By Lorin G. Page, Esq.
In 2015, Congress passed the PATH Act, enacting substantial changes to the law governing captive insurance companies, Internal Revenue Code Section 831(b). This article briefly discusses how those changes affect the use of captives in combination with certain estate planning techniques such as irrevocable trusts or family limited partnerships.
The PATH Act of 2015 directly affects §831(b) captive insurance companies in two primary ways: first, as of 2017, the maximum annual premium amount that qualifying captives may receive is $2,200,000, and is indexed for inflation. Second, §831(b) captives must now also meet one of two new “diversification tests.” These tests were designed to target perceived abuses involving the use of captive insurance companies to leverage estate tax avoidance strategies, increasing the amount of wealth transferred to younger generations outside of the tax system. Congress attempted to remedy these perceived abuses by inhibiting the inter-generational transfer of §831(b) captive insurance companies.
To accomplish this, Congress modified §831(b) to basically require that the ownership of closely held captive insurance companies must be nearly the same (within 2%) of the ownership of the underlying business. These regulations are applicable to ALL §831(b) insurance companies going forward, regardless of whether they were created before 2017, meaning that anyone who is looking to establish a captive now or anyone who already established one needs to examine the ownership of that captive to ensure that it complies with the law.
If you have a captive insurance company owned by an irrevocable trust, for instance an Intentionally Defective Grantor Trust, or owned by another business entity like a Family Limited Partnership, you may be in violation of the new rules. Under the “Specified Holder” test, a captive that receives more than 20% of it’s premiums from a single premium payer must have substantially identical ownership to the underlying companies. Irrevocable Trusts, Family Limited partnerships and the like, however, divide up ownership interests between generations and often allocate certain assets – for instance those anticipated to increase in value – disproportionately to younger generations in order to push more wealth out of a person’s taxable estate. This means that many estate plans put rapidly growing businesses, including captives, inside Irrevocable Trusts or Family Limited Partnerships. To be direct, many if not most of these arrangements are likely in violation of the PATH Act requirements for captives, meaning they either need to be unwound or the captive will lose its preferntial treatment under §831(b).
The best way to ensure you are not is to have an attorney conduct an audit of the ownership of the captive, but for those curious about the law itself, a more detailed analysis follows. Contact us here if you would like to speak to us about performing a review of PATH Act compliance for your captive insurance company.
The Twenty-Percent Test
The effect of the PATH Act’s diversification provisions is that as of January 1, 2017, §831 captive insurance companies must meet either of two tests. The first test is codified in §831(b)(2)(B)(i) and requires that “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.” This test incorporates the attribution rules of Internal Revenue Code sections 267(b) and 707(b), so that policyholders who are related or who are members of the same controlled group within the meaning of those sections will be treated as a single policyholder.
Of particular importance to this test are the attribution rules under §831(b)(2)(C), which provide (1) that “in determining whether any company is described in clause (i) of subparagraph (A), such company shall be treated as receiving during the taxable year amounts described in such clause (i) which are received during such year by all other companies which are members of the same controlled group as the insurance company for which the determination is being made,” and that “in determining the attribution of premiums to any policyholder under subparagraph (B)(i), all policyholders which are related (within the meaning of section 267(b) or 707(b)) or are members of the same controlled group shall be treated as one policyholder.”
The definition of “controlled group” under §831(b) incorporates and modifies the definition of “controlled group of corporations” provided in Code Section § 1563 (a)(1). A controlled group (either a parent-subsidiary controlled group or a brother-sister controlled) is one in which an entity owns stock or interests amounting to “more than 50 percent” of another entity.
In addition to “controlled group” attribution, for purposes of determining what constitutes “20 percent of [premiums] attributable to any one policyholder,” the first diversification test also requires inclusion of premiums paid by “related” policyholders, as defined in code sections 267(b) and 707(b). Section 267(b), in particular, contains sweeping attribution language which provides for attribution among “related persons,” which means, inter alia, “members of a family” (defined by reference to entail siblings, spouses, ancestors, and lineal descendants), “[a]n individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual,” “[a] grantor and a fiduciary of any trust,” “[a] corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership.” All premiums made by any of the above named parties will be aggregated together when considering the $2,000,000 premium limitation and also what constitutes “premiums to any policyholder” for the “Twenty Percent” Test.
The “Specified Holder” Test
If a captive fails to meet the Twenty Percent Test, it may qualify under 831(b) if it meets the less difficult (but more opaque) “Specified Holder” test. Code Section §831(b)(2)(B)(ii) provides that an insurance company which fails the above test may qualify if “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.”
