For many years, captive insurance companies have enjoyed significant tax savings due to Section 831(b) of the Internal Revenue Code. Under Section 831(b), a property and casualty insurance company can make an election to be taxed solely on its net investment income. In order to qualify for this election, the company’s net written premiums (or direct written premiums, if greater) must be less than or equal to the limitation specified in the statute. For tax years beginning before December 31, 2016, this limitation is $1,200,000. Once the 831(b) election is made, it remains in effect for all future tax years unless permission is received from the Internal Revenue Service (IRS) to revoke the election. This favorable tax treatment allows captive owners to take advantage of a number of tax opportunities.
It is important to note that captive insurance companies utilizing the Section 831(b) election (frequently referred to as microcaptives) may not be organized solely as investment or tax planning vehicles. These companies must be able to show that their principle purpose is to provide legitimate insurance against risks faced by the insured operating companies. When determining if a microcaptive has a true insurance purpose, the IRS examines all relevant facts and circumstances surrounding the organization and operation of the company.
On December 18, 2015, President Obama signed the Protecting Americans from Tax Hikes Act of 2015. This new law made significant changes to section 831(b) of the Internal Revenue Code for tax years beginning after December 31, 2016. The two principle changes can be summarized as follows:
- The limitation on net written premiums (or direct written premiums, if greater) for 831(b) insurance companies increased from $1,200,000 to $2,200,000. Going forward, the $2,200,000 limit will be indexed for inflation.
- To qualify for the 831(b) election, a captive insurance company must meet either of the following diversification requirements:
- No more than 20% of its net written premiums (or direct written premiums, if greater) are received from one policyholder (family attribution rules apply), or
- The spouse and lineal descendants of the owner of the business being insured may not have ownership (direct or indirect) in the microcaptive that is more than a de minimis percentage (2%) higher than the ownership they have in the insured business.
Note that no changes were made to the definition of insurance or to the requirement that Section 831(b) insurance companies operate with a valid insurance purpose.
It is unclear how these changes will affect existing and potential microcaptives. Many companies which previously failed to qualify for the Section 831(b) election because their yearly net written premiums exceeded $1,200,000 may now qualify for the election. Conversely, many existing microcaptives may no longer qualify because they fail to meet either of the diversification requirements. It is likely that these captives will either terminate their insurance operations in 2016, make changes to their premium or ownership structure in order to continue to qualify under Section 831(b), or choose to be taxed under Section 831(a) as a traditional insurance company. The more restrictive 831(b) requirements may also discourage companies from organizing new microcaptives. We are hopeful that additional guidance, clarification, and transition rules will be issued by the IRS during 2016 to help captives comply with the new law.
If you have any questions about captive insurance companies or the changes to the requirements for making the Section 831(b) election, please contact Scott Rogers at 801-313-1900.