The eligibility rules for small property and casualty insurance companies to elect Code Sec. 831(b) status have been modified to increase the premium limit and index it to inflation, and to add certain diversification requirements. The existing $1.2 million limit on net written premiums or direct written premiums (whichever is greater) is increased to $2.2 million (indexed for inflation).
Insurance companies other than life insurance companies are commonly referred to as property and casualty insurance companies. These are companies for which more than 50 percent of its business in a tax year consists of issuing insurance or annuity contracts or reinsuring risks underwritten by insurance companies (Code Sec. 831(c)). Under this rule, it is not possible for a company’s investment activities to exceed its insurance activities and still have the company considered an insurance company for that tax year.
The taxable income of a property and casualty insurance company is generally calculated by combining the amounts earned from underwriting and investments (and any other gains) and subtracting any allowable deductions. The corporate tax rates apply to the taxable income of every insurance company other than a life insurance company.
Very small property and casualty companies with net or direct written premiums less than $1,200,000 may elect to be taxed only on their taxable investment income (Code Sec. 831(b)(2)(A)). This allows companies whose sole activity is the reinsuring of risks to be treated in a like manner to other insurance companies, even if the company has little or no premium income. These companies are frequently referred to as captive insurancebecause they are often formed only for the purpose of insuring the risks of affiliated companies. These qualifying small insurance companies operate for legitimate risk management purposes, the affiliated businesses can deduct their premium payments to the 831(b) insurance company, and—if the election is in place—the can take in up to the $1,200,000 premium limit without being subject to income tax on those premiums. Once made, the election may not be revoked without the consent of the IRS.
In the case of a controlled group of corporations, the premium receipts of the controlled group are aggregated in order to determine if the company may make the election. In determining whether there is a controlled group, the test of Code Sec. 1563(a)(1) is used, except that a threshold of ownership of “more than 50 percent” is applied rather than “at least 80 percent.”
The Treasury and Joint Committee on Taxation have expressed concerns regarding abuse of this election in connection with estate planning, irrevocable trusts, and the use of 831(b) assets to purchase life insurance.
NEW LAW EXPLAINED
Dollar limit modified and diversification requirement added for 831(b) small insurance companies.—The eligibility rules for small property and casualty insurance companies to elect Code Sec. 831(b) status have been modified to increase the premium limit and index it to inflation, and to add certain diversification requirements (Code Sec. 831, as amended by the Protecting Americans from Tax Hikes (PATH) Act of 2015. The existing $1.2 million limit on net written premiums or direct written premiums (whichever is greater) is increased to $2.2 million. In addition, this increased limit will now be adjusted for inflation using the cost-of-living adjustment calculation. A calculated inflation-adjusted amount that is not a multiple of $50,000 should be rounded down to the next lowest multiple of $50,000.
A diversification requirement has also been added to the 831(b) eligibility requirements. There are two methods of meeting this requirement. The primary method (“risk diversification test”) is to have no more that 20 percent of the company’s net written premiums (or, if greater, direct written premiums) attributable to one policyholder in a tax year. In determining the attribution of premiums to any policyholder, all policyholders that are related or are members of the same controlled group are treated as one policyholder.
Small insurance companies that fail to meet this test may be able to meet the alternative (“relatedness test”) requirements. This second chance requires that no person who holds (directly or indirectly) an interest in the company be a “specified holder” with aggregate interests in the company (held directly or indirectly) that are a percentage of the entire interests in that insurance company that are greater than a de minimis percentage higher than the percentage of interests in the specified assets with respect to the company held (directly or indirectly) by the specified holder.
For this purpose, a specified holder is any individual holding (directly or indirectly) an interest in the small insurance company who is a spouse or lineal descendant (including by adoption) of another individual who holds an interest (directly or indirectly) in the“specified assets” of such insurance company. An indirect interest is one that is held through a trust, estate, partnership or corporation. Specified assets are the trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of the company are paid. Also, unless otherwise specified by regulation or other guidance, a de minimispercentage is two percentage points or less for these purposes.
Any existing small insurance company with an 831(b) election in effect will be required to meet any information and substantiation reporting requirements regarding the diversification test as may be established by the IRS.
►Effective date. The provision applies to tax years beginning after December 31, 2016.
If you have any questions regarding this new provision or your captive insurance company, please do not hesitate to contact us.