The spending bill signed into law by President Obama on December 18, 2015 (H.R. 2029 – Consolidated Appropriations Act of 2016) included an amendment to §831(b) of the Internal Revenue Code (the IRC) affecting small captive insurance companies.
The amendment, effective January 1, 2017, will have a significant effect on existing 831(b) captives and could make it more difficult to either maintain the 831(b) election or to qualify for it. However, it also may greatly benefit some small captives that have been subject to the same premium limits for nearly 30 years.
There were two main changes included in the amendment:
- It increases the written premium limit for small captive election
- It creates diversification requirements associated with risk distribution
First, the amendment increases the limit on direct premium that may be written by insurers who have, or are choosing to make, the 831(b) election. The limit increased from $1.2 million to $2.2 million and is now indexed to inflation – something that was previously missing from the IRC.
Second, to make an 831(b) election, an insurance company must meet one of two alternative tests for each year in which it is taxed under Section 831(b).
To meet the first test, a diversification test, no more than 20% of the insurance company’s premiums can come from any one policyholder. The broad definition of ‘policyholder’ applies the attribution rules of Sections 267(b) and 707(b), as well as a modified version of the controlled group rules of Section 1563(a). In general, if one policyholder is related to another, those policyholders will be treated as one policyholder for this diversification test. This first test will most significantly affect single-owner 831(b) captives and will require more participation in separate risk pools.
The second test, an alternative to the first, essentially requires that ownership of insured businesses and assets mirror (within a 2% de minimis margin) ownership of the insurance company. Indirect interests (i.e., interests held through corporations, partnerships, estates or trusts) must be considered when qualifying for the alternative diversification requirement. The alternative diversification test will significantly affect the usefulness of a small captive in estate planning.
What this means is that every insurance company that has made a Sec. 831(b) election, and plans to going forward, will need to review its policyholder and ownership structure and potentially “fix” these areas if they will not meet the requirements under the new rules.