Charles J. Lavelle

Partner, Greenebaum Doll & McDonald PLLC

Organising a small property and casualty (P&C) insurance company that elects section 831(b) tax treatment—a 831(b) company—can be a powerful solution to a closely held business’s insurance needs, says Charles J. Lavelle.

Only a dreamer would deny that there is a real threat of government

regulation targeting captives. For the realists, however, this threat to captives’ status and capital requirements has prompted action, largely in the form of far-reaching protective measures.

Redomiciling to a more financially favourable domicile is one option, albeit with all its attendant costs; another is to meet the threat to capital head-on through self-regulation. One of the more popular vehicles is section 831(b). A provision of the United States Internal Revenue Code (Code), it is designed to simplify the administration and taxation of small property and casualty insurance companies. It typically takes the form of an ‘election’.

This article attempts to identify what a section 831(b) election is, discussing the benefits and detriments, and setting forth reasons for the rapid growth in the number of captives, including section 831(b) companies. The article also notes the similarities and differences with other captive and non-captive companies, sets forth some strategies for stock ownership, and concludes by laying out the technical issues and requirements.

A good and bad thing

A section 831(b) company is taxed only on its ‘taxable investment income’ and not on its underwriting (or insurance) income; conversely, an underwriting loss is not deductible against its taxable investment income. Thus, net underwriting profits will not be taxed until withdrawn. If the business written is volatile, care must be taken before a section 831(b) election is made, because underwriting losses cannot offset taxable investment income. Thus, the section 831(b) company may have a tax liability in years when it has an overall loss.

The net operating losses of a section 831(b) company cannot

be carried to another year to offset income in that year. An 831(b) election is made with the insurance company’s federal income tax return. Once made, the election may only be revoked with the consent of the Commissioner of the US Internal Revenue Service (IRS).

Generally, only a property and casualty insurance company is eligible

to make a section 831(b) election, and then only as long as neither its net written premium nor its direct written premium for its taxable year exceeds $1.2 million. There are elaborate rules regarding how to compute ‘taxable net income’ and the amount of premiums, which are discussed below.

Growth in captives, including section 831(b) companies

The number of captive insurance companies, including section

831(b) companies, has grown rapidly in the last decade because captive insurance has become more ‘mainstream’. In other words, concerns about ‘hard’ commercial markets after 9/11, Hurricane Katrina, the financial meltdown, etc., the burgeoning number of captive domicile alternatives, more user-friendly procedures and costs for smaller businesses, and a favourable 2001 IRS ruling have all played a part.

831(b) companies are insurance companies—just smaller

Some in the industry talk as if section 831(b) companies are different from other insurance companies. Other than the lower volume of premiums, section 831(b) companies

are not that different from other captive insurance companies, nor even from commercial insurance companies. They must meet the same tests as other captive and non-captive insurance companies in order to be recognised for federal income tax purposes. Accordingly, section 831(b) companies must be formed for the same non- tax business reasons as other captive and non-captive insurance companies. These may include: (a) obtaining coverages not available, or not affordable, in the commercial market; (b) capturing the profits of the commercial market; (c) permitting access to the reinsurance market; (d) obtaining better control over the claims process; and (e) obtaining the ability to unbundle insurance services.

In addition to non-tax business reason(s), the other tests for P&C

insurance tax treatment must be met. These tests are: (1) the insured risks must be insurance risks—they cannot be business risks or investment risks. The risks must be ‘real risks’ that can occur, but must also have some possibility that they may not occur; (2) the insurance company and the insurance arrangement should constitute ‘insurance’ in its commonly accepted sense (it must ‘look and feel’ like insurance); (3) the risk must be shifted to the insurance company (this entails, among other things, that the insurance company be adequately capitalised and that no person or entity guarantees its performance); and (4) there must be ‘risk distribution’, which the IRS believes requires the sharing of risks of a number of different entities.

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