2024-09-23
Property and casualty insurance companies are eligible to be exempt from Federal income tax if (1) their gross receipts for the taxable year do not exceed $600,000, and (2) the premiums received for the taxable year are greater than 50% of their gross receipts. Section 501(c)(15).
Small business taxpayers may decide to set up a captive insurance company to take advantage of the $600,000 tax exemption. Insurance companies are highly regulated by each state. To avoid some of this regulation, taxpayers may decide to form an insurance company in an offshore jurisdiction, such as in a Caribbean island nation, where the level of regulation of insurance companies is much lower.
Creating a foreign company may create its own U.S. tax complications. One way to avoid these complications is for the foreign captive insurance company to elect under section 953(d) to be taxed in the U.S. as a domestic corporation. Then, the captive files a U.S. tax return, but doesn’t pay any U.S. tax. The tax benefits of such an arrangement are clear: the U.S. business gets a deduction for insurance premiums paid to the captive, and the captive pays no U.S. income tax. A win-win.
The “rub”, if you will, is when the captive isn’t actually providing insurance. The Internal Revenue Code does not define insurance. The Supreme Court has established two necessary criteria: risk shifting and risk distribution. See Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). It turns out that it is not necessarily easy for a small business with its own captive insurance company to satisfy the risk shifting and risk distribution requirements.
If the payments to the captive don’t qualify as insurance, the payments may not be deductible as ordinary and necessary business expenses. Section 162(a). Further, the captive may not qualify to make a section 953(d) election. If the captive can’t make a section 953(d) election, it is treated as a foreign corporation.
All of a sudden, we have payments from a U.S. person to a foreign corporation that can trigger fixed or determinable annual or periodical (“FDAP”) income tax and withholding requirements. Sections 881, 1442, and 1461. In addition to the payments being nondeductible, the payor may be required to withhold 30% U.S. tax on each payment, and the captive may be subject to 30% U.S. tax on the amounts received. The IRS may assert the 30% tax against both the payor and the recipient, being concerned that the statute of limitations may have run for one or the other. However, it generally should only collect the 30% tax once. Section 1463.
This issue of purported insurance payments being nondeductible and subject to FDAP tax was recently discussed in CCA 202422010. We have created a chart for CCA 202422010.