As part of a tax bill signed by President Obama on December 18, 2015 (The Protecting Americans from Tax Hikes Act of 2015 hereafter, the 2015 Act), the rules governing the deductibility of premiums paid to small captive property and casualty insurance companies will change in significant ways effective January 1, 2017. At present, under Internal Revenue Code (the Code) Section 831(b), captives may elect to be taxed only on taxable investment income if the greater of their net written premiums or direct written premiums does not exceed $1.2 million. Under the new law, while the maximum amount of tax-exempt premiums that can be received by such companies under Section 831(b) of the Code will increase for calendar years after 2015, these captives will become subject to a new diversification requirement designed to prevent abuse. The amendments to Section 831(b) are consistent with concerns expressed by Congress and the IRS in the past several years about the growth in the use of captive insurance companies as a tax shelter.
The number of small captive insurance companies has been expanding steadily since three landmark IRS rulings in 2002 recognized the legitimacy of properly structured captives. Most of this growth has been attributable to the benefits captives provide to their parent companies in reducing the cost of primary insurance, providing direct access to reinsurance coverage, allowing companies to tailor their insurance coverage to their specific needs, and enhancing risk management for the parent companies across a spectrum of different industries. But small, private businesses have also increasingly employed captives as an estate planning or wealth transfer tool. This utility derives from the fact that the captive is a wholly-owned entity of the parent, yet a separate and distinct insurance company. Thus, the parent can fund the captive with significant contributions to provide the required insurance coverage while the captive remains an asset of the parent. If and when the parent decides to discontinue operations, the funds held by the captive remain the property of the parent, as would any other asset of the captive. The owners of the parent can retain ownership of the contributions made to the captive. Alternatively, the owners of the parent, such as the founders of the business, can transfer the captive to a separate entity (a corporation, limited liability company or trust) owned by their heirs and thereby remove the captive from the owners’ taxable estate.
In other instances, business owners have established captives to cover certain risks, such as terrorism, which, while real, are extremely remote given the location or nature of the business. In such cases, the parent companies pay (and deduct) large premiums to the captive without a sound underwriting or actuarial basis and often without ever making claims under the related insurance policies. Such abusive practices have often been aided and abetted by unscrupulous promoters of captives who advertise these captives as a means of tax reduction or tax avoidance. The promoters often manage the captives for substantial fees, taking advantage of unsophisticated taxpayers who are ignorant regarding insurance. For these reasons, the IRS identified small captives on its’ “Dirty Dozen” list of tax scams for the 2015 filing season.1
The 2015 Act
Under the 2015 Act, the amount of tax-deductible premiums that can be paid by a parent to a captive insurance company will increase from $1.2 million to $2.2 million. This amount will also be indexed to inflation for the first time since 1986. The base year for the inflation adjustment is 2013. However, in order to qualify for the deductibility of premiums below the new threshold, the captive must satisfy one of the two new diversification requirements. First, under the risk diversification test, no more than 20% of net written premiums (or, if greater, direct written premiums) for a tax year may be attributed to any one policyholder. In determining the attribution of premiums to any policyholder, all policyholders that are related (within the meaning of Section 267(b) or 707(b)2 of the Code) or are members of the same controlled group are treated as one policyholder. Alternatively, the captive would be eligible for the exemption if the interest of each owner of the captive does not exceed the interest of such owner in the business or assets insured by the captive. Thus, the requirement prohibits a parent insured company from being wholly owned by one person and the captive by his or her heirs. The House Joint Committee on Taxation provides an example of how the second diversification provision would apply3:
[A]ssume that in 2017, a captive insurance company does not meet the [first diversification] requirement…. The captive has one policyholder, “Business,” certain of whose property and liability risks the captive covers… and Business pays the captive $2 million in premiums in 2017. Business is owned 70% by Father and 30% by Son. The captive is owned 100% by Son (whether directly, or through a trust, estate, partnership or corporation). Son is Father’s lineal descendant. [Under the second diversification requirement,] Son…has a non-de minimis [(i.e., more than 2%)] greater percentage interest in the captive (100%) than in the specified assets coverage of which is provided by the captive (30%). Accordingly, the captive is not eligible to elect Section 831(b) treatment.
If, by contrast, all the facts were the same except that Son owned 30% and Father owned 70% of the captive, Son would not have a non-de minims percentage greater interest in the captive (30%) than in the specified assets with respect to the captive (30%). The captive would meet the diversification requirement for eligibility to elect Section 831(b) treatment. The same result would occur if Son owned less than 30% of the captive (and Father more than 70%), and the other facts remained unchanged.4
The new law also provides that for any captive insurance company for which a Section 831(b) election is in effect for a taxable year, the company must report information on the diversification requirements. This would presumably require the IRS to create a new form for captive insurance companies making the Section 831(b) election.
Finally, under the 2015 law, existing captives that previously employed Section 831(b) but may not meet one or the other of the new diversification requirements would not be “grandfathered.” Thus, if such a company did not change its structure to satisfy the new rules, it could become subject to the taxes a non-electing captive would pay or become subject to an IRS investigation or penalties, even if it was not formed as a tax shelter. This situation could create problems for existing captives, so it will be interesting to see how the 2015 Act is enforced.