On December 18, 2015 Congress enacted the Protecting Americans from Tax Hikes Act of 2015 (PATH). This legislation made significant changes to Internal Revenue Code Section 831(b). For those unfamiliar with 831(b), this section of the Code provides an alternative tax calculation for small insurance companies. The IRS defines small insurance companies as those having net annual written premiums of $1.2 million or less. Companies meeting this requirement can elect to be taxed as a Section 831(b) small insurance company which will enable them to pay tax only on their respective investment income and not on the insurance premium income.
Section 831(b) captive insurance companies have become a widely used vehicle to cover specific insurance risks of a business. In many mid-sized privately owned businesses the ownership in the operating company can be considerably different than the ownership in the captive insurance company. These have often been utilized as an estate planning tool to transfer wealth to the next generation in family-owned businesses. Unfortunately some taxpayers have created captive arrangements that have acted more as tax shelters than as bona fide insurance companies that insure real business risk.
The good news is this new legislation increases the annual premium limit from $1.2 million to $2.2 million. However, this legislation also includes two additional tests that could be problematic for existing 831(b) insurance companies.
This new legislation added diversification requirements. These requirements can be met by passing either the risk diversification test or the relatedness test. The prior rules also required risk diversification, but allowed the use of related separately regarded entities to spread risk among a certain number of entities. The new risk diversification test requires that no more than 20 % of the premiums be attributable to any one policy holder. That in and of itself doesn't sound that different from the prior rules. However, one major difference from the old rules is that policyholders who are related or are members of a controlled group are treated as one policy holder for purposes of the risk diversification test. The test to determine if parties are considered related for this purpose is determined by the attribution rules contained in IRC Sections 267 and 707.
The relatedness test essentially requires that the ownership of the insurance company mirrors the ownership of the insured operating business. The IRS does allow the ownership to vary by a de minimis margin, defined as 2 % or less.
Keep in mind that this is an either/or test to achieve either the risk diversification or relatedness test. An 831(b) insurance company is not required to pass both tests. In addition, these provisions are not effective until tax years beginning after December 31, 2016. Therefore, you have some time to address whether your captive insurance company will comply with these new rules. There are several other factors that can impact the risk diversification test. We recommend speaking with a Schneider Downs representative and/or your insurance advisors to ensure these new laws have been addressed based on your current arrangement. If these new tests cannot currently be met, it is critical to develop a plan that will allow the insurance company to become compliant before the effective date.