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PATH Act and Impact on Captives

On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes Act of 2015 (the “Act”).  The Act amends section 831(b) of the Internal Revenue Code in two ways that may affect the tax treatment of small property and casualty insurance companies, including captive insurance companies.

First, the Act increases the amount of premiums that an insurance company may receive and still be eligible to make an election under section 831(b).  Under current law, the limit is $1,200,000.  The Act increases the limit to $2,200,000.  In addition, the limit is indexed for inflation with 2013 the base year for calculating the inflation adjustment.

Second, the Act adds a diversification requirement to section 831(b).  The Act provides two ways in which an insurance company can satisfy the diversification requirement.  The first is the “Risk Diversification Test”.  This test is met if the insurance company receives no more than twenty percent (20%) of its net written premiums (or, direct written premiums, if greater) from a single policyholder.  Should a captive insurance company fail to satisfy this test, it will be required to satisfy the second test.

The second way in which an insurance company can satisfy the diversification requirement is through the “Relatedness Test”.  This test prohibits a spouse or lineal descendant of an owner of the policyholder from having a percentage interest in the insurance company that exceeds his or her interest in the policyholder by more than a de minimis amount.  The term “de minimis amount” is defined as two percent (2%).  To illustrate, let’s assume that the ABC Company forms the ABC Captive Insurance Company.  Let’s also assume that Father owns sixty percent (60%) of the ABC Company and Son owns forty percent (40%) of the ABC Company.  Under this fact situation, Son can own no more than forty-two percent (42%) of the ABC Captive Insurance Company.  If Son owns more than forty-two percent (42%) of the ABC Captive Insurance Company, then it is not eligible to make an election under section 831(b).

There are two additional points to make about the Act.  First, the Act becomes effective for tax years beginning after December 31, 2016.  So, existing captive insurance companies have some time to adjust to the new provisions of section 831(b).  The Act contains no grandfathering provisions.  Second, the Act simply changes the requirements for making an election under section 831(b).  It does not change the law regarding insurance.  A captive insurance company that does not satisfy the diversification requirements of the Act will not be eligible to make an election under section 831(b).  That does not necessarily mean that it is not a bona fide captive insurance company.  It simply means that it will be taxed in accordance with the provisions of section 831(a), like larger property and casualty insurance companies.