Congress just passed its 2015 Appropriation Bill, which this year includes the first significant changes to Internal Revenue Code section 831(b) in nearly 30 years. For those not familiar with this provision, section 831(b) presently allows an insurance company that takes in $1.2 million or less in premiums to make an election so that it is not taxed on its premium income. To obtain this benefit, the company instead gives up the ability to fully take some deductions to which non-831(b) companies would entitled.
Section 831(b) is widely used by mid-sized businesses, and even lately some small businesses, to provide insurance coverage for the business which is either not economical at market prices or is unavailable to the business. Unfortunately, in recent years, 831(b) captives have also been widely abused as tax shelters, where mere lip service is paid to the insurance being provided, and instead the company is used to artificially generate a deduction to the business owner, while passing wealth to the business owner's children.
Congress and the IRS are aware of these abuses, and most of the 2015 changes to 831(b) are targeted at these abuses. But, as will be shown, Congress largely whiffed on this attempt.
The changes to section 831(b) represent, frankly, one of the most poorly-drafted pieces of legislation that I have seen in my long career, and suffice it to say that I have seen a lot of bad legislation. I don't know who drafted this, but I cannot come away with other than the impression that they simply had little idea what they were doing or why. But interpreting legislation is what folks pay lawyers for, and despite the bad drafting these changes are capable of being distilled as follows.
Though encompassing several pages of new legislation, the 831(b) changes actually accomplish very little; in fact, just two things really. By the way, all these changes take effect beginning in 2017.
First, the current $1.2 million limit on premiums will increase to $2.2 million (and be indexed against inflation). This is great news, and is the result of the Hon. Senator Charles Grassley's long-time quest to increase the limit to benefit so-called farm mutual insurance companies that are widely used throughout the Midwest.
That is the good news. But to get us the good news, Grassley had to find a revenue offset to make up for this increase, and he did so by attempting to close a perceived abuse of 831(b) captives which are misused as a wealth-transfer tool. This brings us to the bad news (sort of).
Second, an insurance company that seeks to make the 831(b) election must comply with a new diversification requirement, which means that the captive must comply with at least one of two new tests.
Diversification Test #1 is that no more than 20% of premiums can come from any one policyholder. For this purpose "one policyholder" is broadly defined to include businesses paying premiums to the captive and which are owned by the heirs of the business owner, the business owner's spouse, and members of the same "control group" of companies.
The apparent (we really don't know) goal of this test is to allow Senator Grassley's farm mutual and similar group captives to comply with the diversification requirement, yet weed out abusive captives that use so-called "risk pool" arrangements so as to meet one of the tax tests for risk distribution (which is different than diversification). This test would effectively require a single-owner 831(b) captive to participate in at least four risk pools to meet risk diversification, and even these risk pools could not have the same owner.
But if an 831(b) captive cannot meet Diversification Test #1, then it can instead attempt to meet Diversification Test #2, which, as drafted, is so complicated as to almost be indecipherable by experienced captive attorneys.
Diversification Test #2 is met if the heirs or spouse of the business owner do not, directly or indirectly through a trust or business entity, own more than 2% than the interest they own in the businesses being insured.
This is better explained by way of example than trying to parse the statutory language. Let's say that a manufacturing business which needs products liability insurance is owned 50% by Dad and 50% by Son. In that case, to qualify for the 831(b) election, the captive could be owned by Son only up to 50% (the same as the manufacturing business) plus 2% -- or 52%.
Or, let's say that Dad owns 100% of the manufacturing business; Son could only own 2% of the captive.
This second test is aimed at folks who attempt to abuse 831(b) captives by using them as a wealth-transfer vehicle, by allowing Dad to move tax-deductible premiums to Son, outside of Dad's taxable estate. New definitions provided in the statute make clear that this test will apply whether the ownership of the captive is held by Son, a trust for Son, or another company or partnership in which Son is a member.
Quite bizarrely, the two new diversification tests also apply to spouses of the business owner, i.e., it would apply to Dad's spouse as well as Son. This has the potential to cause a lot of problems in community property states, and it is difficult to discern any greater policy reason for including a spouse in this calculation other than some Congressional staffer was dozing on mescaline while drafting. This is so bad that a technical amendment will probably be required to correct it.
