PATH Act Clarifications
Congress Continues to Show Support
for Small Captives with New Law
Congress made changes in the recently passed Omnibus Spending Bill to a part of the tax code section 831(b) provisions dealing with small insurance companies. The part modified was originally added with the 2015 PATH Act. The industry has been working with Congress, the IRS, and the Treasury Department to get some clarification on the law. Leading this advocacy effort was The Self-Insurance Institute of America, Inc (SIIA). Jeremy Huish, Artex's Sr. VP - Business Development, North America was an integral part of the SIIA team that met with numerous people on Capitol Hill about needed changes to the law affecting small captive insurance companies.
By way of background, the 2015 PATH Act provided a new “diversification” standard for meeting risk distribution. These changes included: Option 1 – no more than 20% of net written premiums from any one policyholder (i.e., The 80% Unrelated Risk Test), OR Option 2 – The business owner’s spouse or descendants may not own more of the captive than they do of the business owner’s business (i.e., Family Ownership Test). SIIA lobbied for clarification in 2016 and 2017 because of some confusing language in the new law.
Three clarifications were recently made to the 831(b) diversification requirements:
- Look-through language
- Relevant specified assets
- Definition of specified holder (the "spouse" fix)
- The PATH Act provided that one of the ways to satisfy diversification is to have no more than 20% of the premium from one policyholder.
- In a reinsurance arrangement, there was a question whether the fronting insurer (or pooling vehicle) was considered the policy holder for purposes of this test or can the captive look through the fronting insurer and view the original insureds as the policy holders.
Solution: Look-through treatment applies. Reinsurer can “look-through” intermediary insurance entities and count the original insureds as the policy holders (for purposes of applying the "no more than 20%" rule.
Relevant Specified Assets
- In calculating the percentage that a child could own of the captive, the original language indicated to look at the child’s percentage of business ownership and have that be the ceiling for ownership of the captive.
- In situations where non-family members owned some or all of the insured business, unsure how those ownership percentages affected this calculation.
Solution: Exclude unrelated persons from the calculation. Testing based on each specified holder’s relationships.
Definition of Specified Holder (the “spouse” fix)
- The insured owner’s spouse was defined as a “specified holder” and therefore limited on how much that person could own.
- This original wording ran contrary to all other tax rules dealing with spousal ownership and spousal transfers of assets.
- Significant problem in community property states.
- Step children and spouses of children were not included in the definition of “specified holder” and could own an unlimited amount of the captive.
If a business owner is otherwise not a “specified holder,” his/her spouse is not deemed to be a “specified holder.” The definition of “specified holder now includes lineal descendants (including by adoption) of a business owner or owner’s spouse (e.g., step child), and spouses of a lineal descendent that meet this definition. Some changes were made to address married couples in community property states. Also, any interest in the insurance company which is held by a spouse of a specified holder, shall be treated as held by the specified holder.
For example, assume “Tom” qualifies as a specified holder for purposes of the 831(b) diversification test because he is either a lineal descendant of a business owner or owner’s spouse, an adopted child of the same, or a spouse of a lineal descendant. The maximum percentage of the captive that Tom could own is a fraction calculated by Tom’s ownership interest in the insured business in the numerator and the denominator is the sum of these persons’ ownership in the insured business: Tom, Tom’s wife; Tom’s parents, grandparents, and stepparents. Excluded from the denominator are ownership interest from non-family members and possibly other family members that are not specified here (e.g., Tom’s brother may be excluded). Further limitations apply if Tom’s wife also owns an interest in the captive because Tom may be treated as also owning her interest.