On December 18, 2015, Congress passed and President Obama signed into law the Protecting Americans from Tax Hikes Act of 2015 (Act), which made several significant amendments to section 831(b) of the Internal Revenue Code. Prior to these amendments, section 831(b) permitted an insurance company with up to $1.2 million in annual underwriting income to elect to exclude its underwriting income from taxable income and be subject to tax only on its investment income. Under the Act, Congress:
- Increased the amount of underwriting income that may be excluded from taxable income annually from $1.2 million to $2.2 million;
- Indexed the $2.2 million ceiling for 2016 and subsequent years; and
- Added alternative anti-abuse provisions to section 831(b) - namely, a diversification requirement and an ownership test.
These changes are discussed in greater detail below.
Changes to the Premium Ceiling
As noted above, the Act increased the amount of underwriting income that may be excluded from taxable income annually from $1.2 million to $2.2 million and indexed the premium ceiling for 2016 and subsequent years. The increased ceiling was long sought by members of Congress who represent states with heavy agricultural industries, because a number of farmers in these states rely on local mutual insurance companies to obtain insurance and were being negatively affected by the $1.2 million ceiling set in 1986.
Sutherland Observation. Small local mutuals have long received unique tax treatment. For example, under the Revenue Act of 1916, farmers’ mutuals “of a purely local character” were exempted from income tax in the statutory precursor to section 501. Pub. L. No. 64-271, section 11(a)(10), 39 Stat. 766 (1916). The 1916 exemption was the statutory precursor to the exemptions for small insurance companies found in sections 501(c)(15) and 831(b).
New Anti-Abuse Provisions
Recently, the Internal Revenue Service (IRS) has increased its scrutiny of 831(b) companies because of its perception that some of them have been established for tax abuse purposes. In February 2015, for example, the IRS added captive 831(b) arrangements to its “Dirty Dozen” list of tax scams. In addition, there are numerous audits of 831(b) companies underway and multiple cases docketed in the United States Tax Court, including, principally, Avrahami v. Commissioner(Docket Nos. 17594-13, 18274-13). In Avrahami, the IRS has argued that the 831(b) company in question was formed for tax evasion purposes – namely, to facilitate deductions under section 162 for premiums paid to a small insurer that were improperly excluded from its income under section 831(b) because the company did not qualify as an insurance company for federal tax purposes. To address the perceived abuses of section 831(b) identified by the IRS (and to offset the cost of the increase in the premium ceiling), Congress added anti-abuse provisions to section 831(b). The Act creates new anti-abuse provisions in the form of a diversification requirement and an alternative ownership test.
Diversification Requirement. To satisfy the diversification requirement, no one policyholder may pay more than 20% of an 831(b) company’s annual net written premiums or, if greater, direct written premiums. For purposes of applying the 20% limitation, the Act applies attribution rules under which all policyholders that are related within the meaning of the attribution rules found in sections 267(b) and 707(b), or are members of the same controlled group, are treated as a single policyholder.
Ownership Test. Alternatively, an 831(b) company that does not satisfy the 20% diversification requirement may qualify to make the election if it meets an ownership test. Under the ownership test, the ownership of an 831(b) company must mirror, within up to a 2% de minimis margin, the ownership of the business or assets being insured. The Act permits the IRS to adjust the 2% de minimis margin in guidance as it sees fit.
- The anti-abuse rules are designed, in part, to prevent a taxpayer from avoiding gift and estate taxes through the transfer of cash held by the taxpayer, ostensibly in the form of premiums, to an 831(b) company owned by a child or grandchild of the taxpayer. According to definitional rules, the ownership test applies to insurance companies owned in whole or in part by spouses or by lineal descendants, including by adoption, of the owners of the insured business or assets.
- The rules reflect the concerns of the IRS and Congress that 831(b) companies are being used abusively to facilitate the tax-free transfer of wealth between generations, in particular by owners of small businesses.
Annual Reporting. The Act also imposes new annual information requirements on section 831(b) companies. In so doing, the Act incorporates former Justice Louis Brandeis’ maxim that “Sunlight is said to be the best of disinfectants. . . .” The Act leaves the specifics of what information must be reported to the discretion of the IRS, which will enable the IRS to identify more efficiently potential abuses of section 831(b).
Effective Date of Amendments
The Act’s amendments are effective for the first taxable year beginning after December 31, 2016. However, there is no grandfather provision in the Act, so the Act’s amendments will apply in 2017 and subsequent years to existing 831(b) companies, as well as to new 831(b) companies. Existing 831(b) companies that do not currently satisfy the amendments will have to restructure themselves during 2016, or they will lose their 831(b) status.
Impact on Reinsurance Companies Unclear
The treatment of reinsurance companies under the Act is unclear. Because reinsurance companies may still qualify as insurance companies under the general definition of an insurance company in sections 831(c) and 816(a), reinsurance companies should continue to be eligible to make the 831(b) election.
Sutherland Observation. If more than 20% of the business of the reinsurer comes from one ceding company with numerous underlying insureds, query whether the principles of Rev. Rul. 2009-26 would apply to allow the reinsurer to look through the reinsurance to the underlying insureds for purposes of applying the diversification requirement.
Given the Act’s focus on addressing evasion of estate and gift taxes through the abuse of section 831(b), it remains to be seen whether, and how, the IRS will continue to audit and litigate cases involving 831(b) companies that, the IRS argues, evade income tax.
- The Act attempts to balance the needs of small mutuals for an increased premium ceiling with perceptions that the section was being abused by others.
- Unless they are able to restructure within the next year to meet the Act’s new requirements, a number of 831(b) companies will lose their current 831(b) status. Many 831(b) companies captured by the new anti-abuse provisions may be unable to restructure successfully.
- Under the Act, it is unclear whether a reinsurance company would treat the ceding company or the underlying insured as the policyholder for purposes of applying the diversification requirement.