Small Captive Insurance Company Rules Updated for Technical Corrections

Editor's Note: P. Bruce Wright and Saren Goldner are partners in the tax department of Eversheds Sutherland (US) LLP situated in the New York office.

The Consolidated Appropriations Act of 2018 (the "Act"), H.R. 1625, commonly referred to as a spending bill, was enacted on March 23, 2018, and contained a number of tax technical corrections, including amendments to IRC section 831(b). Most importantly, the Act clarifies that for purposes of the first diversification test of section 831(b), the term "policyholder" refers to the direct insured under a policy and not to a reinsured. Before this statutory clarification, it was unclear whether the look-through principals of Revenue Ruling 2009-26 would apply for this purpose, but the revision makes it clear they do.

Additionally, for purposes of the second alternative diversification test, the Act clarifies the definition of "specified holder," adds a new concept of "relevant specified assets," and attributes interests held in an electing small insurance company by a specified holder's US citizen spouse as held by the specified holder. In order to meet the second diversification test, all (direct or indirect) "specified holders" of the insurance company (if any) cannot have more than a de minimis percentage¹ higher ownership interest in such insurance company than in the insured business.

The addition of the concept of "relevant specified assets" allows for the aggregation of all "specified assets" held by a "specified holder," including those held by the "specified holder's" spouse, lineal descendants, stepchild, or the spouse of a lineal descendant (but not including, for example, those "specified assets" held by parents or grandparents). This aggregated amount is then utilized for purposes of comparing the "specified holder's" ownership in the insurance company with his or her ownership of the insured assets.

The adding of this new concept also clarifies that for purposes of the comparison, each insured asset is not considered separately. By comparing the aggregated ownership of insured assets to insurance company ownership, the second diversification requirement now more narrowly imposes the congressional intention underlying the 2015 statutory amendments to section 831(b) to which the Act's technical corrections relate; that is to disallow the use of small insurance companies as a means to inappropriately transfer wealth to descendants.²

For example, if a captive was 100 percent owned by a "specified holder" and the insured business was 20 percent owned by the "specified holder," 20 percent owned by the "specified holder's" spouse, and 60 percent owned by the "specified holder's" father, this situation would not meet the requirements of the second diversification test because the father's ownership in the "relevant specified assets" (i.e., the insured business) would not be aggregated with the "specified holder's ownership." On the other hand, if the captive was 100 percent owned by a "specified holder" and the insured assets were 20 percent owned by the "specified holder," 20 percent owned by the "specified holder's" spouse, and 60 percent owned by the "specified holder's" daughter, this situation would meet the requirements of the second diversification test because the daughter's ownership in the "relevant specified assets" (i.e., the insured business) would be aggregated with the "specified holder's ownership."

Finally, the definition of "specified holder" was expanded to include stepchildren, spouses of lineal descendants, and noncitizen spouses in order to expand the group of descendants to which wealth transfer could be limited by the imposition of the second diversification requirement.³ For example, if a mother's stepchild owned 100 percent of a captive and the mother owned 100 percent of the insured assets, this situation would not meet the requirements of the second diversification test under the revised statute. Under the statute before revision, however, the stepchild would not have been treated as a "specified holder," and the second diversification test would have been met.

1. For these purposes, a de minimis percentage is 2 percent or less except as otherwise provided in regulating.
2. In this regard, in general, insured assets acquired by a spouse, stepchild, lineal descendant, or the spouse of a lineal descendant by bequest, devise, or inheritance from a decedent during the taxable year or the prior year are not included as "relevant specified assets."
3. Noncitizen spouses are generally not eligible for the unified estate and gift tax marital deduction.