Charlene Luke’s excellent article, Captivating Deductions, analyzes the tax treatment of captive insurance arrangements under current law and proposes reforms that would better align the treatment of such insurance arrangements with a normative Haig-Simons income tax base. Luke focuses on the treatment of insurance premiums from the insured’s perspective, rather than the special treatment afforded to insurance companies under the Code. For these insureds, captive insurance arrangements can convert non-deductible savings into deductible business expenses, with an added tax benefit if the insurance company can avoid current taxation on returns to any investments made with premiums received. Luke casts such (abusive) arrangements as “in substance, designer investment contracts,” and Luke’s reading of judicial and administrative guidance in this area as fundamentally misguided is undeniably correct.
After a detailed and illuminating exegesis of the law and economics of various insurance arrangements, Luke proposes three “bright-line rules” that would circumvent the morass of case law that plagues current enforcement efforts. First (and most importantly), Luke would restrict premium deductibility in the related-party context. To the extent that the insured and insurer are under common control, premium payments reflect transfers from one pocket to another, with a reversal of these transfers if—or when—any payouts are made. In these situations, there is no change in wealth in a Haig-Simons sense. (Luke would permit partial premium deductibility where the insurer has a diverse portfolio of insureds, which loosens the relationship between premium payments and eventual recoveries.) Second, Luke would disallow current deductions for insurance premiums where payouts are not contingent with respect to both timing and amount (that is, where a payout occurs on a specified date or where the insured-against event is almost certain to occur). Instead, such premiums would be treated as investments in a long-term contract, with any tax reckoning deferred until the contract matures. Finally (and related to her second proposed rule), Luke would deny deductibility for premiums paid to insure against “non-physical harm resulting from systemic market forces.”
In Captivating Deductions, Luke highlights a serious area of concern that has mostly eluded academic examination, especially compared to higher-profile but less-prevalent transactions such as corporate inversions. Big ideas are at stake. Luke fluently engages with the tax system’s longstanding struggle over entity formalism, and her article also implicates broader issues of arbitrage between state-law categories and federal tax concepts. More fundamentally, Luke lays bare the intractability of insurance as a coherent economic concept. Insurance-like features are threaded throughout the deep structure of late-stage capitalism, and financialization has enabled the purchase and sale of bespoke products that pluck at these strings in deliberate and manipulative ways. My sense, however, is that one motivation for Luke’s project is the anecdotal evidence that these types of captive insurance arrangements have expanded beyond sophisticated multinationals to more “middle-class” businesses. Just as the increased use of tax shelters by lower-bracket taxpayers motivated portions of the Tax Reform Act of 1986, the trickle down of abusive insurance products might drive some of the legislative changes that Luke recommends. This trajectory warrants further explication in Luke’s work.
Although Luke’s policy recommendations squarely address the problems she identifies, I couldn’t help but imagine alternatives that might prove easier to implement and administer. Rather than relying on what surely would be intricate definitions of common control or constructive ownership, one could instead achieve some form of rough justice by simply denying all deductions for insurance premiums paid. Reciprocally, insurance proceeds would not be accounted for when calculating casualty losses. If some form of premium deductibility is normatively or politically desirable, then one could limit such deductions to the amount of any payouts under insurance contracts, with a carryforward of any unused deductions into future years. This type of basketing represents a common response to potentially abusive activities; current § 165 treats gambling losses and personal casualty losses similarly, at least through the end of 2025. Either of these alternatives would leverage expansive state-law definitions of insurance (which reflect states’ efforts to expand their regulatory purview) and taxpayer-friendly case law (which has severely circumscribed the scope of abusive insurance arrangements). In this way, Congress could turn the tables on aggressive tax planners with less administrative overhead than Luke’s more precise proposals.
Finally, I found myself returning to Luke’s reliance on a Haig-Simons income tax base as her normative lodestar. Other points of reference exist, of course. What Luke views as a race to the bottom, with captive insurance arrangements eroding the tax system’s integrity, might instead be a race to the top, with such schemes implementing a de facto version of some sort of cash-flow tax or consumption base. To the extent that an income tax base is undesirable but entrenched politically, the kind of private planning could be fine. Indeed, the appropriate policy response might be virtual nonenforcement, in order to lower the transaction costs associated with such arrangements. There are good grounds for skepticism about this variety of back-door tax policy, but such concerns do not generate a presumption that policymakers should strive blindly towards the Haig-Simons ideal.
In conclusion, Luke’s thoughtful and well-researched article makes a timely and significant contribution to debates about business taxation. Luke’s article should be of interest to scholars working in both domestic and international tax policy, as well as others interested in corporate and insurance law.