Blurb on new 831(b) Provisions

1. In December, 2015, President Barrack Obama signed into law the Tax Increase
Prevention and Real Estate Investment Act of 2015 amending and adding certain provisions to
26 U.S.C. §831(b). Most encouraging to captive owners are the amendments to §831(b)(2)
increasing the tax exemption from $1,200,000 to $2,200,000 and the addition of the inflation
adjustment to the tax exemption. However, with these benefits come additions to §831(b)
aimed to restrict its application.
Generally, the new provisions aim to restrict the estate planning application of captive
insurance companies. While captive insurance companies should be established for the
primary purpose of mitigating risk of an operating business, they have historically also served as
a tool for transferring wealth to subsequent generations by establishing the business owner’s
spouse and/or heirs as owners of the captive insurance company.
With this intent in mind, the new law provides two options for achieving applicability of
the §831(b) election. The first is through risk diversification. The revised statute provides that
the §831(b) election can be made if:
“(I) 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.”
This far exceeds the 50% safe harbor previously adopted by the IRS in Rev. Rul. 2002-89, which
provides that adequate risk distribution is present when the captive receives at least 50% of its
premiums from unrelated businesses. Very few captive owners will possess at least five (5)
insured entities with the revenues necessary to attain the requisite risk diversification internally.
Further, as a result of the amendment, captive owners will be unable to look to a single
reinsurance provider to attain the requisite risk diversification. Thus, a predominant number of
captive owners will be unable to obtain §831(b) status through the risk diversification
requirement and will be forced to rely on the second requirement.
Captive owners that do not qualify for §831(b) treatment under the risk diversification
requirement may still effectively elect §831(b) treatment provided the ownership requirement
is satisfied. The revised statute provides that the §831(b) election can be made if:
“(II) such insurance company does not meet the requirement of subclause (I) and no
person who holds (directly or indirectly) an interest in such insurance company is a
specified holder who holds (directly or indirectly) aggregate interests in such insurance
company which constitute a percentage of the entire interests in such insurance
company which is more than a de minimis percentage higher than the percentage of
interests in the specified assets with respect to such insurance company held (directly or
indirectly) by such specified holder.”

2. The practical effect of the ownership requirement is that no spouse or heir of the operating
business owner can own an interest in the captive insurance company that is more than two
percent (2%) greater than the spouse or heir’s interest in the operating business. Therefore,
there is no prohibition on passing the interest in the captive insurance company to the spouse
and/or heirs of the operating business owner provided the spouse and/or heirs own an interest
in the operating business proportional to that of their interest in the captive insurance
company.
Further, if the ownership requirement is satisfied, the 50% risk distribution safe harbor
of Rev. Rul. 2002-89 and not the above risk diversification requirement will continue to govern
pooling arrangements. Additionally, captives satisfying the ownership requirement and looking
to obtain internal risk diversification will continue to seek authority under the safe harbor of
Rev. Rul. 2002-90, which provides that adequate risk distribution is present when no more than
15% of the premiums paid to a captive by subsidiaries owned by the same parent are paid by a
single insured subsidiary.
Because most captive owners will be unable to satisfy the risk diversification
requirement, captive owners will predominantly be forced to rely on the ownership
requirement in making the §831(b) election. This may require substantial ownership
restructuring of many captive insurance companies and/or operating businesses. While the
new law was passed in December, 2015, the provisions amending §831(b) do not become
effective until January 1, 2017 in an attempt to allow existing captive owners ample time to
make the appropriate changes to become compliant.