The U.S. District Court for the Middle District of Florida held that payments received by an insurance company from the state of Florida were capital contributions and not income, since the state intended the payments to be nonshareholder capital contributions to encourage capital investment by private insurers in the Florida insurance market.
IRC § 118(a) excludes “any contribution to the capital of the taxpayer” from gross income. Treas. Reg. § 1.118-1 permits the exclusion of capital contributions of shareholders and nonshareholders from income, including contributions of money or property by a government, if used as an inducement to relocate or expand the recipient’s business. However, if the payments are received in return for services provided or to limit production, they are included in income.
The Supreme Court in U.S. v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973), stated that the intent or motive of the nonshareholder transferor determines whether there is a capital contribution and listed five characteristics of a nonshareholder capital contribution. The payment must become part of the recipient’s permanent working capital, be bargained for, result in a benefit to the recipient in an amount roughly equal to the payment, and be used to produce additional income. It may not be received in return for an identifiable good or service. The Eleventh Circuit Court of Appeals, in U.S. v. Coastal Utilities Inc., 514 F.3d 1184 (2008), added that other characteristics may be examined if they are helpful to determine intent.
Southern Family Insurance Co. was formed in 1996 to take advantage of a program established by Florida after the number of private insurers writing windstorm policies in the state drastically decreased after Hurricane Andrew in 1992. The Florida Legislature created the Residential Property and Casualty Joint Underwriting Association (JUA) to be the insurer of last resort for windstorm policies; however, by 1996 the JUA had almost a million policies in force. To encourage private insurers to write more windstorm policies, new legislation provided takeout bonuses of up to $100 per policy transferred from the JUA to private insurers. The bonuses were put into an escrow account, and if the private insurer provided coverage for three years and complied with other provisions of the law, the insurer would receive the bonuses. For policies written by Southern Family, the JUA deposited into escrow $7,125,000 for 1996; $4,754,281 for 1997; $2,430,458 for 1998; and $832,100 for 1999.
The latter year’s amount was released at the end of the escrow period to the company, which reported it on its corporate tax return as a nontaxable capital contribution. The IRS determined the bonuses for 1996–99 should have been included in Southern Family’s income in the same year the JUA deposited the money into the escrow accounts. Southern Family paid the taxes and filed suit in District Court for a refund of those taxes. In July 2010, the court held that the amounts should not be income when deposited into the escrow account; however, that holding would matter only if the court later ruled that the amounts were income (included in income in the year of release), not capital contributions.
In December 2010, the court held that the payments were capital contributions and thus excludable from income. It held that the language of Florida’s legislation intended that the bonuses would be paid-in capital, not income. After applying the five factors of Chicago, Burlington & Quincy Railroad Co., the court held that the bonuses became part of Southern Family’s permanent capital. The bonuses were bargained for, since the two parties negotiated the takeout arrangements. Also, the bonuses were paid in cash, causing the benefit received by Southern Family to correspond to the value of the bonuses. Also, those bonuses helped Southern Family write more policies, which produced additional income. The court also held that any services provided by Southern Family were to its policyholders, not to the JUA. The JUA received no direct benefit from those payments, and the sole purpose of the payments was to benefit the private insurance market in Florida.
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
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