On December 18, 2015, Congress passed, and President Obama signed into law, a 2016 appropriations bill, which includes the Protecting Americans from Tax Hikes Act of 2015 – the PATH Act. The PATH Act includes the first significant changes to Internal Revenue Code section 831(b) in nearly 30 years. Section 831(b) currently allows a small property and casualty insurance company with $1.2 million or less in premium income to make an election to be taxed only on investment income (and, therefore, not on its insurance underwriting income).
Section 831(b) insurance companies (often called 831(b) “captive insurance” companies, because they insure the risks of parent or brother-sister entities) are widely used by small- and mid-sized businesses to insure risks that are costly or unavailable in the commercial insurance market. There have been two major changes to Section 831(b).
First, the $1.2 million premium limit will increase to $2.2 million and will be indexed to the Consumer Price Index. Second, to make an 831(b) election, an insurance company must meet one of two alternative tests for each year in which it is taxed under Section 831(b).
To meet the first test, a diversification test, no more than 20% of the insurance company’s premiums can come from any one policyholder. The broad definition of ‘policyholder’ applies the attribution rules of Sections 267(b) and 707(b) and a modified version of the controlled group rules of Section 1563(a). In general, if one policyholder is related to another, those policyholders will be treated as one policyholder for this diversification test.
The second test, an alternative to the first, essentially requires that ownership of insured businesses and assets mirror (within a 2% de minimis margin) ownership of the insurance company.
The apparent anti-abuse goal of the diversification test is to ensure that small insurers with unrelated policyholders are eligible to make the 831(b) election easily, while forcing small insurers with related policyholders to meet an alternative test aimed at curbing estate planning abuses.
It is unclear whether the new diversification test also was aimed at reinsurance pools. If the IRS applies the principles of Rev. Rul. 2009-26, the insurance company would look through the reinsurance to the underlying insureds to determine who is a ‘policyholder.’ However, the statute and the Joint Committee on Taxation Technical Explanation do not address this issue. If the principles of Rev. Rul. 2009-26 apply, an insurance company directly insuring only one policyholder, from which it receives no more than 20% of its premiums, might meet this requirement with one pool (comprising many underlying insureds, none of which pay more than 20% of the premiums). If those principles do not apply, that same insurance company might have to participate in at least four reinsurance pools, with no pool’s aggregate premium accounting for more than 20% of the insurance company’s premiums.
The alternative test, an ownership test, is met (1) if no one who holds, directly or indirectly, an interest in the insurance company, directly or indirectly, is a spouse or lineal descendant of someone who holds, directly or indirectly, an interest in any insured business or asset; or (2) where anyone who holds, directly or indirectly, an interest in the insurance company is a spouse or descendant of anyone who holds direct or indirect interest in an insured business or assets, if each person’s ownership of the insurance company mirrors (within a 2% margin) that person’s ownership in the insured businesses and assets.
Regarding direct ownership, application of the ownership test is best explained using examples:
Example 1. Dad owns 100% of each of 12 insured incorporated businesses. Dad owns 100% of insurance company that takes in $90,000 premium from each business. Insurance company CAN elect 831(b), because no spouse or lineal descendant of Dad owns an interest in insurance company.
Example 2. Dad owns 100% of each of 12 insured incorporated businesses. Son owns 100% of insurance company that takes in $90,000 premium from each business. Insurance company CANNOT elect 831(b), because Son owns more than 2% (0% ownership of insureds + 2%) of insurance company.
Example 3. Dad owns 80% of incorporated business A; son owns the other 20% of A. Son owns 100% of 11 more insured incorporated businesses. Dad and Son own insurance company 50% each. Insurance company takes in $90,000 premium from each business. Insurance company CANNOT elect 831(b) because Son owns more than 22% of insurance company (20% ownership of A + 2%).
Example 4. Dad owns 100% of each of 12 insured incorporated businesses. Mom and Dad own insurance company 50% each. Insurance company that takes in $90,000 premium from each business. Insurance company CANNOT elect 831(b), because Dad’s spouse owns more than 2% of insurance company (0% ownership in insureds + 2%).
Example 5. As in example 1, Dad owns 100% of each of 12 insured incorporated businesses, one of which, A, he inherited from his father. Dad owns 100% of insurance company that takes in $90,000 premium from each business. But now, let’s say Dad is married and lives in a community property state, the law of which provides that Dad’s ownership interest in A is separate property. Dad has no agreement with Mom that provides that his shares of the 11 insured companies he founded during his marriage or the shares of insurance company are separate property. Apparently, insurance company CANNOT elect 831(b), because Mom’s community interest in insurance company means she owns more than 2% of insurance company (0% ownership of A + 2%).
The new statute provides that, “An indirect interest includes any interest held through a trust, estate, partnership, or corporation.” That’s all. We are given no clue about the potential application of other attribution statutes or IRS guidance (e.g., does Rev. Rul. 85-13 apply?). If a person is one of a ten beneficiaries of a wholly discretionary trust that owns an insurance company, for purposes of 831(b), does that person indirectly own a 10% interest in the insurance company? A 100% interest (the most that could be distributed to that beneficiary)? What if the trust is a grantor trust – is the grantor treated as the owner, regardless of the identity of the beneficiaries?
The changes are effective for tax years beginning in 2017 and beyond. The changes apply will apply to new and existing 831(b) insurance companies. There are no grandfather provisions. If an existing 831(b) insurance company does not meet one of the new tests, the insurance company and/or the insured companies must be restructured to continue to qualify under 831(b). Existing 831(b) companies that do not or cannot meet one of the new tests beginning in 2017 must be prepared to wind up or accept ordinary insurance company taxation under Subchapter L.
Owners of existing 831(b) captives and businesses and assets insured by 831(b) captives should review the ownership structures to determine whether the captive and insured businesses meet the new ownership requirement. If they do not, it may be possible to restructure the ownership of the captive and/or the insured businesses and assets to ensure continued eligibility for the benefits of Section 831(b). To discuss your situation, contact Chris Riser.