Indirectly, the new diversification requirement not only significantly limits an 831(b) company's usefulness for estate planning, but it probably also knocks out a related use for 831(b) companies, which is to act as a vehicle to purchase life insurance with pre-tax dollars. The requirement does so by effectively trapping the proceeds of a life insurance policy within Dad's taxable estate, at least in substantial part, which of course from an estate and gift tax perspective is highly undesirable.
Folks who have used their captive to purchase life insurance will now need to figure out how to get it out of the captive, pronto. Thanks for playing.
Similarly, captives that are owned in trusts and other estate planning vehicles, such as family limited partnerships and family LLCs, will need to evaluate whether they are in compliance with the new 831(b) diversification requirements. Doubtless, there will be a number of these arrangements for which remedial action will be required in 2016 before these changes go into effect.
Also on the subject of the new diversification requirement, Congress has authorized the IRS to seek information (read: require the filing of a form) to ensure that the diversification requirements are being met.
Well, that's it for the changes, which really are not great. The vast majority of real 831(b) captives that actually provide real insurance to businesses will be unaffected, other than they will have to meet the IRS reporting requirements when and if the IRS comes out with a new form. These changes do not affect or supplant the existing tax rules for risk shifting and risk distribution.
For example, let's say that Dad owns the businesses being insured, and Dad also owns the captive. Before these changes, the captive arrangement was fully in compliance with all risk shifting and risk distribution requirements. In this scenario, Dad, the businesses and the captive will all be able to carry on as before, apparently unaffected by these changes other than somebody might have to file an IRS form on diversification someday, and in 2017 the premiums can go up to $2.2 million if actuarially justified.
Otherwise, the 831(b) captives that do not comply with the new diversification requirements now have until December 31, 2016, to either come into compliance, wind-up, or prepare to comply with the ordinary insurance company tax rules outside the 831(b) election.
Perhaps more important than the actual changes is what Congress did not do, which is that Congress did not widely address the abuses of 831(b) captives. This very likely means that the IRS is likely to promulgate its own guidance to deal with these companies, and in this regard the IRS will be able to point to Congress' statement that there are abuses in the industry to fuel its efforts.
Which is to say that the IRS is quite unlikely to back off its current enforcement efforts against abusive 831(b) captives, which so far have resulted in at least a half-dozen promoter audits of captive managers whom the IRS apparently believes have been involved in the sale of tax shelter captives. Indeed, if anything, the IRS is probably more likely to increase its current extensive efforts than to back off of them.
To this end, the IRS is still likely to address with future guidance:
- Risk-free risk pooling arrangements, i.e., risk pooling arrangements that purport to provide 50% third-party insurance to captives, but are really just devices to pass money through to give the appearance that risk distribution is being met.
- Premium amounts that bear little if any relationship to market pricing, i.e., somebody paying $50,000 for $500,000 in coverage that they could obtain on the open market for $1,000 for $1 million in coverage.
- Insurance coverages that are so remote that no business would reasonably pay large premiums for the coverages, such as a ski lodge in Aspen that purchases tsunami insurance (even if the outside risk existed, the premium should be $1 or something).
- Actuaries who enable the tax abuses by some captives by signing off on coverages and premium amounts that are unsupportable and unrealistic (identical to how some real estate appraisers will give you whatever number that you want so long as your check clears).
It is also quite possible that the IRS will make some types of captive transactions a "listed transaction", so as to deter the worst conduct and hold the Statute of Limitations open for past abusive transactions. But it is equally likely that the IRS may just follow its long-proven tactic of "naming and shaming" the worst promoters as a deterrent to the rest.
At the end of the day, the honest and compliant businesses that are using captives need not worry about what the IRS will or will not do, and they can celebrate Senator Grassley's achievement in raising the 831(b) limit to $2.2 million.
Most of the rest squirm over whether the IRS will be coming for them if they are not already. And that's the way it should be. The industry shakeout of "real captives" versus "tax shelter captives" has been a long time coming, and for the industry it will be a good thing in the long run.
And maybe in the short term as well.
This article at http://onforb.es/1OfWtcV and http://goo.gl/WDmTR4
