On March 23, the President signed into law H.R. 1625. This legislation, also known as the “Consolidated Appropriations Act, 2018,” provides appropriations for the Federal Government through Sept. 30, 2018. However, H.R. 1625 also retroactively amends IRC § 831(b), by making changes to the diversification requirements imposed by the PATH Act of 2015.
The Path Act, in addition to increasing the limitation on premiums under 831(b), also required taxpayers to pass one of two tests. For ease, we will call these: 1) the 20 Percent Test or 2) the Ownership Test. However, questions arose regarding both of these tests – thus resulting in changes under H.R. 1625.
The 20 Percent Test
Under the 20 Percent Test, no more than 20 percent of the annual net written premiums of the captive insurance company can be attributable to one policyholder. For purposes of this test, brother/sister corporations are considered to be one policyholder.
Questions arose under this test regarding reinsurance, fronting, and intermediary arrangements. For example, consider a captive that is a member of a risk management pool which received 81 percent of their premiums through a reinsurance agreement with the pool. The question then becomes, is the pool one policyholder under this arrangement or should you consider each of the underlying insured to be the policyholders? In an attempt to resolve this confusion, Congress amended the statute to define policyholder as “each policyholder of the underlying direct written insurance with respect to such reinsurance or arrangement.” This means that the pool itself is not considered the policyholder, but rather each insured paying premiums into the pool is considered a policyholder. Therefore, as long as none of those insureds accounts for more than 20 percent of the total premiums paid to the captive, the 20 Percent Test would be met. This change should have a profoundly positive effect on the captive insurance industry.
The Ownership Test
Captives failing the 20 Percent Test may still qualify for 831(b) treatment if they pass the Ownership Test. The Ownership test was devised as a way to prevent captives from being utilized as estate planning vehicles. Originally, a captive would fail this test if a specified holder (spouse or lineal descendant) owned an interest in the captive that is greater than 2 percent of that individual’s ownership interest in specified assets (interest in the insured) of the captive. In other words, a captive would fail this test if a spouse or lineal descendant of an owner/shareholder of an insured business, owned a greater share of the captive than they owned in the business (allowing for a de minimis difference). Several questions arose under this arrangement regarding community property and attribution laws.
H.R. 1625 clarifies the spousal issue by eliminating spouses from the definition of specified holder, unless they are not a US citizen. Therefore, under the new rules, the ownership test now only applies to lineal descendants of either spouse, spouses that are not US citizens, and spouses of lineal descendants. Furthermore, a new aggregation rule has been applied to certain spousal interests. Under the new law, any interest held, directly or indirectly, by the spouse of a specified holder is deemed to be held by the specified holder.
Lastly, the test was also modified to look at the “relevant specified assets” of the captive, rather than the specified assets. Specified assets were defined as trades, businesses, rights, or assets with respect to which the net written premiums of an insurance company are paid. Relevant specified assets on the other hand are defined as the aggregate amount of an interest in the trade, business, rights, or assets insured by the captive, held by a specified holder or the spouse of a specified holder. This rule excludes assets that have been transferred to a spouse or other relation passed “by bequest, devise, or inheritance from a decedent during the taxable year of the insurance company or the preceding taxable year.” Unfortunately, these changes do not help a taxpayer determine how they should determine the amount of the interest that is held by a specified holder. Further guidance will be required in this area.
Although these amendments go a long way to address the ambiguity and unforeseen consequences of the changes made in the PATH Act, there are still many items for which taxpayers entering into captive arrangements should be on the lookout. Taxpayers should consult an attorney prior to entering into a captive insurance arrangement. Should you have any questions regarding captive insurance arrangements, 2018’s Dirty Dozen, or any other complex tax issue please contact Steven Miller, alliantgroup, LP’s National Director of Tax, at Steven.Miller@alliantgroup.com.