A reinsurance company seeking the special tax treatment of Internal Revenue Code section 831(b) cannot receive more than $1.2 million of annual premium in 2016 or $2.2 million of annual premium beginning in 2017 (indexed for inflation). The $1.2 million limit through 2016 was first made effective in 1986 and was not changed for 30 years. Note that for any year that the annual premium exceeds this limit, the special tax treatment of section 831(b) is not available (meaning a tax on insurance profits for that year). IRC section 831(b)(2)(A) provides:

(b) Alternative tax for certain small companies

(1) In general
In lieu of the tax otherwise applicable under subsection (a), there is hereby imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable investment income of such company for such taxable year by the rates provided in section 11(b).

(2) Companies to which this subsection applies

(A) In general. This subsection shall apply to every insurance company other than life if—

(i) the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed $2,200,000,
(ii) such company meets the diversification requirements of subparagraph (B), and
(iii) such company elects the application of this subsection for such taxable year. The election under clause (iii) shall apply to the taxable ear for which made and for all subsequent taxable years for which the requirements of clauses (i) and (ii) are met. Such an election, once made, may be revoked only with the consent of the Secretary.

If an insurance or reinsurance company qualifies for federal taxation under IRC section 831(b), then the only federal income tax it will pay is a tax on investment income. Underwriting profits are not taxed. This allows the insurer to develop its insurance reserves.

Subchapter L of the Internal Revenue Code governs the taxation of reinsurance companies. The Code provides incentives that allow insurance companies to accumulate reserves for the payment of future claims. For example, insurance premiums of qualifying companies are not counted in taxable income. The insured company receives a tax deduction for the payment of insurance premiums to the direct insurer. A portion of those premiums will be ceded to the reinsurer. Those ceded premiums will not be included in the taxable income of a qualifying reinsurance company.

A reinsurance company is taxed pursuant to Internal Revenue Code section 831(b). That section provides that the reinsurance company will pay income tax only on its investment income using C corporation rates. It will not pay tax on premiums. Neither will it pay income tax on insurance profits (premiums minus claims). Here are the key provisions of Code 831(b):

A reinsurance company will be a Subchapter C corporation for federal tax purposes. All of the tax benefits of a C corporation are available to shareholders of the reinsurer including preferential rates for dividends; section 243 dividend deductions, capital gains treatment upon dissolution of the reinsurer; compensation and fringe benefits for directors, officers, and employees.

A reinsurance company is required to file an annual federal income tax return using Form 1120PC. This is a specialized return for insurance companies. The election for the special tax treatment under Internal Revenue Code 831(b) must be made in the initial 1120PC filing.

There are no direct tax implications regarding ownership since any legitimate individual or corporate entity can own the company. As in any multi-company structure, the taxpayer should be aware of potential opportunities and consequences relative to ownership.

From an insurance premium deductibility perspective, there are certain corporate structures to be avoided. The Internal Revenue Service has attempted to deny the deductibility of premiums paid by a “parent” company to a wholly owned “subsidiary” company, therefore it is preferential to avoid a parent/subsidiary (or child) structure. A type of corporate structure that has been accepted to create deductibility is a brother/sister type of relationship. Results have been mixed.

A brother/sister relationship exists when two organizations have a common parent. For example, in an automobile dealer situation, this is fairly easy to accomplish because the dealer principal (or other entity) would normally own both the premium payor (such as an automobile dealership) and the reinsurance company (who is the ultimate payee). Instead of a parent/child relationship, this creates a brother/sister relationship which has been upheld as creating a transfer of risk. Court cases supporting this position are Humana, Inc. vs. Commissioner, Kidde & Co. vs. Commissioner and Hospital Corp of America vs. Commissioner.

Premiums are based on risk. Premiums are never based on the net income of the insured company. Consequently, premiums cannot be altered late in the tax year of the insured company based on its net income projections.

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.

The special tax treatment under IRC 831(b) is not automatic. The reinsurance company must file an 831(b) election with its initial income tax return (Form 1120PC) to receive the 831(b) tax treatment. The Insurance Manager will oversee the process for making this election.
The election need only be made once. However, the requirements of IRC 831(b) must be met each year to receive the elective treatment. For example, the premium limitation must be adhered to each year in for which the 831(b) elective tax treatment is sought. See IRC section 831(b) for requirements relating to the election.

IRC Section 953(d) allows a controlled foreign corporation (CFC) engaged in the insurance business (an electing corporation) to elect to be treated as a U.S. corporation for purposes of imposing United States income tax. An electing corporation agrees to compute its U.S. income tax liability as if it were a domestic corporation.
For example, reinsurance company may be formed in Turks & Caicos due to that jurisdiction’s favorable insurance laws and regulations. That same reinsurance company may file an IRC section 953(d) election to be treated as a US corporation for tax purposes.
This election need only made once. The Insurance Manager will oversee this process. See IRC section 953(d) for requirements relating to the election.