Alan Fine of Brown Smith Wallace explains three key options to maintain compliance with changes to Section 831(b)
The Protecting Americans from Tax Hikes Act of 2015 created changes for 831(b), a section of the Internal Revenue Code that had not been amended in 29 years. As originally written and enacted, Section 831(b) provided “small” property and casualty insurance companies with premiums less than $1.2 million, an annual option to elect to be taxed solely on their investment income (rather than the sum of their underwriting and investment income).
As a result of the changes in the act, captive owners are asking what their options are in order to bring their captive into compliance with the new law.
One of two diversification tests must be met
The act’s changes take effect on 1 January 2017. These changes are geared toward curtailing the use of the micro captive insurance structure as a means of distributing wealth to heirs without being subject to either estate or gift taxes, which US Congress deemed to be abusive. It is important to note that this does not mean that structures taking advantage of this benefit prior to 1 January 2017 will be deemed to be abusive or overturned due to the estate planning benefit taken.
In addition to increasing the premium limitation to $2.2 million per year, the amended law also provided two “diversification” tests, at least one of which must be met in order for the company to be eligible to make the Section 831(b) election.
The first diversification test provides that no single policyholder may account for more than 20 percent of the insurer’s net written premiums (or, if greater, direct written premiums). Importantly, this threshold is measured on a controlled group basis, meaning that all companies with more than 50 percent common ownership are treated as a single policyholder for these purposes.
The alternate diversification test provides that in situations where a spouse or lineal descendant of a business owner has ownership of the insurance company, their ownership in the operating business must be within 2 percentage points of the insurance company. This test in particular is designed to eliminate the potential estate planning benefit associated with having a captive owned by one’s heirs.
Options to ensure your captive complies with the new law
One of the diversification tests must be met for years beginning on or after 1 January 2017, in order to be eligible for the 831(b) election.
Change ownership: one option is to actually change the ownership of the existing captive so that it conforms to the requirements of the new law. If, for example, the children of the business owner own 100 percent of the captive but none of the operating businesses, they could sell their interest back to their parent. It is important to recognise that this will create a gain on which the children will have to pay income tax. Should this strategy be preferred, it is critically important that the sale be structured on an arms’ length basis in order to avoid challenges by the IRS for a bargain sale. Accordingly, a valuation of the captive should be performed by a reputable service provider with experience in this area.
It may be determined that the needs which led to the creation of the captive no longer exist. In that case, the captive could surrender its license and liquidate. It is important to note that this liquidation may lead to two levels of tax: one at the corporate level, to the extent that the captive is holding appreciated assets, and a second by the owner of the captive. Therefore, it is vitally important to make sure that an appropriate valuation is performed of both the captive itself as well as the assets it owns.
Freeze current captive: the second option available would be to ‘freeze’ the current captive—discontinue paying premiums to this entity and surrender the insurance licence. The benefits of implementing this strategy include deferring the tax that would be imposed by implementing the first option and keeping the amounts out of the parent’s estate. The former captive, with its existing capital, could be used to create or buy a new business or to lend funds to the operating businesses as needed.
The idea of borrowing from the former captive is similar to that of creating the captive, in that there is more flexibility in structuring the terms of the loan agreement (as long as they remain on an arm’s’ length basis). The business owners could then create a new captive that does meet the new ownership requirements of Section 831(b).
Forgo 831(b) election: finally, in some situations it may make sense for the captive to forgo the 831(b) election. This doesn’t mean that the premiums paid to the captive would not be deductible. Instead, the captive would pay tax on all of its taxable income, not just its investment income. This may make particular sense for those captives, which incur significant/frequent losses, as these losses would now be deductible (which is not the case for an insurer making the election to be taxed solely on investment income).
This has the added benefit of not having to restructure the ownership of the captive. It may also not require a change in business plan or approval of the department of insurance, depending on the captive’s domicile. It is strongly suggested to consult with your advisor before concluding no communication is necessary with the department of insurance.
The changes to Section 831(b) provide an enhanced opportunity for those choosing to utilise a captive insurance strategy. Each captive owner should consult with someone experienced in this area in order to understand whether they are in compliance with the new law, and what the best alternative is for those situations where the new requirements are not met. CIT
