IRS Section 831(b) Tax Code Changes for 2017

At the end of 2015, Congress passed the PATH Act, which included changes that apply to section 831(b) of the IRS tax code. These changes apply to ALL captive insurance companies (CICs) that take the 831(b) election in the year 2017. There are essentially two changes that impact CICs. One change impacts the yearly premium amount, while the other change impacts the ownership structure of the captive, in relation to the ownership structure of the insured entity(ies). Regarding the premium amount:

The maximum annual premium allowable to take the 831(b) election is raised to $2.2MM. This increase applies to premiums on policies issued by the CICs in the year 2017. Each year thereafter, the allowable maximum premium will be adjusted based on an inflationary index. To justify this increase, it is imperative that there should be appropriate risk, and legitimate policies issued. A responsible CIC manager should utilize an independent actuary familiar with captive insurance risks and coverages, to perform a feasibility study to determine appropriate premium amounts.

The CIC ownership structure restrictions are a little more complicated. The intent of this ownership change is to prevent CICs from being used as a way to avoid estate and gift taxes. The primary purpose of CICs should always be to utilize best risk management practices – insuring a business against risks difficult to insure on the commercial market. Too often, CICs that are set up purely for estate tax planning purposes. To eliminate this abuse, the IRS has pushed to have the tax code changed as follows:

When there are certain family relationships involved in the ownership of both a business and a CIC, the ownership structure of the CIC may be restricted. Specifically, family members to whom this rule applies cannot own a larger share of the captive than they own of the business. There are a few rules that define how these guidelines apply:

1.  The ownership constraints only apply to situations where there is a spouse, or where lineal descendants are involved. If partners, siblings, in-laws, cousins, or uncles/aunts & nieces/nephews are involved in both the business and CIC ownership, this constraint does not apply. If a lineal descendant (child, grandchild, etc.) or spouse are involved in ownership of the CIC, they cannot own a larger percentage of the CIC than they own of the business. Here are some examples that may help clarify this rule:

a. If a father, his wife, and one child jointly own the business being insured, with dad owning 51%, mom owning 25%, and the son owning 24% of the business, the spouse or child cannot own a larger percentage of the CIC than what they own of the business. They can, however, own a smaller percentage of the CIC than their ownership share of the business.

b. If three brothers each own 33% of the business, and one brother does not want to own the CIC, the other two brothers can each own 50% of the CIC, since the brothers do not constitute a lineal relationship.

c. If a family trust owns 80% the business, and the parents own 20% of the business, the family trust cannot own more than 80% of the CIC.

2.  There is a 2% de-Minimis allowance. The ownership percentages for applicable family members allow for a 2% deviation between business ownership and CIC ownership. For example, if a parent owns 52% of the business and a child owns 48% of the business, the parent and child can each own 50% of the CIC.

If you try to interpret the purpose and meaning behind these changes, you can come to a few different assumptions:

1.  Captive Insurance is protected by Congress. Initially, the IRS lobbied for stronger restrictions and revisions for section 831(b). But other industry lobbyists and legislators who recognize the value of captive insurance pushed back, and the existing language is a valid compromise. By increasing the premium limit, one can reasonably assume that congress recognizes the value and legitimacy of captive insurance, and has created an opportunity for small business owners to take full advantage of self-insuring through this powerful strategy.

2. The changes incorporate an effort to address captive insurance fraud. Many CIC managers and professionals welcome the intent to address CIC formation for purposes other than risk management and business protection. Estate planning has been a huge benefit for owning a CIC, and this has gone away to some degree. But this change also sends a clear signal that CICs are to be used for the right purpose.

3. Investment practices are still left up to the CIC owner. Before the changes to the tax code were revealed, there was some thought that the changes may include language that addresses investment practices; specifically solvency needs, “seasoning,” or “vesting” of premiums, purchasing life insurance within the captive, etc. Congress is certainly aware that investment practices can be grey areas, and areas of abuse by CIC owners. But congress left this aspect of CIC ownership alone. The CIC owner still bears the responsibility of prudent money management, in keeping with best-practice investment guidelines for CICs. In addition, the CIC’s domicile should have regulations in place that may control or restrict certain investment strategies. A responsible CIC manager should give appropriate investment advice to CIC owners and their investment advisors.

Posted on October 24, 2016 .