A captive insurance company is created to insure the risks of a specific business. Even though a business can transfer risk to an insurance carrier, exclusions in conventional insurance contracts often force business owners to absorb the hefty costs of a claim. Fortunately, owning a captive can minimize or even eliminate these exclusions.
To create a captive, an individual typically hires an attorney or an experienced captive management firm who establishes an insurance company. Once licensed, the captive functions just as most insurance companies do. It can sell insurance coverage (but generally such sales are only made to its owners), receive premium dollars, invest those premiums to pay claims and, when needed, approach the reinsurance market to purchase reinsurance to cover losses. These coverages allow the owner to simultaneously manage its risk and potentially minimize its current insurance cost by having the captive assume that risk.
If its insurance claims are low, the captive could accumulate significant money, thus creating a profit center for its owner. The structure of the captive will determine the manner in which the income of the captive is taxed during both the accumulation and the payout phases. Of course, a properly structured captive can minimize the tax impact of gains realized by the captive.
For the first time in 30 years, there have been significant changes to the IRS code pertaining to captive insurance companies. Specifically, there are two main modifications. First, starting in January 1, 2017 the limits for an IRC 831(b) election will increase from $1.2 million per year to $2.2 million per year. So, what is an 831(b):
- 831(b) effectively allows a small insurance company currently to receive up to $1.2 million per year in premiums, without paying any income taxes on those premiums.
- The 831(b) election has no effect on the deductibility of the premiums paid by the operating business to the Captive. Premiums are otherwise deductible; they may be deducted by the operating business just like any premium payments to a Captive.
- This creates a current tax deduction of up to $1.2 million for the operating business once premiums are paid to the Captive. In turn, the Captive does not pay any income taxes on the receipt of those premiums.
Additionally, there will be an annual adjustment for inflation starting in 2016. Second, in order to qualify for the 831(b) election the captive must pass 1 of 2 diversification tests. The two diversification tests are called (1) risk diversification and (2) relatedness test (ownership test). I have included below a thorough explanation provided by the staff of the Joint Committee on Taxation as well as an analysis of the Joint Committee on Taxation’s explanation regarding these tests.
Risk Diversification Test
According to the Joint Committee on Taxation, the Risk Diversification test is met when no more than 20 percent of an insurance company’s net written premium (or, if greater, direct written premiums) for the taxable year is attributable to any one policyholder.
For example, if a policyholder pays $1,000,000 of premium to a captive that they are the only policyholder in, that would mean that the policyholder of such company has 100% interest in the net written premiums. Of course, because this interest is greater than 20%, this would fail the Risk Diversification test. As a result of this failure, the Insurance Company would need to qualify for the Relatedness Test (ownership test) for the captive to qualify for IRC 831(b) status.
Relatedness Test (Ownership Test)
Under the Relatedness Test, according to the Joint Committee on Taxation, no person who holds (directly or indirectly) an interest in the company is a “specified holder” who holds (directly or indirectly) aggregate interests in the company that constitute a percentage of the entire interests in the company that is more than a de minimis percentage higher than the percentage of interests in the specified assets with respect to the company held (directly or indirectly) by the “specified holder”. Except as otherwise provided in regulations or other guidance, ownership of two percent or less is treated as “de minimis.” Further, in the context of an insurance company, a “specified holder” is any individual who holds (directly or indirectly) an interest in the insurance company. This includes spouses or lineal descendant (including by adoption) of an individual who holds an interest (directly or indirectly) in the specified assets with respect to the insurance company. Here, an “indirect interest” includes any interest held through a trust, estate, partnership, or corporation. And, with respect to an insurance company, “specified assets” refer to the trades or businesses, rights, or assets for which the net written premiums (or direct written premiums) of the operating company are paid.
This test, in my opinion, is designed for estate planning purposes. For example, let’s say we have a father who owns 100 percent of an operating business and he establishes a captive to insure that operating business. Subsequently, if he transfers (typically through a gift or “bargain” sale) an amount greater than 2 percent of his stock in the captive to his 2 sons (or any other “related parties”—spouse, lineal descendant or adopted children), the captive would not qualify as an IRC 831(b) company because the father still owns 100 percent of the operating business. In particular, if the operating company pays premiums to the captive and the current captive owner has more than 2 percent captive ownership and does not own the same percentage of the operating company, then the Captive would not pass this test. Simply put, if you have a family business and you want to participate and qualify for an IRC 831(b) election, under this test, you need to own the same percentage in the operating business paying premiums to the captive and the Captive itself. If however, you own 60 percent of the Operating Company but you have 2 unrelated partners that own the other 40 percent of the Operating Company, and you are the only party who owns the captive, then you would pass this test.
Below is the example on this test of Relatedness from the staff of the Joint Committee on Taxation.
Assume that in 2017, a captive insurance company does not meet the requirement that no more than 20 percent of its net (or direct) written premium is attributable to any one policyholder. The captive has one policyholder, Business, certain of whose property and liability risks the captive covers (the specified assets), and Business pays the captive $2 million in premiums in 2017. Business is owned 70 percent by Father and 30 percent by Son. The captive is owned 100 percent by Son (whether directly, or through a trust, estate, partnership, or corporation). Son is Father’s lineal descendant. Son, a specified holder, has a non-de minimus percentage interest in the captive (100 percent) greater than in the specified assets with respect to the captive (30 percent). Therefore, the captive is not eligible to elect section IRC 831(b) treatment. (It fails this test)
If, by contrast, all the facts were the same except that Son owed 30 percent and Father owned 70 percent of the captive, Son would not have a non-de minimis percentage greater interest in the captive (30 percent) than in the specified assets with respect to the captive (30 percent). The captive would meet the diversification requirement for eligibility to elect section 831(b) treatment. The same result would occur if Son owned less than 30 percent of the captive (and Father more than 70 percent), and the other facts remained unchanged.
Any insurance company for which an 831(b) election is in effect for a taxable year must report information required by the Secretary relating to the diversification requirements imposed under the provision.
The complexity of these new rules clearly demonstrates the importance of working with an experienced captive insurance administrator to ensure compliance. With proper structuring, a business owner employing a captive can still achieve efficient tax benefits, minimize insurance cost, manage their risks, and create a profit center.