HR 1625 provided some much-needed guidance for taxpayers with micro captives, primarily regarding section 831(b) diversification requirements implemented in the PATH Act 2015.
HR 1625 provided some much-needed guidance for taxpayers with micro captives, primarily regarding section 831(b) diversification requirements implemented in the PATH Act 2015. John Dies and Matthew Spradling break down the changes
Captive insurance companies exist because the business world is full of unknowns. A business owner can turn to a captive insurance company to mitigate their risk, however, what happens when the unknowns involve the tax treatment of a captive? Captive owners utilising an Internal Revenue Code section 831(b) micro captive, have been left with unanswered questions. The passage of HR 1625 has, however, provided taxpayers with micro captives with some much-needed guidance.
On Friday 23 March 2018, US President Donald Trump signed into law HR 1625, the Consolidated Appropriations Act 2018. In addition to funding the US government for the remainder of this year, HR 1625 provided clarification regarding section 831(b) diversification requirements as previously implemented by the Protecting Americans from Tax Hikes (PATH) Act 2015.
The PATH Act increased the maximum annual premium limitation for section 831(b) micro captives from $1.2 million to $2.2 million and provided for an inflation adjusted increase for future years. This was a victory for small and mid-sized businesses who rely on section 831(b) micro captives as an integral risk management tool. However, in light of increased scrutiny by the Internal Revenue Service (IRS) Congress also implemented additional requirements to address the potential abuse of micro captives. Most notably, the act implemented two diversification tests: the 20 percent test and the ownership test. To qualify as a section 831(b) captive, the taxpayer must meet at least one of these tests.
The 20 percent test
The 20 percent test, provides that no more than 20 percent of the annual net written premiums of the captive insurance company may be attributable to one policyholder. For purposes of this test, controlled groups and related entities within the meaning of sections 267(b) or 707(b) are considered to be one policyholder.
The implementation of this test originally created questions regarding reinsurance, fronting, and intermediary arrangements. For example, consider a captive that is a member of a risk management pool which received 81 percent of their premiums through a reinsurance agreement with the pool. Prior to the recent changes it was unclear whether such a situation would constitute one policyholder, or whether each underlying insured would be a policyholder. HR 1625 implemented a look-through provision to resolve this confusion. The statute was amended to define policyholder as “each policyholder of the underlying direct written insurance with respect to such reinsurance or arrangement”.
This means that the pool itself is not considered the policyholder, but rather each discrete insured paying premiums into the pool is a policyholder. Therefore, as long as none of the insureds in our example above account for more than 20 percent of the total premiums paid to the captive, the 20 percent test would be met.
This common sense change will allow the diversity requirement to be met with an appropriately structured reinsurance pooling agreement. The tax treatment of the reinsurance agreement now reflects the real-world effects of the pooling arrangement. Overall, this change is anticipated to have a profoundly positive effect on the captive insurance industry.
The ownership test
Captives failing the 20 percent test may still qualify for 831(b) treatment if the entity meets the requirements of the relatively more complex ownership test. The ownership test was devised as a way to prevent captives from being utilised as estate planning vehicles. Originally, a captive would fail this test if a “specified holder” (spouse or lineal descendant) owned an interest in the captive that is greater than two percent of that individual’s ownership interest in “specified assets” (interest in the insured) of the captive. Put more simply, a captive would fail the ownership test if a spouse or lineal descendant of an owner/shareholder of an insured business, owned a greater share of the captive than they owned in the business (the test did, however, allow for a de minimis difference of two percent). Several questions arose under this arrangement, especially with regards to the treatment of community property.
HR 1625 clarifies the spousal issue by eliminating spouses from the definition of specified holder, unless they are not a US citizen. Therefore, under the new rules, the ownership test now only applies to lineal descendants of either spouse, spouses that are not US citizens, and spouses of lineal descendants. Furthermore, a new aggregation rule has been applied to certain spousal interests. Under the new law, any interest held, directly or indirectly, by the spouse of a specified holder is deemed to be held by the specified holder.
Lastly, the test was also modified to look at the “relevant specified assets” of the captive rather than the specified assets. Specified assets were defined as trades, businesses, rights, or assets with respect to which the net written premiums of an insurance company are paid. Relevant specified assets, on the other hand, restricted the determination to the aggregate amount of an interest in the trade, business, rights, or assets insured by the captive, held by a specified holder or the spouse of a specified holder. The new rule excludes assets that have been transferred to a spouse or other relation passed “by bequest, devise, or inheritance from a decedent during the taxable year of the insurance company or the preceding taxable year”.
Remaining areas of uncertainty
Although a move in the right direction, these changes do not resolve all of the uncertainties surrounding the PATH Act tests. For example, the new law does not provide guidance as to the definition of an ‘interest’. It is unclear whether interest exclusively denotes ownership, and how to calculate the amount of ownership if the interest is held by multiple individuals through a trust or other entity. It is also unclear how to quantify the amount of interest when there are multiple insureds involved. Further guidance is still desperately needed in this area.
Although these amendments go a long way to address the ambiguity and unforeseen consequences of the changes made in the PATH Act, there are still many items for which taxpayers entering into captive arrangements should be on the lookout. Taxpayers using or considering a captive insurance arrangement should consult an attorney.
