President Obama signed the passage of the Consolidated Appropriations Act, 2016 (H.R. 2029), which includes the first significant changes to Internal Revenue Code section 831(b). Two significant amendments affect some small insurance companies, including captives, which will take effect Jan. 1, 2017.
First, the Act increases the premium income limit to $2.2 million from $1.2 million and will be indexed for inflation. This is good news. It allows those small insurance companies which previously were above the threshold to meet the requirement for the 831(b) election to be taxed only on investment income.
Second, an insurance company that seeks to qualify for the benefits of section 831(b) must comply with a new diversification requirement, which means the company must comply with at least one of two new tests.
Test 1: The diversification requirement states 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 policyholder. In determining whether the 20 percent threshold is met, the broad definition of “one policyholder” applies the attribution rules of sections 267(b) and 707(b) and a modified version of the controlled group rules of section 1563(a). In general, if one policyholder is related to another, those policyholders will be treated as one policyholder for this diversification test.
Test 2: If an insurance company does not meet the diversification requirement, it can instead attempt to meet an alternative requirement. This alternative requirement is satisfied if the heirs or spouse of the business owner do not, directly or indirectly through a trust or business entity, own more than 2 percent of the interest in the businesses being insured.
These amendments will affect an unknown number of small insurance companies, including captives, formed in recent years. The increase in the premium income limit will increase the number of companies eligible for the benefits of section 831(b). The new diversification requirements, however, will make it more difficult for some companies to qualify.
As a result of these amendments, some companies with existing section 831(b) elections will become ineligible. There will be a number of arrangements for which remedial actions will be required in 2016 before these changes go into effect.
For more information on this topic, or to learn how Baker Tilly insurance specialists can help, contact our team.