Locke Lord QuickStudy: Third Circuit Affirms IRS Against ‎Delaware Captives Bureau

In an opinion^[1] published late last month, the United States Court of Appeals for the Third Circuit (“Third Circuit”) affirmed the Internal Revenue Service’s (“IRS”) authority to compel the production of documents and testimony from the Delaware Department of Insurance (“Department”). The Third Circuit affirmed the district court’s conclusion that reverse preemption under the McCarren Ferguson Act^[2] does not apply where the Delaware insurance statute at play does not directly pertain to the “business of insurance.” If the ruling stands, it will be a significant victory for the IRS at the expense of state insurance departments but especially against independent captive managers. The context of this case is the IRS’s continuing skepticism toward Section 831(b) microcaptives as potentially abusive tax shelters.

Background

Almost a decade ago, the Internal Revenue Service first singled out microcaptive transactions as potential transactions of interest.^[3] Since then, certain microcaptive transactions have been included by the IRS on its annual “dirty dozen” list identifying potential scam transactions.  Most recently, in response to certain judicial decisions and taxpayer comments calling into question the scope of Notice 2016-66, Treasury and the IRS have issued proposed regulations identifying certain microcaptive transactions as either listed transactions or transactions of interest under certain provisions of the Internal Revenue Code.^[4]  Properly formed, a captive insurance company (which is a special form of insurance company that is generally constrained as to the insureds that it serves - typically insuring the risks of only affiliated businesses) can offer benefits over traditional insurance or the alternative course of self insurance, including certain tax benefits.  Microcaptive nonlife insurance companies meeting certain specified requirements (including a cap on net written premiums) can further elect under Internal Revenue Code Section 831(b) to be taxed only on their net investment income, thus effectively excluding their underwriting income from federal income taxation. This potential exemption of a microcaptive’s underwriting income under Section 831(b) has often been used advantageously by captive managers to benefit taxpayers, and has thus garnered the IRS’s attention to the issue.^[5]

Insurance companies, including captive insurance companies, are creatures of state insurance law. Insurers are formed under state insurance law and they are regulated by state insurance departments. In fact, contrary to the normal course under the U.S. Constitution’s Supremacy  Clause,^[6] under the federal McCarran-Ferguson Act federal laws are reverse preempted when “the activity in question constitutes the business of insurance and … the specific state law was enacted with the ‘end, intention, or aim’ of adjusting, managing, or controlling the business of insurance.”^[7] This reverse preemption of federal law when it conflicts with contrary state insurance law is the stage for the conflict in this case.

Facts of the Case

As part of an investigation of potentially abusive tax shelters by captive managers forming microcaptives in Delaware, the IRS obtained e-mail correspondence between the captive managers being investigated and the Department. The IRS then issued an administrative summons to the Department seeking testimony and records pertaining to filings by and communications with the captive managers being investigated. The Department declined the IRS’s summons citing confidentiality objections pursuant to Section 6920^[8] of the Delaware Insurance Code which prohibits the Department from disclosing covered information, even to the federal government, unless the captive consents, or the federal agency agrees in writing to hold the information confidential. The IRS declined to agree in writing, the Department refused to comply, and thus, the IRS filed a petition in federal district court. The Department sought to quash the summons on the grounds of reverse preemption per McCarran-Ferguson, but a federal magistrate judge disagreed, the district court concurred, and ultimately, the Third Circuit affirmed.

The Business of Insurance

Why did multiple federal judges reject reverse preemption of a state insurance law pertaining directly to the regulation of insurance companies? The short answer is that all 5 federal judges^[9] concluded that the discrete act of resisting an IRS summons is not part of the business of insurance “rather than examining how the ostensibly reverse-preempting provision of state law fits into the State’s overarching regulatory scheme.”^[10] The long answer pertains to the limits of the McCarran-Ferguson Act and the nature of the business of insurance under federal law.

Congress enacted the McCarren-Ferguson Act in response to a U.S. Supreme Court ruling that threatened to undermine the preexisting paradigm of state-based insurance regulation. In its haste, Congress drafted a very brief act which over the years required significant interpretation by the Supreme Court. The Court found that Congress’s aim was to preserve the preexisting “state regulation that centers around the contract of insurance” and that the “core of the ‘business of insurance’” is “[t]he relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation, and enforcement.”^[11] However, the Act’s preemptive scope is not limited to only the regulation of the insurer-insured relationship and the contract between them but may also include “other activities of insurance companies [that] relate so closely to their status as reliable insurers that they too must be placed in the same class.”^[12] But as the Court later clarified the Act “exempts the ‘business of insurance’ and not the ‘business of insurance companies.’”^[13]

The phrase “business of insurance” is not defined in the McCarran-Ferguson Act and as stated above, the Supreme Court has declared that the core of the “business of insurance” is the relationship between the policyholder and the insurance company. A request for documents by the IRS as to interactions between captive managers and their state insurance regulators does not on its face pertain to policyholders. The Magistrate Judge recommended that courts should look to the discrete conduct in question concluding that the confidentiality provisions of Section 6920 of the Delaware Insurance Law does not pertain to the business of insurance per se but rather to the dissemination of records which may or may not pertain to policyholders. The district court and the appeals court concurred with the magistrate. In fact, the Third Circuit dismissed the Department’s concerns that providing testimony and documents to the IRS would undermine its regulatory scheme as applicants would be less forthcoming with the Department.^[14]

Conclusion

We do not know whether the Department will choose to appeal or if the U.S. Supreme Court would accept certiorari. Presuming that this case ends here, this case establishes federal precedent applicable in the Third Circuit which consists of Delaware, New Jersey, and Pennsylvania. Delaware is one of the largest domestic venues for forming captive insurance companies. Dozens of captive managers are authorized in Delaware. If the IRS is feeling confident it may seek to establish similar precedent in the Second and Fourth Circuits which include other large captive forming states such as Connecticut,^[15] North Carolina,^[16] South Carolina,^[17] and Vermont,^[18] each of which has similar confidentiality provisions in its insurance law.

---