We previously wrote about how a profitable business can use a captive insurance company arrangement as an effective and flexible business risk management tool that also provides potentially significant tax and asset protection benefits. In late 2015, Congress enacted legislation effective for tax years after 2016 expanding the benefits available to small captive insurance companies, but also imposing new requirements designed to limit some perceived abuses.
THE GOOD NEWS – INCREASES IN ALLOWED PREMIUMS
The new legislation increases – from $1.2 million (not indexed) to $2.2 million (indexed annually for inflation) – the amount of premiums that a captive insurance company can receive and still qualify as a "small" insurance company. An insurance company that qualifies as a small insurance company is taxed only on its taxable investment income -not its underwriting income.
This change significantly increases the amount of income that may be sheltered from tax within a single captive insurance company. Additionally as we noted previously, even very large companies that contemplate annual premiums of more than $2.2 million may be able to use multiple captives to keep premiums in any one captive below the $2.2 million limit.
THE BAD NEWS – LIMITATIONS ON INCOME AND WEALTH TRANSFER TAX PLANNING
In our prior article, we illustrated a structure in which the operating business was owned by a single owner and the captive insurance company was owned by a family trust. We noted that, in addition to risk management and asset protection benefits associated with the arrangement, the structure produces potentially significant tax benefits. First, there is an income tax benefit from the conversion of high-taxed ordinary operating income earned by the business into deferred and low-taxed dividends paid by the insurance company. Second, the income tax benefits are enhanced if the trust's income is taxable to younger family members in lower income tax brackets. Third, there is also a wealth transfer tax benefit associated with moving income from the owner to younger generations without incidence of gift or estate taxes and without using any of the owner's annual or lifetime exclusion amounts.
Congress decided these intra-family benefits were a little too generous. In the recent legislation, Congress effectively eliminated the ability to divert taxable income and wealth from the operating business owners to their family members. Under the new rules, to qualify as a small insurance company (and be eligible for the exemption from tax on underwriting income), the insurance company must meet one of two new diversification tests.
Policyholder test. An insurance company satisfies the policyholder test if no more than 20% of the insurance company's premiums come from any one policyholder (insured).
Ownership test. In general, to satisfy the ownership test, the spouse and lineal descendants of the operating business owners may not own a direct or indirect interest in the insurance company that is 2 percentage points or more greater than the spouse's or descendant's interest in the operating company.
Going forward, single business captive arrangements will be structured to comply with the ownership test. The ownership test effectively eliminates the ability to divert income and wealth to younger generations.
CONCLUSION
Although some of the potential tax benefits associated with a captive insurance arrangement have been eliminated, captive insurance companies continue to offer significant tax benefits in the form of converting high-taxed ordinary operating income into low-taxed qualified dividend income. The recent legislation effectively reaffirms the risk management and asset protection planning benefits provided by small captive insurance companies.
We continue to recommend captive insurance arrangements for profitable privately held companies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
