It’s no secret that the IRS has been eyeing – closely – the small captive insurance industry. This industry embraces Section 831(b) of the Internal Revenue Code, which generally permits an electing insurance company with no more than $1.2 million of annual underwriting income to exclude such underwriting income from taxable income. In that case, the insurance company is only subject to tax on its investment income. Back in February 2015, the IRS placed these small captive insurance arrangements on its “Dirty Dozen” list –– a list of commonly-promoted techniques that the IRS contends are abusive tax shelters. This was part of a broader IRS crack down on the small-captive insurance industry, which has involved large-scale IRS examinations, promoter investigations and several test cases awaiting decision in the courts.
With the Protecting Americans from Tax Hikes Act of 2015 (“Path Act”), signed into law on December 18, Congress has come to the IRS’ aid in the IRS’ efforts to ferret out abuses involving Section 831(b). The Path Act made several important statutory changes that, starting in 2017, will apply to newly-formed and existing small insurance companies alike.
The most significant change to Section 831(b) is the addition of a diversification requirement. This requirement can be met in one of two ways. First, the requirement is met if no more than 20% of the premiums of the Section 831(b) insurance company are attributable to any one policyholder. For purposes of applying the 20% limitation, the Path Act invokes attribution rules whereby related policyholders are treated as a single policyholder. [In today’s market, it is not uncommon for a Section 831(b) company to have up to 49% of its premiums attributable to a single policyholder, which would fail this requirement.] The second way to satisfy the diversification requirement is compliance with an “ownership” test. The statutory language surrounding the ownership test is hardly a model of clarity, speaking in terms of “specified holders” and their interest in the insurance company relative to their interest in “specified assets.” Generally speaking, however, the ownership test provides that if the captive is owned by any family member of the owner of a business insuring its risks through the captive, that family member must have the identical ownership (within a 2% margin of error) in the insuring business. By way of illustration, if “Dad” owns 100% of a business whose risks are being insured in part through a Section 831(b) captive owned solely by “Son,” the ownership test is not met. For the ownership test to be met, “Son” would have to own at least 98% of the insuring business. Clearly, the ownership test is aimed at restricting the often-touted transfer tax benefit associated with having a small captive insurance company owned by family members either directly or through an estate planning vehicle such as an irrevocable trust or family limited partnership.
To help insure that the new diversification requirement is universally met, Congress has imposed a new annual information reporting requirement, the details of which are to be determined by the IRS. For those small captive arrangements that can meet this new diversification requirement, Congress has rewarded them with an increased annual exclusion of underwriting income – from $1.2 million to $2.2 million.
It is critical to note that starting January 1, 2017, every captive must satisfy this new diversification requirement. Existing captives are not exempt from or “grandfathered” under these rules. Accordingly, many captive insurance arrangements will need to be restructured in order to comply with these significant changes in the law.
If you have any questions regarding the changes to Section 831(b), or questions about ways to help your clients become compliant with these upcoming legal requirements, please do not hesitate to contact Anthony Daddino at (214)749-2464.