart’s and BRIC revealed that BRIC had not paid salaries or other compensation or rental expense during the years at issue. Further, Stewart’s admitted that the contracts between Stewart’s and BRIC did not meet the definition of an insurance contract for federal income tax purposes, and the payments did not qualify as a premium for federal income tax purposes (note that the deduction was not relevant for federal tax purposes because the entities were all in a consolidated federal return). Nonetheless, at least nominally, BRIC provided differing types of captive insurance coverage during the years at issue, and Stewart argued it was entitled to the deductions for New York state tax purposes. New York state’s Division of Taxation and Finance (the Division) disallowed the deductions for premiums paid during the audit period.
The Division argued that former section 208(9) of the New York Tax Law imposed a tax on entire net income, which was defined presumptively to be equal to federal taxable income. Further, there were no separate provisions in New York Tax Law that provided for a deduction of insurance premiums. Therefore, according to the Division, an insurance premium was deductible for New York state tax purposes to the extent that it was deductible for federal income tax purposes. Put differently, the deduction for premiums paid carries through to the state level as a result of the definition of "entire net income," and, if a premium was not deductible for federal income tax purposes, it was not deductible for New York state income tax purposes.
Stewart’s, on the other hand, noted that the statute used the word "presumably," and, when viewed in conjunction with the enactment of the captive insurance provisions by New York state in 1997, it was therefore entitled to a deduction for the premiums paid.
The ALJ summarily dismissed Stewart’s reliance on the word "presumably." The ALJ noted that Stewart’s bore "the burden of proof and bears the burden of demonstrating entitlement to a claimed exemption or deduction by demonstrating that the only reasonable interpretation of applicable law so provides him."2 The ALJ further noted that the court in In re Dreyfus Special Income Fund, Inc. v. New York State Tax Commission, 126 A.D.2d 368, 372 (3d Dep’t 1987), observed that the word "presumably" was added to the statute in 1918 in order to provide a taxpayer with an opportunity for a hearing in the case of an inaccuracy in the numbers reported to the federal government. Absent this exception, however, the Dreyfus decision determined that there was clear legislative intent that the state "net income" figure was to be the same as the federal amount.
The ALJ also noted that a provision in New York Tax Law former section 208(9)(b)(18) required taxpayers to add back deductions taken for premiums paid for environmental remediation insurance — language that would be superfluous if federal taxable income were not the starting point for the entire net income calculation.
Stewart’s also argued that the modifications to the Insurance Law in 1997 to provide for captive insurance companies should be read in pari materia with the Tax Law, and, as such, the deductions should be allowed. The ALJ refuted this argument because the statutory language regarding the starting point of entire net income was clear and unambiguous, and, therefore, an in pari materia argument or reading of the statutes together was unwarranted.
Having determined that the proper starting point for entire net income is federal taxable income, the ALJ then turned to the issue of whether the transactions between Stewart’s and BRIC gave rise to deductions for Stewart’s under federal income tax law. The ALJ noted that, while premiums are deductible, amounts placed in reserve as self-insurance are not deductible for federal income tax purposes. The critical test for determining whether an insurance relationship arises for federal income tax purposes is whether both risk shifting and risk distribution have taken place.
The ALJ undertook a comprehensive review of the arrangement between Stewart’s and BRIC and determined that the risks involved in the relationship were actual insurable risks under federal tax law and that the arrangement met commonly accepted notions of insurance. However, the ALJ found that Stewart’s did not, under the captive arrangement, shift its risk of loss to BRIC, nor did BRIC distribute whatever losses that were shifted to the policyholders, as occurs in traditional insurance relationships. The ALJ evaluated a number of federal income tax cases that involved insurance relationships in the context of a parent and a subsidiary. These decisions focused on the parent-subsidiary relationship in determining that risk shifting did not occur, because payments from BRIC to Stewart’s to cover a loss would, by definition, have a direct effect on Stewart’s balance sheet and net worth. Because of this, risk shifting could not be said to have occurred under the arrangement; further, there was no risk distribution among the various subsidiaries as a result of the relationship between BRIC and Stewart’s.
There are two significant lessons to be gleaned from this decision. The first, and most obvious, is that captive insurance arrangements, in New York and in certain other states, are often dependent on the federal treatment of the relationship as insurance for federal income tax purposes. The decision also underscores the importance in those states that conform to federal tax law in whole or in part, especially those that use federal taxable income as a starting point, of making sure that tax positions are either supported by a federal interpretation or are otherwise justified by other provisions in the state’s tax law, perhaps in the additions and subtractions.