The Delaware Department of Insurance (DDOI) recently announced it appealed the Third Circuit’s decision in United States of America v. Delaware Department of Insurance, which involved the application of the McCarran Ferguson Act (MFA) to an IRS summons. The plot thickened on July 26 after Judge Alito requested briefing on the issue. The story abruptly ended the next day when the DDOI announced it settled with the IRS.
This is disappointing as this would have been the first ruling involving the MFA reverse preemption in a Micro-Captive case. Delaware asserted the Act as a defense in briefs and in oral arguments, only to lose due to a Third Circuit precedential anomaly explained below. The written record to this conflict contains not only the most thorough attempt to argue the MFA in the Micro-Captive context but may also provide taxpayers with a new line of attack in captive litigation.
A review of the MFA and its application by the Third Circuit are needed. Before the Supreme Court’s South-Eastern Underwriters decision in 1944, states had the exclusive right to regulate insurance. The was overturned in South-Eastern, much to the consternation of the insurance industry, which quickly lobbied Congress to pass the MFA in 1945. The law contains two key passages.
Congress hereby declares that the continued regulation and taxation by the several States of the business of insurance is in the public interest, and that silence on the part of the Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States.
South-Eastern ruled that insurance was interstate commerce, placing it under Congress’ authority granted by the constitution’s commerce clause. The above section of the MFA returns that power to the states.
A second clause states:
No Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance.
This is referred to as the reverse preemption clause, which means that a state law will overrule a federal law if the following three factors from two Supreme Court cases (Humana v. Forsyth) are met: 1) That the federal law at issue does not specifically relate to the business of insurance; 2) That the state law regulation activity was enacted for the purpose of regulating the business of insurance, and; 3) That applying federal law would invalidate, impair, or supersede state law. If these factors are met, reverse preemption occurs.
Third Circuit precedent added a threshold inquiry. The court had to determine if the company act in question constituted, “The business of insurance.” For this analysis, the Third Circuit relied on the Royal Drug and Perino factors: 1) whether the practice has the effect of transferring or spreading a policyholder’s risk; 2) whether the practice is an integral part of the policy relationship between the insurer and the insured, and 3) whether the practice is limited to parties within the insurance industry. The analytical wrinkle was key to the Third Circuit’s decision.
Returning to the issue at hand, the conflict between the IRS and DDOI started when the IRS issued a summons to the department as part of its ongoing Micro-Captive audits. The IRS sought various communications between the department and a captive manager. Delaware law mandated that the Department could release this information to a federal agency only if it agrees, “… in writing to hold [the information] confidential and in a manner consistent with [the Delaware Captive Insurance Statute].” The IRS refused. The DDOI and the IRS continued negotiations but did not resolve their differences. Throughout, Delaware did provide other information as allowed by law.
The Service eventually filed a motion to enforce the summons, which the DDOI tried to quash, arguing it was preempted by the MFA. But before analyzing the case using the MFA, the Delaware courts focused on the question added by Third Circuit precedent: “does the act [the confidentiality of records] in question involved the business of insurance?” The Third Circuit district and appellate courts ruled no.
The DDOI then petitioned the Supreme Court, arguing in its brief that the Third Circuit’s threshold “business of insurance” inquiry not only ran against two Supreme Court cases (Fabe and Humana) but also against ten (10) other circuit courts. After Justice Alito requested briefs on the issue, the DDOI and IRS settled, although the terms were not disclosed.
There are several observations from these developments. First, the speed of the settlement indicates the Service did not want to test the Supreme Court on these facts. Second, several comments to the newly proposed 831(b) regulations specifically raise MFA challenges. The Oklahoma Department of Insurance and National Counsel of Insurance Legislators both reference potential issues raised by the proposed rules. Whether these lead to successful challenges are a matter for future litigation. But these facts will likely support filing such a challenge with the goal of appealing to the Supreme Court. It’s clear that tax litigators believe this line of attack will at least bear some fruit.
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