Posted by Adam Necelis, CPA
Last December when Congress passed the Protecting Americans from Tax Hikes Act of 2015, or PATH Act as it is more commonly known, many tax provisions were impacted. One such provision that was impacted by the PATH Act is related to captive insurance companies. Section 831(b) of the Internal Revenue Code (IRC) allows for small property casualty insurers to be taxed on their investment income only and not on their insurance premium income. Prior to the passage of the PATH Act of 2015, a small insurer was considered to be an insurer who received less than $1.2 million of annual insurance premiums. This was the annual volume amount determined by the Tax Reform Act of 1986, which was the last time any significant changes were made to Section 831(b). With the passage of the PATH Act, the annual premium has increased to $2.2 million, starting in 2017, and will be adjusted for inflation going forward.
In addition to increasing the annual premium to determine who qualifies as a small insurer, the PATH Act also added diversification requirements not included in the previous language. The diversification requirements are designed to prevent companies from taking advantage of and abusing the benefits that are provided by Section 831(b). The benefits provided by Section 831(b) are very advantageous. Consequently, some companies would artificially manipulate the premiums to maximize their benefits. The new requirements are meant to combat those tactics. The IRS recently named abusive tax shelters, including the misuse of captive insurance companies, as one of the 2016 “Dirty Dozen” tax scams.
Diversification Test Requirements
The diversification requirements are made up of two tests. The first test is no more than 20% of the net written premiums of the insurer are attributable to any one policyholder. If an insurer meets the first test, the second diversification test is not required. If an insurer does not meet the first test, the second test states “no person who holds an interest in the insurance company is a specified holder who holds (directly or indirectly) aggregate interests in the insurance company that is more than a de minimis percentage higher than the percentage of interests in the specified assets with respect to the insurance company held (directly or indirectly) by the specified holder.” This means that an owner cannot have more than a de minimis ownership difference, defined as 2% for this test, between their ownership percentage in the insurance company and their ownership in the assets that the insurance company is insuring.
With the increase in the annual premium, captive insurance companies are becoming more advantageous. However, with the addition of the diversification requirements, it will become even more important to seek out professional help to ensure that your current captive insurance company passes one of the two tests. As well as any new captive insurance company properly set-up to ensure it will pass one of the two tests. Failure to comply with the new requirements will prevent your insurance company from receiving benefits under IRC Section 831(b).