Recent Changes to Small Captive Insurance Companies
Recent changes increase allowable premiums.
The PATH Act, signed into law at the end of 2015, has two delayed features that impact small insurance companies taxed under IRC Section 831(b) for the tax years beginning on or after January 1, 2017. The first is generally viewed as a favorable provision and is relatively straightforward in its application. The second is a little more complex and places an additional hurdle on small insurance company taxpayers to qualify to be taxed only on investment income.
The first provision increases the allowable maximum net premium income received, in order to qualify as a small insurance company, from $1.2 million to $2.2 million. Companies that qualify as a small captive insurance company are taxed only on net investment income. This means that qualifying small insurance companies can exclude from their taxable income up to $2.2 million in net premium income.
However, the second provision, also referred to as the “diversification” rules, places a requirement that limits small insurance companies to having not more than one policyholder representing greater than 20% of their premium income. Alternatively, a small insurance company can satisfy the diversification rules through a family lineal ownership restriction test.
The new rules limit the family ownership of a small insurance company. The insured or policyholder of a small insurance company may not be a spouse or lineal descendent of the owner of the small insurance company owning more than a deminimus amount more in the insurance company than they do in the insured company. A deminimus amount for this purpose is defined as 2%.
The best way to illustrate the family ownership restriction is by way of an example. Assume that father and son own an operating company, XYZ, Inc., 75% and 25%, respectively. The father and son decide to form ABC Insurance Company in order to insure against a risk of XYZ, Inc. ABC Insurance Company may not be owned more than 27% by the son in order for ABC Insurance Company to be eligible to be taxed only on investment income as a small insurance company.
Many small business owners using a small insurance company (or a captive insurance company, as they have been termed) in their business structure still have time to conform to the new rules before year-end. Captives are still viable tax savings structures, insurance solutions, and generational wealth transfer tools, but taxpayers need to ensure that they are structured properly under the new rules in order to qualify for the favorable tax treatment under IRC Section 831(b).