Small Insurance Company Tax Regulations
This article is provided by Strategic Risk Services. Contact details for the company can be found at the end of this article.
The Internal Revenue Code has historically provided two very powerful tax advantages to small insurance companies, including captive insurers, in order to provide them additional financial resources to pay claims. These regulations, which are contained in sections 501(c)(15) and 831(b) of the Code, were amended in April of this year with the passing of the Pension Funding Act of 2004. This article examines the provisions of these two regulations, the effect of the recent changes and the potential use of these regulations for captive insurance companies going forward.
Internal Revenue Code 501(c)(15)
Under this section of the Code, a property and casualty insurance company can elect to be exempt from U.S. taxes. This means that: ? All underwriting income earned by the company is not subject to tax ? Investment income received is not taxed ? Long-term capital gains are not taxed, i.e. a contributed asset to a 501(c)(15) company could be sold and those assets re-invested with no tax effect ? Short-term capital gains and dividends are not taxed. Obviously this provision presents some powerful tax advantages to an insurer, and eligibility for this election is limited to small insurance companies. The origins of the provision lie with small agricultural insurers that were granted preferential tax status to encourage their creation and fill a gap in the commercial market. To qualify insurers must be writing business below a certain revenue threshold. They must also be predominantly engaged in the business of insurance and be deemed insurance companies for tax purposes. Prior to the recent changes the revenue threshold to qualify under 501(c)(15) was $350,000 in direct or net written premium, whichever was the greater. This definition had inadvertently opened up the 501(c)(15) regulation to abuse by insurance companies with questionable insurance risk and overcapitalization. The most recognized of these cases was an individual who formed a 501(c)(15) to write less than $5,000 in premiums and avoided federal taxes on $173 million in income by contributing appreciated assets into the insurance company and liquidating those assets. April 2004 Changes To clamp down on the potential abuse of IRC ?501(c)(15), a significant change was made to the revenue threshold for eligibility. The $350,000 premium threshold was replaced by a threshold of $600,000, but applying to gross receipts. Premiums received must account for at least 50% of gross receipts. For the purposes of eligibility, the gross receipts of all members of a related group are aggregated. This would include parent and brother, sister companies of the insurance company, whether or not they are insurance companies themselves. Applicability to Captives These changes effectively remove the 501(c)(15) election as an option for captives. To qualify the total revenue of the captive and its parent combined would have to be less than $600,000 (and premium income would have to be more than 50% of the combined revenue). Virtually all 501(c)15 captives formed in recent years no longer meet the requirements under this definition and starting with fiscal year 2004 will no longer be tax exempt.
Internal Revenue Code 831(b)
IRC 831(b) allows for a property and casualty insurance company to elect to be taxed only on its investment income. Under this structure the significant advantage is that the company is able to accumulate surplus from underwriting profits free from tax. This election is only open to insurance companies of a certain size. April 2004 Changes The Pension Funding Act of 2004 removed the minimum size criteria to be eligible for the election. This had previously been set at direct premium (or written if greater) of $350,001 to dovetail with the IRC ?501(c)(15) election. The maximum size criteria was left unchanged at $1.2 million in direct premium (or written if greater). No gross receipts measure is applied to 831(b) companies. The $1.2 limitation includes all premiums written by companies within the same consolidated group. Companies must also be deemed insurance companies for tax purposes to be eligible for the election. Applicability to Captives The changes leave IRC ?831(b) as a viable and powerful option for captive insurance companies. Many captives previously formed under Section 501(c)15 would meet the requirements of Section 831(b) and could now make this election. As well as onshore captives, the IRC ?831(b) election is available to offshore captives that choose to be taxed as a U.S. company by making a 953(d) election. The ability to accumulate underwriting surplus tax free has significant advantages for the funding of shorter-tail more volatile lines of coverage such as property. Lacking the ability to create IBNR reserves under annual insurance contracts, captives have not been an attractive option to fund medium frequency (1-in-5 to 1-in-10 year) events as income tax is payable in the years with good loss experience. This "tax drain" can considerably limit the accumulation of surplus in the captive and increase the cost of funding medium frequency events. Withdrawing Funds It is important to note that while a 831(b) pays no taxes on underwriting profit, its owners are taxed on dividends and other compensation received from the 831(b). Further when the 831(b) is sold or liquidated, its owners will pay tax on any gains on the value of their stock at long-term capital gains rates. For distributed surplus, this structure may allow for tax deferral and change the rate of taxation from ordinary income rates to long-term capital rates. No income tax will be paid on funds distributed as losses, making the funding of medium frequency, medium severity losses in this structure particularly attractive.
Note : The above discussion of taxation of captive insurance companies is highly dependent on individual circumstances. It should not be viewed as tax advice. Consult your tax professional for an opinion of the applicability of these sections to your situation.
About SRS
SRS provides underwriting, management and wholesale brokerage services in the alternative insurance market. They design, implement, manage and grow captive and ART programs on behalf of corporations, groups and insurance companies. SRS is an approved manager of captive insurance companies in Arizona, Bermuda, Cayman Islands, South Carolina & Vermont. Through a wholly owned subsidiary SRS is also licensed as an insurance broker in Bermuda. For more information on SRS, visit them at www.strategicrisks.com. Contact: info@strategicrisks.com, Tel: 781 487 9800
