Changes to elections by small captive insurance companies.

• Author: Mitra, Surjya

Businesses have long used captive insurance companies (captives) to manage insurable risks. A typical captive is owned by the business owners and insures the risks of the business. If properly structured and operated, captives can allow businesses to finance insurable risks through an alternative platform, consolidate their insurance purchases, and access the reinsurance market.

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Certain small captives may elect to be taxed only on their investment income. However, there have been recent changes to the eligibility requirements to make the election.

Small Captives: Sec. 831(b)

Some captives (831(b) captives) have taken advantage of a special election under Sec. 831(b), which permits, in lieu of the otherwise applicable tax, certain property and casualty insurance companies to elect to be taxed only on their investment income. The election is available only to a company whose net written premiums or direct written premiums, whichever are greater, do not exceed $1.2 million in a tax year.

An 831(b) captive sometimes is owned by the children or grandchildren of the owner of an insured business. The captive insures the risks of the business, which deducts the premiums paid. The captive, however, does not report underwriting income or loss; instead, it is taxed only on its net investment income.

The eligibility rules for making a Sec. 831(b) election recently have been changed. As a result, it will be more difficult to meet the requirements of Sec. 831(b) when, for example, a family-owned business is insured by a captive owned by the lineal descendants of the business owner. Therefore, existing captives that have made the election may no longer qualify for it. In addition, any future tax planning that includes making the Sec. 831(b) election requires careful analysis under the new law, as discussed below.

Change in Law: New Sec. 831(b)

Sec. 831(b) was amended significantly by the Protecting Americans From Tax Hikes (PATH) Act of 2015, which was signed into law on Dec. 18, 2015, as part of the Consolidated Appropriations Act, 2016, P.L. 114-113. The amendment will be effective for tax years beginning after Dec. 31, 2016.

Under the act, the good news is that the maximum amount of net or direct written premiums that an insurance company may receive and still be eligible for the election is increased from $1.2 million to $2.2 million, which will be indexed for inflation. But the act also adds new diversification requirements...