A “Specified Holder” is “an individual who holds (directly or indirectly) an interest in such insurance company and who is a spouse or lineal descendant (child, grandchild, great-grandchild) of an individual who holds an interest (directly or indirectly) in the specified assets with respect to such insurance company.” A “Specified Asset” includes “trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of such insurance company are paid.”  “Indirect Interest” means “any interest held through a trust, estate, partnership, or corporation” and the “de Minimis Amount” is “two percentage points or less.” 
The House Joint Committee on Taxation provides the following contrasting examples:
The captive has one policyholder, “Business,” certain of whose property and liability risks the captive covers… and Business pays the captive $2 million in premiums in 2017. Business is owned 70% by Father and 30% by Son. The captive is owned 100% by Son (whether directly, or through a trust, estate, partnership or corporation). Son is Father’s lineal descendant. [Under the second diversification requirement,] Son…has a non-de minimis [(i.e., more than 2%)] greater percentage interest in the captive (100%) than in the specified assets coverage of which is provided by the captive (30%). Accordingly, the captive is not eligible to elect Section 831(b) treatment.
If, by contrast, all the facts were the same except that Son owned 30% and Father owned 70% of the captive, Son would not have a non-de minims percentage greater interest in the captive (30%) than in the specified assets with respect to the captive (30%). The captive would meet the diversification requirement for eligibility to elect Section 831(b) treatment. The same result would occur if Son owned less than 30% of the captive (and Father more than 70%), and the other facts remained unchanged.
Boiled down, these requirements mean that individuals or groups owning an underlying company writing premiums to a §831(b) captive must own proportionate interests (within a 2% margin of error) in that the captive. If the ownership of the business and the insurance company are identical, the captive insurance company satisfies the diversification requirement. In short, as Kimberly S. Bunting and Phyllis Ingram write in the Journal of Accountancy: “Under the diversification requirements, ownership in the insured operating businesses must be aligned with ownership of the captive if a spouse or lineal descendant (child or grandchild) of an individual who owns an interest in the operating company/insured has ownership in the captive.”
 26 U.S.C. 831(b)(2)(A)(ii)
 26 U.S.C. 831(b)(2)(B)(i)(I)
 26 U.S.C. §831(b)(2)(C)(i)(I)
 26 U.S.C. §831(b)(2)(C)(i)(II)
 26 U.S.C. § 1563 (a)(1).
 As modified by §831, the a parent-subsidiary controlled group is defined as “[o]ne or more chains of corporations connected through stock ownership with a common parent corporation if — (A) stock possessing [more than 50 percent] of the total combined voting power of all classes of stock entitled to vote or [more than 50 percent] of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is owned (within the meaning of subsection (d)(1)) by one or more of the other corporations; and (B) the common parent corporation owns (within the meaning of subsection (d)(1)) stock possessing [more than 50 percent] of the total combined voting power of all classes of stock entitled to vote or [more than 50 percent] of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations.”
A brother-sister controlled group, by contrast, is one of “[t]wo or more corporations if 5 or fewer persons who are individuals, estates, or trusts own […] stock possessing more than 50 percent of the total combined voting power of all classes of stock entitled to vote or more than 50 percent of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation.”
 26 U.S.C. 267(b) encompasses: “Members of a family [brothers and sisters, spouse, ancestors, and lineal descendants]”; “An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual”; “Two corporations which are members of the same controlled group (as defined in subsection (f))”; “A grantor and a fiduciary of any trust”; “A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts”; “A fiduciary of a trust and a beneficiary of such trust”: “A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts”; “A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust”; “A person and an organization to which section 501 applies and which is controlled directly or indirectly by such person or […] by members of the family of such individual”; “A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and (B) more than 50 percent of the capital interest, or the profits interest, in the partnership”; “An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation”; “An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation”; or (13) “an executor of an estate and a beneficiary of such estate.”
 IRC §707(b) disallows loss deductions for sales or exchanges of property with respect to controlled partnerships
“from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between—
(A) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or (B) two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests.”
 26 U.S.C. 831(b)(2) (B)(i)(II)
 26 U.S.C. 831(b)(2) (B)(ii)(I)
 26 U.S.C. 831(b)(2) (B)(ii)(II)
 26 U.S.C. 831(b)(2) (B)(ii)(III)
 26 U.S.C. 831(b)(2) (B)(ii)(III)
 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029 (Rules Committee Print 114-40), (JCX-144-15), December 17, 2015. This document can also be found on the Joint Committee on Taxation website at www.jct.gov
 Kimberly S. Bunting, J.D., and Phyllis Ingram, CPA http://www.journalofaccountancy.com/issues/2016/nov/captive-insurance-tax-requirements.html#sthash.Pp7zAbyz.dpuf