Tax Court Issues Second Small Insurance Company Case

On June 18, 2018, the US Tax Court issued its opinion in Reserve Mech. Corp. v. Commissioner, holding for the Internal Revenue Service (IRS). The facts of the case appear substantially similar to LTR 201609008, issued by the IRS in 2016.

Reserve Mechanical Corp. (Reserve) was an Anguilla-domiciled insurance company that had made an election under IRC section 953(d) to be subject to US federal tax as a US company. Presumably, Reserve applied to be treated as a small insurance company under IRC section 501(c)(15), as Reserve filed its US tax returns on this basis. Reserve had to be an insurance company for US federal tax purposes for its 953(d) election and 501(C)(15) status to be respected, and the court concluded that insurance characterization was not appropriate. As a result, the court concluded that Reserve should be characterized as a non-US company.

Because Reserve was characterized as a non-US company, the court concluded that Reserve was subject to the 30 percent withholding tax on the premium it had received. This resulted from the fact that Reserve had reported the premiums it received as program service income on its US Form 990 and did not provide proof to the court that these amounts should not be considered fixed, determinable, annual, periodical income.

In considering the insurance question, the court focused first on risk distribution, looking both to the number of insureds and to the number of exposure units, and concluded that Reserve's risk distribution was inadequate. In considering the risk distribution question, the court considered whether the risks received by Reserve from PoolRe, pursuant to a quota share pooling arrangement, should be included in the risk distribution analysis. Ultimately, the court decided that they should not be included because Reserve had not shown that these transactions were properly characterized as insurance for US federal tax purposes.

Although a conclusion that risk distribution is not present on its own results in the denial of insurance characterization, the court also considered whether Reserve's transactions constituted insurance in the commonly accepted sense—and determined they were not.

A more detailed view from Eversheds Sutherland on the current issues surrounding the tax court's opinion will be published in the August edition of Captive Insurance Company Reports (CICR). Find out about CICR!