831(b) Captives for Small-Sized Firms
In the past couple of years, companies of a certain size increasingly have chosen to make an 831(b) election in their captive – whether to a single parent, group, RRG, etc. Described as a small captive, micro captive or mini captive, an 831(b) election offers small-sized companies an introduction to alternative risk transfer and its benefits.
An 831(b) captive is an insurance company whose premiums do not exceed $1.2 million per year and which elects to have those premiums exempted from taxation. If the captive has proper “risk distribution”, then the insured company can deduct the premium being paid to the captive, while the captive pays no income taxes on that premium. After the payment of losses and expenses, any profits in that captive can be distributed at a favorable dividend rate or can be distributed in a full liquidation of the captive, and the shareholders will receive those accumulated profits at capital gains rates. And if the captive is owned by trusts or adult children, the entrepreneur can also enhance the benefits in his or her estate plan by side stepping the estate tax.
However, be aware that the while the tax benefits of the 831(b) election are attractive, it is not available to everyone. It is designed for small property & casualty insurance companies and insurers must fall within that category to qualify. This includes:
- Insurance Company for Tax Purposes: If a captive does not meet the requirement to be treated as an insurance company for tax purposes, the election cannot be made or worse would be reversed after being made with resulting negative implications. These could include fines and interest on top of the tax owed.
- $1.2M Premium Limitation: The election is only for small insurance companies – defined as companies with no more than $1.2 million in net written premiums or direct written premiums, whichever is the greater.
- Controlled Group: If there is more than one insurance company that is part of a consolidated return or controlled group, the premiums of all insurance companies must be aggregated in order to determine if the $1.2 million threshold has been exceeded.
- Frequency and Severity of Losses: Lower frequency, higher severity risks are more suitable as the election allows for a more tax efficient build-up of surplus to pay for the losses in the years in which they occur. High frequency, low severity risks have less volatility and are easier to predict and accurately fund for. Underwriting income for these risks should not fluctuate greatly from year to year, and many captives aim to underwrite at a break-even position passing on savings through premium reductions instead.
- Long-tail vs. Short-tail: As insurers are able to expense discounted loss reserves, for long-tail lines of coverage (such as workers compensation and liability), this means that underwriting results and taxable income can be deferred for many years until claims mature. The benefit of the tax exemption under the 831(b) election will be reduced for those lines of coverage. Conversely for short-tail lines of coverage (such as property), there is limited ability to hold IBNR reserves. In years where losses are low, the 831(b) election will have a greater impact, allowing the underwriting surplus to be grow tax- free.
Risks that are commonly seen in 831(b) captives are low frequency, high severity coverage types that may not be available in the commercial market or are very expensive. Examples include property and related coverages (e.g. mold), weather risks, cyber risk, pollution liability and cleanup, and difference in conditions/difference in limits.
The most significant to the 831(b) election is the inability to carry forward net operating losses
(NOL). This limitation is broadly applied in any year in which the company is taxed under section 831(b). Other drawbacks are the inability to deduct incurred losses and the limitation on the deduction of operating expenses to investment expenses. While the election works to your benefit when you make an underwriting profit, it can work against you when you have losses.
To successfully utilize the 831(b) election, the captive must be first and foremost a risk management tool with legitimate risks and properly priced premiums. If the captive is structured in this manner and meets the qualifications to make an 831(b) election it should withstand any scrutiny from the IRS.
Caitlin-Morgan has expert consultants that will assess your clients needs and customize a captive solution that is perfect for them, including the 831(b) election. Give us a call at 877.226.1027.