Organising a small property and casualty insurance company with section 831(b) tax treatment—a 831(b) company—can be a powerful solution to a closely held business’s insurance needs, says Charles J. Lavelle.
Only a dreamer would deny that there is a real threat of government regulation targeting captives. For the realists, however, this threat to captives’ status and capital requirements has prompted action, largely in the form of far-reaching protective measures.
Redomiciling to a more financially favourable domicile is one option, albeit with all its attendant costs; another is to meet the threat to capital head-on through self-regulation. One of the more popular vehicles is section 831(b). A provision of the United States Internal Revenue Code (Code), it is designed to simplify the administration and taxation of small property and casualty insurance companies. It typically takes the form of an ‘election’.
This article attempts to identify what a section 831(b) election is, discussing the benefits and detriments, and setting forth reasons for the rapid growth in the number of captives, including section 831(b) companies. The article also notes the similarities and differences with other captive and non-captive companies, sets forth some strategies for stock ownership, and concludes by laying out the technical issues and requirements.
A good and bad thing
A section 831(b) company is taxed only on its ‘taxable investment income’ and not on its underwriting (or insurance) income; conversely, an underwriting loss is not deductible against its taxable investment income. Thus, net underwriting profits will not be taxed until withdrawn. If the business written is volatile, care must be taken before a section 831(b) election is made, because underwriting losses cannot offset taxable investment income. Thus, the section 831(b) company may have a tax liability in years when it has an overall loss.
The net operating losses of a section 831(b) company cannot be carried to another year to offset income in that year. An 831(b) election is made with the insurance company’s federal income tax return. Once made, the election may only be revoked with the consent of the Commissioner of the US Internal Revenue Service (IRS).
Generally, only a property and casualty insurance company is eligible to make a section 831(b) election, and then only as long as neither its net written premium nor its direct written premium for its taxable year exceeds $1.2 million. There are elaborate rules regarding how to compute ‘taxable net income’ and the amount of premiums, which are discussed below.
Growth in captives, including section 831(b) companies
The number of captive insurance companies, including section 831(b) companies, has grown rapidly in the last decade because captive insurance has become more ‘mainstream’. In other words, concerns about ‘hard’ commercial markets after 9/11, Hurricane Katrina, the financial meltdown, etc., the burgeoning number of captive domicile alternatives, more user-friendly procedures and costs for smaller businesses, and a favourable 2001 IRS ruling have all played a part.
831(b) companies are insurance companies—just smaller
Some in the industry talk as if section 831(b) companies are different from other insurance companies.
Other than the lower volume of premiums, section 831(b) companies are not that different from other captive insurance companies, nor even from commercial insurance companies. They must meet the same tests as other captive and non-captive insurance companies in order to be recognised for federal income tax purposes. Accordingly, section 831(b) companies must be formed for the same nontax business reasons as other captive and non-captive insurance companies. These may include: (a) obtaining coverages not available, or not affordable, in the commercial market; (b) capturing the profits of the commercial market; (c) permitting access to the reinsurance market; (d) obtaining better control over the claims process; and (e) obtaining the ability to unbundle insurance services.
In addition to non-tax business reason(s), the other tests for P&C insurance tax treatment must be met. These tests are: (1) the insured risks must be insurance risks—they cannot be business risks or investment risks. The risks must be ‘real risks’ that can occur, but must also have some possibility that they may not occur; (2) the insurance company and the insurance arrangement should constitute ‘insurance’ in its commonly accepted sense (it must ‘look and feel’ like insurance); (3) the risk must be shifted to the insurance company (this entails, among other things, that the insurance company be adequately capitalised and that no person or entity guarantees its performance); and (4) there must be ‘risk distribution’, which the IRS believes requires the sharing of risks of a number of different entities.
"The definition of taxable investment income is critical because a section 831(b) company is only tazed on its taxable investment income."
If the insured owns the captive, there must be sufficient unrelated risks. The IRS says 10 percent is too little, while 50 percent is always sufficient, but does not comment on the range between 10 percent and 50 percent; although one case held that 29 percent unrelated business was sufficient. If the insureds do not own any stock in the captive, the IRS has established a safe harbour that there is insurance if there are 12 insured entities all representing between five percent and 15 percent of the risk. At the other end of the spectrum, the IRS has ruled that there is no insurance if there are only two insureds, one of which represents 90 percent of the risk (or if there is only one insured).
Because section 831(b) companies are smaller, they are often used in closely held business environments. Sometimes, there is great utility in having the ownership of the insurance company differ from that of the operating companies. For instance, some operating companies have a long-standing trusted operating officer who is not a family member. If such a person has restricted stock in the section 831(b) (or other) captive, he or she will tend to stay working for the business in order to retain his/her stock in the captive. By having stock in the captive, he or she has the economic upside of and ownership in the captive, but does not have a vote, or ownership, in the operating companies. Similarly, family members who are not involved in the operating business, or owners who are of a different generation to the owners of the business, may own stock in the captive. This may promote family succession and similar goals.
Counting premiums of affiliates
The election is only available if neither the insurance company’s net written premiums nor its direct written premiums exceed $1.2 million for the taxable year. If there are other insurance companies in the same ‘controlled group of corporations’, the premiums of those other insurance companies are added to the taxpayer’s premiums in measuring against the $1.2 million. A controlled group of corporations includes a situation where five or fewer people own more than 50 percent of two or more corporations. In addition, there are robust ‘attribution’ rules, under which stock held by relatives, owned entities, etc. will be treated as owned by others. Special rules apply to siblings and adult children.
The rules are technical, so if there is more than one insurance company within a related group, it is imperative to determine whether they are in the same controlled group.
Net operating losses
Generally, an insurance company’s net operating loss cannot be carried to or from a year for which a section 831(b) election is in effect. Moreover, a net operating loss cannot be carried from a loss year to another year, if there is a year between those two years for which a section 831(b) election was in effect.
So how does it work?
The definition of taxable investment income is critical because a section 831(b) company is only taxed on its taxable investment income, which is defined in section 834 of the Code. It is a technical definition consisting of two parts: (1) ‘gross investment income’ less (2) allowable deductions.
Gross investment income is the gross amount of income from a variety of sources:
(1) Interest, dividends, rents and royalties
(2) Contracts (including leases, mortgages or other agreements) from which interest, rent or royalties are derived, or alterations or terminations of those contracts
(3) Capital gains
(4) The gross income from any trade or business (other than insurance) by the company or a partnership in which it is a partner.
From this gross income, a variety of deductions are permitted:
(1) Interest that would have been tax-exempt
(2) Investment expenses paid or incurred during the year are deductible
(3) Properly allocated general expenses are also deductible, but may not exceed one quarter of one percent of the average of the book value of invested assets held at the beginning and end of the year, plus 25 percent of the amount by which taxable investment income (before deduction for tax-free interest, investment expenses and dividend received deduction) exceeds 3.75 percent of such average book value.
(4) Real estate expenses, depreciation and depletion are deductible
(5) Interest (other than interest on debt used to purchase tax-exempt bonds)
(6) Capital losses allowed under the Code against capital gains are deducted from gross investment income. Under some circumstances (and elaborate calculations), capital losses are also deductible if they are incurred in order to obtain funds to meet abnormal insurance losses and to provide for the payment of dividends and similar distributions to policyholders
(7) The dividends received, and most similar deductions, are deductible
(8) Trade or business deductions not attributable to the insurance business are deductible, but net operating losses are not deductible.
Charles J. Lavelle is a partner with Greenebaum Doll & McDonald PLLC. He can be contacted at: email@example.com