Businesses have long used captive insurance companies (captives) to manage insurable risks. A typical captive is owned by the business owners and insures the risks of the business. If properly structured and operated, captives can allow businesses to finance insurable risks through an alternative platform, consolidate their insurance purchases, and access the reinsurance market.
Certain small captives may elect to be taxed only on their investment income. However, there have been recent changes to the eligibility requirements to make the election.
Small Captives: Sec. 831(b)
Some captives (831(b) captives) have taken advantage of a special election under Sec. 831(b), which permits, in lieu of the otherwise applicable tax, certain property and casualty insurance companies to elect to be taxed only on their investment income. The election is available only to a company whose net written premiums or direct written premiums, whichever are greater, do not exceed $1.2 million in a tax year.
An 831(b) captive sometimes is owned by the children or grandchildren of the owner of an insured business. The captive insures the risks of the business, which deducts the premiums paid. The captive, however, does not report underwriting income or loss; instead, it is taxed only on its net investment income.
The eligibility rules for making a Sec. 831(b) election recently have been changed. As a result, it will be more difficult to meet the requirements of Sec. 831(b) when, for example, a family-owned business is insured by a captive owned by the lineal descendants of the business owner. Therefore, existing captives that have made the election may no longer qualify for it. In addition, any future tax planning that includes making the Sec. 831(b) election requires careful analysis under the new law, as discussed below.
Change in Law: New Sec. 831(b)
Sec. 831(b) was amended significantly by the Protecting Americans From Tax Hikes (PATH) Act of 2015, which was signed into law on Dec. 18, 2015, as part of the Consolidated Appropriations Act, 2016, P.L. 114-113. The amendment will be effective for tax years beginning after Dec. 31, 2016.
Under the act, the good news is that the maximum amount of net or direct written premiums that an insurance company may receive and still be eligible for the election is increased from $1.2 million to $2.2 million, which will be indexed for inflation. But the act also adds new diversification requirements that will make it difficult to use captives for estate planning. The act also requires any insurance company that makes the Sec. 831(b) election to furnish information relating to the diversification requirement to the IRS upon request.
Under the new risk-diversification requirement, no more than 20% of the net or direct written premiums, whichever are greater, can be attributable to any one policyholder. In determining whether the 20% threshold is met, all policyholders that are related (under Sec. 267(b) or Sec. 707(b)) or are members of the same controlled group are treated as a single policyholder. For example, under the new law, if an individual business owner owns a group of corporations that are policyholders that buy insurance from a captive that is owned by the grandchildren of the business owner, the captive would be considered to insure only one policyholder and would fail the risk-diversification test.
An insurance company that does not meet the above diversification requirement instead may qualify under Sec. 831(b) based on an alternative diversification requirement. This alternative requirement is satisfied if no "specified holder" directly or indirectly holds a percentage of the entire interests in the insurance company that is greater than the specified holder's percentage of interest in "specified assets," which are the trades or businesses, rights, or assets for which premiums are paid. A specified holder is an individual who holds an interest in the insurance company and who is a spouse or lineal descendant of an individual who holds an interest in the specified assets of the insurance company. There is an exception to this test for de minimis (2%) differences in ownership percentages.
Example: A father, F, owns 70% of a group of companies, and his son, S, owns the other 30%. S also owns 100% of the captive, which insures the risks of the group of companies and receives net written premiums annually of less than $2 million. Because S has a greater interest in the captive (100%) than in the assets with respect to the captive (i.e., the trades or businesses or assets insured) (30%), the captive is not eligible to elect Sec. 831(b) treatment. If, however, S owned 30% and F owned 70% of the captive, S would not have a greater interest in the captive (30%) than in the assets with respect to the captive (30%), and the captive would meet the diversification requirement for eligibility to elect Sec. 831(b) treatment. The same result would occur if S owned less than 30% of the captive, F more than 70%, and the other facts remained unchanged.
Recent IRS Scrutiny
Business owners should be aware that the IRS identified Sec. 831(b) captives in February 2015 on its "dirty dozen" list as potentially abusive tax shelters. The IRS asserts that unscrupulous promoters persuade closely held entities to establish small captive insurance companies and assist with creating and "selling" to the entities often poorly drafted "insurance" binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant "premiums," while maintaining their economical commercial coverage with traditional insurers. Underwriting and actuarial substantiation for the insurance premiums paid either are missing or insufficient. The promoters manage the entities' captives year after year for hefty fees, assisting taxpayers unsophisticated in insurance to "continue the charade," the IRS said.
Notwithstanding IRS concern, some small captives can qualify as insurance companies and are eligible to elect under Sec. 831(b) to be taxed only on investment income. To be respected as insurance for U.S. federal income tax purposes, the insurance arrangements with the captive must involve insurance risk, must shift the risk from the insured to the captive and distribute that risk among multiple policies, and must constitute insurance in the commonly accepted sense. Also, for a captive to be treated as an insurance company, more than half the business of the captive during the year must involve issuance of insurance contracts or reinsurance of risks underwritten by other insurance companies. Captive insurance companies in general, including 831(b) captives, must meet all these requirements, in addition to the premium and diversification requirements discussed above, to qualify for the election under Sec. 831(b).
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.