Micro-Captive IRS Audit Guidance Indicates Withholding Tax To Be Imposed

In Reserve Mechanical Corp. v. Comm'r,¹ an insured paid amounts to a micro-captive insurance company domiciled in a non-US jurisdiction that had made an election under section 953(d) of the Internal Revenue Code of 1986, as amended (IRC), which ostensibly resulted in the company being exempt from federal income tax as a small insurance company under IRC Sec. 501(c)(15). The Tax Court found that the arrangement was not insurance and that the micro-captive was not an insurance company for federal tax purposes, which resulted in the election under section 953(d) being void and small insurance company status under section 501(c) (15) being inapplicable. As such, the court characterized the payments received by the captive not as premium but as "fixed or determinable annual or periodic income" (FDAP) under IRC section 881 and subject to withholding tax at a rate of 30 percent.  

In "Chief Counsel Advice 202422010" (the CCA), released on May 31, 2024, the Internal Revenue Service (IRS) Office of the Chief Counsel considered a fact pattern similar to that in Reserve Mechanical for purposes of providing guidance to revenue agents examining "abusive micro-captive arrangements." The stated facts in the CCA are as follows.

1. A domestic entity directly or indirectly (when the micro-captive is a reinsurer) made payments to a micro-captive that were characterized as premium payments.
2. The insured did not withhold any tax on the payments under IRC section 1442.
3. The micro-captive filed a return as a domestic insurance company.
4. The micro-captive reported payments as income on a Form 1120-PC and excluded payments from taxable income under IRC section 831(b).
5. As a result of an examination, it was established that the payments were not insurance payments for federal tax purposes and a revenue agent denied the insureds premium deduction.
6. As a result of the forgoing, the micro-captive would not be characterized as an insurance company for federal tax purposes because more than half of its business was not the business of insurance; thus, it did not qualify as an insurance company under IRC section 831(c) and was ineligible to make an election under IRC section 953(d).

The CCA indicates that because the burden of proof is on the taxpayer, unless the micro-captive can prove that the amounts that were characterized as premium should be characterized as a type of payment that would be excluded from withholding tax (e.g., as a capital contribution or as non-US source), an agent may properly assert the amounts received by the micro-captive are FDAP and subject to withholding tax (i.e., a 30 percent tax on the purported premium payment), even if a denial of the deduction for the premium payment has been asserted. Also, the agent can assert the tax liability against both the insured in the form of withholding liability as well as the micro-captive, although the CCA recognizes that tax obligation cannot be imposed in a duplicative manner.

It seems logical that after the Reserve Mechanical case, where the taxpayer failed to present an alternative to the IRS' US source FDAP conclusion, the IRS would utilize this approach in other cases where the taxpayer has not met its burden of proof. However, in analyzing the issue, there are a number of considerations, such as whether the micro-captive's activities were conducted in the United States.  As such, although in some cases the IRS' position may be problematic, factual issues in each case may have an impact, if properly raised, on the IRS' ability to assert the position enunciated in the CCA.

Footnote

1. Reserve Mechanical Corp. v. Comm’r, T.C. Memo 2018-66, aff’d 34 F. 4th 881 (10th Cir. 2022).