In a flurry of legislative activity in mid-December of 2015, Congress passed and President Obama signed a so-called “Tax Extenders” bill titled H.R. 34. This created a stir in the captive insurance industry both before and after passage, as H.R. 34 included Section 262 titled, “MODIFICATIONS TO ALTERNATIVE TAX FOR CERTAIN SMALL INSURANCE COMPANIES.” These modifications impact small captive insurance companies (CICs) that make an 831(b) tax election.
These small captive insurance companies are often described as micro-captives or 831(b) captives. Both of these names are really a misnomer. “Small” captives are real insurance companies that usually serve small and mid-market companies in the same way that “large” captives serve larger companies. 831(b) is simply a tax election designed to encourage small and mid-size companies to improve their risk management posture by owning their own insurance company. Small captives are good for small business (CLICK HERE) and good for America (CLICK HERE).
What Is A Captive Insurance Company?
Simply put, businesses or their owners can choose to OWN THEIR OWN INSURANCE COMPANY. A captive insurance company is a licensed, closely-held insurance company. Captives are formed to provide insurance protection to businesses and related entities. They are usually owned by the business, business owners or other related parties. Businesses pay premiums as an ordinary business expense to their captive insurance company(ies). The captive issues insurance policies to the company. Captive policies are priced by an actuary. When the business files an insured claim, the captive pays it. Like commercial insurance companies, captives also accumulate loss reserves. Reserves can be invested in accordance with the captive’s Investment Policy Statement (IPS). The IPS is usually approved by the domicile that licenses the captive.
What Is An 831(b) Tax Election?
Small captive insurance companies, as define d in Section 831(b) of the Internal Revenue Code, may elect to pay no federal income taxes on their underwriting profits each year. Underwriting profit is simply calculated as premiums received less claims paid.
Prior to H.R. 34, “small” captives were defined as having premium revenues of less than $1.2 million annually. Starting in 2017, thanks to H.R.34, this increases to $2.2 million and adjusts for inflation each year thereafter.
What Has Changed With The Passage Of H.R. 34?
In addition to adding an additional reporting requirement for small captive insurance companies, H.R. 34 makes essentially two changes to the existing 831(b) election. First, it increases the maximum premium revenue that a CIC can receive and still be eligible to make an 831(b) election, a big “win” for taxpayers. Second, it adds a “diversification” requirement that impacts either ownership structure or risk distribution. To meet the “diversification” requirement to be eligible for an 831(b) election, a small captive must meet one of two new tests starting in 2017.
What Is The Specific Language Of H.R. 34 Regarding “Diversification” Requirements?
‘‘(i) IN GENERAL.—An insurance company meets the requirements of this subparagraph if no more than 20 percent of the net written premiums (or, if greater, direct written premiums) of such company for the taxable year is attributable to any one policyholder.
‘‘(ii) ALTERNATIVE DIVERSIFICATION REQUIREMENT.—
An insurance company meets the requirements of this subparagraph if—
‘‘(I) such insurance company does not meet the requirement of clause (i),
‘‘(II) no person who holds (directly or indirectly) an interest in such insurance company is a specified holder who holds (directly or indirectly) aggregate interests in such insurance company which constitute a percentage of the entire interests in such insurance company which is more than a de minimis percentage higher than the percentage of interests in the specified assets with respect to such insurance company held (directly or indirectly) by such specified holder.
What Does That Mean in Plain English?
Essentially, to be eligible to make an 831(b) election, a captive insurance company must meet one of two tests starting in 2017.
The second test is rather “clean” and straightforward. It simply means that the ownership of the captive insurance company (as a percentage) must closely mirror the ownership of the parent company (ies). Many captives managed by CIC Services, LLC meet this test already. Others may be able to meet this test with slight ownership adjustments to their captives or parent companies or insured companies.
The first test is a bit more complicated, as it states a captive may not receive more than 20% of net premiums from one policy holder. This language requires business owners to either share a common captive insurance company making an 831(b) election (also known as a “group” captive), or it will require more “cross-insurance” or re-insurance than most small captive structures currently employ. Our initial assessment (and the assessment of other industry experts) is that risk distribution or re-insurance pools utilized by small captive insurance companies can be modified to meet this second test, and this will likely be the preferred approach of most clients.
CIC Services, LLC is thoroughly scrutinizing this new legislation and be proactively contacting its clients to discuss beneficial ways of complying with the new rules. Again, the new rules do not take effect until 2017, so there is plenty of time to consider options and get things right.
What Is CIC Services, LLC’s Perspective On H.R. 34?
Unlike many of the nay-sayers in the industry who have wrung their hands and gnashed their teeth at the changes (CLICK HERE), we see H.R. 34 as a net positive for small captive insurance companies and the small and mid-size businesses they serve.
Consider the following analogy.
In the glory days of college basketball, Dean Smith’s Tar Heels would run the stall with a 2 point lead and 15 minutes left in the 2nd half. At the same time, massive centers like Ralph Samson, Hakeem Olajuwon, and Patrick Ewing would park near the basket and shield off defenders. These monster centers would take a pass down low and make an easy short jumper or shoot a close skyhook. The game was often slow and a bit cumbersome.
What happened? Basketball changed by making a few new rules. They added a shot clock and made the 3 second lane wider, forcing teams to adapt their style of play. However, they also added the 3 point line! These rule changes combined to open up the game, making it far more exciting for players and fans.
Congress essentially did the same thing for small CICs making an 831(b) election. The new rules on diversification are manageable. Yes, they will likely require adjusted risk sharing arrangements and possibly new ownership structures (in the worst cases), but the benefits far outweigh the costs. Basketball teams easily adapted to the new rules, and most small captives will also. In fact, many small captives comply with the new rules already and require no adjustment at all.
And everyone will directly or indirectly benefit from the higher 831(b) limits. Raising the maximum premium level from $1.2 million to $2.2 million for CICs making an 831(b) election (and indexing it to inflation) is like adding a 3 point line. For some clients, it’s more like adding a 4 point line!
What Additional Perspective Can CIC Services, LLC Provide On H.R. 34?
What is most striking about H.R. 34 is not what it says, but what it doesn’t say. In 2015, The I.R.S. and the Self Insurance Association of America (SIIA) specifically asked Congress to ban trust ownership of captives and to ban captives from investing in life insurance. However, after thoughtfully considering the issue, Congress declined both requests in favor of the new rules discussed above, which are much more reasonable. We can now say with confidence that both Congress and the Courts are skeptical of the IRS’s claims of rampant abuse of captive insurance structures.
When Does H.R. 34 Take Effect?
The amendments apply to taxable years beginning after December 31, 2016. This provides a full year for captives and their corresponding risk distribution pools to restructure to meet the new requirements. In the weeks ahead, CIC Services, LLC will be publishing additional perspective on H.R. 34 and providing guidance to captive owners and prospective captive owners on complying with the new legislation. In the meantime, readers can rest confident that the benefits of captive insurance companies to small and midmarket businesses are greater than ever and rest on even stronger legal footing.