Illinois Appellate Court Respects Characterization of Captive Insurance Company

In Wendy’s International, Inc. v. Brian Hamer1, decided earlier this week, the Illinois Appellate Court found that Taxpayer had met its burden and proved that its subsidiary insurance company was a bona fide insurance company for purposes of federal income tax law as it met the statutory requirements during the applicable years, and engaged in the necessary risk shifting and risk distribution. The court found that no evidence was presented that indicated that the insurance company was formed as a sham business or lacked a valid business purpose. Given the facts of the case, the court found that the insurance company was properly treated as such for federal income tax purposes, and should have been treated in a similar fashion for the Illinois Income Tax Act. Thus, the Appellate Court reversed the trial court’s entry of summary judgment in favor of the defendants and denied Taxpayer’s motion for summary judgment.

Background

Wendy’s International, Inc. ("Wendy’s" or "Taxpayer") is an Ohio corporation with commercial domicile in Ohio and the parent company of an affiliated group of corporations operating restaurants throughout the United States, including in Illinois. In 2001, Wendy’s determined it would make financial sense to create a wholly owned insurance company that would also make it possible to obtain insurance for risks for which external coverage could not be obtained, such as protecting against outbreaks of mad cow disease.

Wendy’s formed and licensed Scioto Insurance Company ("Scioto") in the state of Vermont as a captive insurance company that insured affiliated entities. Subsequent to the formation, Scioto acquired Oldemark LLC, a Wendy’s affiliate that held Wendy’s trademarks. Oldemark licensed to Wendy’s the right to use and sublicense the trademarks in exchange for a royalty of 3 percent of the gross sales of all United States business.2 In October 2001, Scioto was licensed to transact business as an insurance company in the state of Vermont. Scioto issued insurance policies to Wendy’s and Wendy’s affiliates, covering workers’ compensation, general liability, auto liability, auto physical damage, property, crime liability, business interruption, excess liability insurance, product recall, terrorism coverage, strike insurance, pollution wraparound, and price volatility coverage, using actuarially determined rates in setting the premiums charged for insurance policies.

Scioto was included in Wendy’s federal consolidated income tax returns. The Internal Revenue Service (the "IRS") audited Wendy’s federal consolidated returns and examined whether Scioto was an insurance company for federal income tax purposes. The IRS did not dispute Scioto’s claimed status as an insurance company in any of the audits of the federal consolidated tax returns for the tax years 2001 through 2006.

Wendy’s excluded Scioto from its Illinois unitary business group and did not include the Scioto income in the Illinois combined income tax returns for the tax years 2001 through 2006. In 2004, the Illinois Department of Revenue (the "IDOR") issued two notices of deficiencies for corporate income taxes against Wendy’s. The IDOR concluded Scioto was not a true insurance company because (1) its transactions with Wendy’s and Wendy’s affiliates did not involve actual risk shifting and risk distribution and, thus, did not constitute insurance for federal income tax purposes, (2) the majority of its income was derived from the intercompany royalty payments received by Oldemark, and (3) it was not regulated as an insurance company in all states in which it wrote premiums.

Wendy’s paid the deficiencies under protest and filed two separate actions pursuant to the State Officers and Employees Money Disposition Act (the "Protest Monies Act")3 alleging (1) Scioto qualified as an insurance company under the Illinois Income Tax Act4 and (2) that the uniformity clause of the Illinois Constitution5 prohibited the IDOR from treating Scioto differently from other insurance companies. Wendy’s filed a motion for summary judgment in May 2011, arguing that it was not required to include Scioto in its Illinois combined tax returns because Scioto is a bona fide insurance company. Furthermore, Wendy’s argued that Scioto met the definition of an insurance company under federal law and, thus, the IDOR should treat it the same as all other insurance companies. Wendy’s claimed that Scioto was engaged in the insurance business because it effectuated both risk shifting and risk distribution. Additionally, Wendy’s argued that the Illinois Constitution prohibits treating an entity that has been determined to be a non-Illinois insurance company as anything other than an insurance company for Illinois tax purposes.

The IDOR filed a cross motion for summary judgment, claiming (1) Scioto did not meet the definition of an insurance company under the Internal Revenue Code and (2) that Scioto’s royalty income was not income from an insurance business. The trial court allowed defendant’s motion for summary judgment, finding Scioto was not an insurance company pursuant to the Illinois Income Tax Act.

Upon appeal, the court looked at Scioto’s income from premiums, royalty income, and interest income, finding that while the income from insurance premiums was dwarfed by its royalty and interest income, it is not the percentage of income that determines whether a company is taxable, but rather the character of the business. Scioto’s only business was to furnish insurance, and the ownership of Oldemark was directly related to Scioto’s ability to satisfy the capitalization requirements under Vermont insurance law.

The court found that the character of Scioto’s business was one of insurance and, under federal income tax law, the arrangements with affiliates met the requirements of risk shifting and risk distribution. The court also found that the conformity with federal and state laws required that Scioto be treated as an insurance company for Illinois income tax purposes, as it was treated as such by Vermont and the IRS. The court did not address the uniformity clause argument.

The court determined that Wendy’s met its burden and should have been treated as an insurance company for Illinois income tax purposes, and reversed the trial court’s judgment granting the defendants’ motion for summary judgment. The court remanded the case back to the trial court for the issuance of an order granting Wendy’s motion for summary judgment.

  1. Wendy’s International, Inc. v. Brian Hamer, 2013 IL App. (4th) 110678 (October 7, 2013).
  2. For more on the Virginia income tax treatment of the royalty payments to Oldemark, see our earlier Alert.
  3. 30 ILCS 230/1 to 6a (West 2008).
  4. 35 ILCS 5/101 to 250 (West 2008).
  5. Ill. Const. 1970, art. IX §2.

Topics:  Captive Insurance Company, Income Taxes, Insurers, Wendy's

Published In: Business Organization Updates, Civil Procedure Updates, General Business Updates, Insurance Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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