New ownerships rules were introduced in IRC section 831 in December 2015 and made effective January 1, 2017. Under the new ownership rules, there are limitations when family members are involved in ownership. In a nutshell, if family members are involved in ownership of the captive, then the ownership of the captive insurer must mirror the ownership of the insured operating company plus or minus two percent. This ownership limitation is found in IRC section 831(b)(2)(B) which provides:
(B) Diversification requirements
(i) In general. An insurance company meets the requirements of this subparagraph if—
(I) [“20 Percent Test”] no more than 20 percent of the net written premiums (or, if greater, direct written premiums) of such company for the taxable year is attributable to any, one policyholder, or
(II) [“Ownership Test”] such insurance company does not meet the requirement of subclause (I) and no person who holds (directly or indirectly) an interest in such insurance company is a specified holder who holds (directly or indirectly) aggregate interests in such insurance company which constitute a percentage of the entire interests in such insurance company which is more than a de minimis percentage higher than the percentage of interests in the specified assets with respect to such insurance company held (directly or indirectly) by such specified holder.
(ii) Definitions. For purposes of clause (i)(II)—
(I) Specified holder
The term “specified holder” means, with respect to any insurance company, any individual who holds (directly or indirectly) an interest in such insurance company and who is a spouse or lineal descendant (including by adoption) of an individual who holds an interest (directly or indirectly) in the specified assets with respect to such insurance company.
(II) Specified assets
The term “specified assets” means, with respect to any insurance company, the trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of such insurance company are paid.
(III) Indirect interest
An indirect interest includes any interest held through a trust, estate, partnership, or corporation.
(IV) De minimis
Except as otherwise provided by the Secretary in regulations or other guidance, 2 percentage points or less shall be treated as de minimis. [emphasis and bracketed titles added]
The diversification rules are alternatives. A taxpayer may satisfy either the “20 Percent Test” rule or the “Ownership Test.”
If family members are involved in ownership of the insured operating company and the captive insurer, then the “Ownership Test” will be satisfied if the ownership of the two entities does not vary by more than two percent. For example, if Father and Daughter each own 50 percent of Widget Corp, then their ownership of a captive insurer that insures risks of Widget Corp must also be 50 percent each plus or minus two percent. Note that attribution rules apply for ownership of an entity through trusts or other entities.
Non-family members that are owners of the insured operating company and a captive insurer easily meet the requirements of the “Ownership Test.” This is the case because they will not be tripped up by the “specified holder” language which is focused on ownership by a spouse or lineal descendant. A “specified holder” is an individual who holds an interest in the insurance company and who is a spouse or lineal descendant of an individual who holds an interest in the specified assets of the insurance company.