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Small captive owners face specific rules to prevent IRS scrutiny

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BOCA RATON, Fla. — Legislation passed in 2015 that changed the requirements for how small captives are allowed to be structured will create lots of work for managers and lawyers into the next year, a captive expert predicts.

The Protecting America From Tax Hikes Act of 2015, signed into law in December, changed section 831(b) of the Internal Revenue Code by increasing the maximum in premiums for small captive insurers to $2.2 million and adding a requirement to meet one of two diversification tests. All changes go into effect in 2017.

The diversification tests came about after “voluminous captive audits,” were held and for the first time ever the IRS linked 831(b) captives with tax shelters, labeling captives as part of the “Dirty Dozen,” said David Snowball, Salt Lake City-based director of captive insurance for Utah, while speaking Tuesday at the 2016 World Captive Forum in Boca Raton, Florida. However, “just because the IRS is investigating doesn't mean anyone did anything wrong,” he said.

Mr. Snowball explained the diversification tests in examples of captive structures that would and would not meet one of the two tests. “The first diversification test is for when you have multiple insurers,” he said. “Not one of them can pay more than 20% of the premium from any one policy holder.”

As an example, if a captive is structured where 12 corporations insured with a group captive that is owned by 12 unrelated people, each of them is going to pay 8.33% of the premium. This captive meets the diversity test and can elect section 831(b), he said.

If one of the 12 people in the captive owned three corporations while the other 11 people in the captive each owned one corporation, then the one person owning three corporations would pay more than 20% of the premiums and the captive would not qualify to elect 831(b), he said.

“Test 2 is for when related family members share ownership of the captive. Here, any one family member can't own more of the captive than they own in the operating company,” Mr. Snowball said.

So if a father owned 70% of a business and 70% of a captive and the son owned 30% of that business and 30% of that captive, then the captive is eligible to make an election under section 831(b), he said.

But if the son, instead of owning 30% of the captive owned 100%, then the captive is not eligible for the 831(b) election.

Mr. Snowball estimates there are close to 5,000 small captives that can take advantage of the 831(b) election. They can also take advantage of the tax benefit and the insurance benefit of being a small captive, he said.

“This has nothing to do with the definition of insurance; it only tells you who gets to be elected (for 831b), and if you do not, then you will be taxed under 831(a), which is how other insurance companies are taxed,” Mr. Snowball said.