New statute contains limitations on micro captive insurance companies
INSIGHT ARTICLE |
The Protecting Americans from Tax Hikes (PATH) Act of 2015 has been promoted for its permanent and temporary tax benefits, but near the end of the act, amendments to section 831(b) modified the allowable deduction for micro captive insurance companies and increased restrictions on who can make the section 831(b) election. This election is made once but the requirements must be met each year to qualify for preferential treatment. These changes are effective for tax years beginning after Dec. 31, 2016.
Section 831(b) allows small, non-life, insurance companies to pay income tax on investment income only if they meet certain criteria. Prior to Dec. 31, 2016, a parent company could form a captive insurance company making the owner’s children shareholders while the parent maintained ownership of the parent company. The parent company could pay premiums to the captive insurance company in exchange for insurance effectively transferring the premium payments to the children without income or gift taxes while receiving a deduction for the premiums paid within the parent company. The IRS has considered some micro captive insurance companies a legitimate, but abusive, tax structure even going so far as listing it on their “Dirty Dozen” list of tax scams for 2015.
Under the new PATH Act legislation, the maximum amount of premiums paid to a captive insurance company will increase from $1.2 million to $2.2 million. This new benchmark will be indexed annually for inflation.
A new diversification requirement is added to the section 831(b) requirements. An insurance company must now meet one of two conditions:
1. 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 policy holder, or
2. Such insurance company does not meet the requirement of subclause (I) and 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 constitutes 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.
Defining a “specified holder” as any individual who holds an interest in the captive insurance company and who is a spouse or lineal descendant of an individual who owns an interest in the specified assets, and “specified assets” as the trades or businesses, rights, or assets to which net written premiums are paid to the captive insurance company.
While the second condition is convoluted, it essentially states, if a lineal descendant’s interest in a captive insurance company is greater than 2 percent, their ownership of the parent company must be, at least, the same percentage plus or minus 2 percent. These conditions effectively prevent using a micro captive insurance company as a wealth transfer tool.