In Matter of Stewart’s Shops Corp., DTA No. 825745 (N.Y.S. Div. of Tax App., Mar. 10, 2016), a New York State Administrative Law Judge concluded that a corporation operating a convenience store chain could not deduct on its New York corporate franchise tax returns the insurance payments that it made to its wholly owned captive insurance company because such payments would not qualify as valid insurance premiums under federal income tax law. 

Facts. Stewart’s Shops Corp. (“Stewart’s Shops”) owns and operates over 300 convenience stores in New York and Vermont. In the face of increasing insurance costs for its operations, Stewart’s Shops started self-insuring certain of its risks in 1992. Subsequently, in late 2003 to early 2004, Stewart’s Shops decided to create a captive insurance company, Black Ridge Insurance Corp. (“BRIC”), to insure some of its self-insured risks. BRIC received authorization to operate as a captive insurance company licensed by the New York State Insurance Department (“Insurance Department”) and provided Stewart’s Shops coverage for: (1) losses incurred within the threshold deductible amounts and in excess of the maximum losses covered by its outstanding policies with thirdparty insurance companies; (2) its self-insured risks and claims from periods before the formation of BRIC (“loss portfolio transfer”); and (3) other risks, including pollution, identity theft, and crime, for which it did not have any insurance at the time of the formation of BRIC.

In the months prior to the formation of BRIC, William Dake, Stewart’s Shops’ President, engaged in discussions with the Insurance Department’s captive insurance group. Mr. Dake testified that, as a result of these discussions, he understood that insurance payments paid to a New York captive insurance company would be deductible for New York corporate franchise tax purposes and believed that Stewart’s Shops could not create a stable captive insurance company “without deducting the payments made to BRIC.” However, an Insurance Department representative involved in the discussions with Mr. Dake testified that he could not recall representing that the payments were deductible.

BRIC filed annual statements with the Insurance Department and was never contacted by the Insurance Department with any concerns about the annual statements. BRIC also paid New York insurance company franchise tax on the insurance payments from Stewart’s Shops. In response to a 2004 tax refund claim from BRIC related to payments received for the loss portfolio transfer coverage, in 2005 the Department issued a letter stating that such payments were properly classified as taxable “premiums” for New York insurance company franchise tax purposes.

In 2010 and 2011, the New York State Department of Taxation and Finance audited BRIC and Stewart’s Shops. The Department concluded that BRIC was subject to the insurance company franchise tax and could not be included in Stewart’s Shops’ combined corporate franchise tax returns because BRIC was an insurance corporation. Nonetheless, the Department also disallowed Stewart’s Shops’ deductions for insurance payments to BRIC, concluding that such payments would not be allowable deductions for federal income tax purposes. During the audit, Stewart’s Shops had conceded that, for federal income tax purposes, the insurance contracts between it and BRIC did not qualify as insurance contracts, and that payments made on such contracts did not constitute insurance premiums.

The Law. New York’s corporate franchise tax is calculated based on a corporation’s entire net income (“ENI”), and ENI is defined by New York tax law as being “presumably the same as” a corporation’s federal taxable income. Tax Law § 208(9). While New York calculates taxable ENI by making numerous adjustments and modifications to the federal taxable income amount, no such adjustments were relevant to Stewart’s Shops’ insurance payments to BRIC. 

The Decision. Based on the language of Tax Law § 208(9), the Department argued that Stewart’s Shops’ insurance payments were not deductible for New York corporate franchise tax because such payments were not deductible for federal income tax purposes. Stewart’s Shops, on the other hand, argued that the term “presumably” in Tax Law § 208(9) allows a departure from federal taxable income when accounting for Stewart’s Shops’ insurance payments to BRIC, and that such a departure is justified, in part because of the legislative history of New York’s captive insurance law, which was designed to increase the number of captive insurance companies operating in the State. 

The ALJ decided the first issue in the Department’s favor, citing case law stating that “[f]ederal law controls for the purpose of defining ‘entire net income’” unless there is a specific state departure. Matter of Dreyfus Special Income Fund, Inc. v. N.Y.S. Tax Comm’n, 126 A.D.2d 368, 372 (3d Dep’t 1987), aff’d 72 N.Y.2d 874 (1988). The ALJ rejected Stewart’s Shops’ claim that New York Tax Law amendments requiring certain captive insurance companies to be included in a New York corporate franchise tax combined return affected such analysis and further concluded that Tax Law § 208(9) did not contain any ambiguity necessitating an examination of the legislative history of New York’s captive insurance law. 

Although Stewart’s Shops had conceded during audit that its insurance payments to BRIC did not constitute insurance premiums for federal income tax purposes, the ALJ nonetheless conducted an independent analysis of federal law and reached the same conclusion. Specifically, the ALJ identified four criteria in determining the existence of insurance for federal income tax purposes: (1) the arrangement must involve insurable risk; (2) the arrangement must meet commonly accepted notions of insurance; (3) the arrangement must shift the risk of loss to the insurer; and (4) the insurer must distribute the risks among its policyholders. While the ALJ concluded that Stewart’s Shops satisfied the first two criteria, she also determined that the insurance arrangements with BRIC did not shift the risk of loss or distribute risks among policyholders. The ALJ stated that numerous federal tax cases on the issue had a “common thread,” in that “payments from a parent to a wholly-owned captive do not qualify as deductible insurance premiums because the arrangement lacks risk shifting and risk distribution.” 

The ALJ also rejected Stewart’s Shops’ claim that the Department was estopped from denying the deductibility of the insurance payments. The ALJ explained that the record did not support a conclusion that the Insurance Department made any representation related to the deductibility of insurance payments by Stewart’s Shops to BRIC, and that the Department’s letter to BRIC classifying insurance payments as premiums for New York insurance company franchise tax purposes had no bearing on the classification of such payments for federal income tax or New York corporate franchise tax purposes. However, the ALJ waived penalties in part because she found Stewart’s Shops’ reliance on such letter from the Department on the payments classification under the Insurance Law to be reasonable.

Additional Insights

The Stewart’s Shops decision is notable because there is no prior New York precedent examining the deductibility of insurance payments to a captive insurance company. The decision suggests that the deductibility of insurance payments to captive insurance companies for New York corporate franchise tax purposes will generally depend on whether such insurance payments are properly classified as insurance premiums under federal income tax law. However, as decisions from New York ALJs are not precedential, additional guidance from the New York State Tax Tribunal may be necessary to bring further clarity to taxpayers.