Jeremy Colombik is president of Management Services International (MSI). MSI currently manages over a hundred businesses that are utilising a captive insurance company structure. MSI currently is one of the largest captive managers in the state of North Carolina. Below, he discusses the Path Act and IRS Notice 2016-66.
There has been much discussion regarding the Path Act as well as IRS Notice 2016-66, but not as much discussion as to the notice’s effect regarding the new law that took effect 1 January 2017. This notice, if it stands, will have the effect of nullifying he Path Act law that was just recently passed. Let’s first discuss the Path Act and then Notice 2016-66.
The Path Act was passed and signed into law in December of 2015. For the first time in 30 years, there were significant changes to the IRS Code pertaining to captive insurance companies. Specifically, there were two main modifications.
First, starting 1 January 2017 the limits for an IRC 831(b) election increased from $1.2m per year to $2.2m per year. So, what is an 831(b) company?
- 831(b) effectively allows a small insurance company, currently, to receive up to $2.2m per year in premiums, without paying any income taxes on receipt of those premiums.
- The 831(b) election has no effect on deductibility of the premiums paid by an operating business to the captive. Premiums, if otherwise deductible, may be deducted by the operating business as with any premium payments to an insurance company or captive insurance company.
- This creates a current income tax deduction of up to $2.2m for the operating business once premiums are paid to the captive. In turn, the captive does not pay any income tax upon receipt of those premiums.
Additionally, there will be an annual inflation adjustment starting in 2016. Second, in order to qualify for the 831(b) election, the captive must pass one of two diversification tests. The two diversification tests are:
(1) risk diversification and
(2) relatedness test (ownership test).
There have been many articles released which go into more detail about these tests, but since the IRS still has not provided guidance on this, the precise interpretation remains unclear.
Notice 2016-66 was published in November of 2016 to the surprise of the captive industry (to say the least). This noticemade captives under certain qualifications a “transaction of interest”. Below are the qualifications to be classified as a “transaction of interest”, which is a reportable transaction that requires participants to file form 8886.
- A — a person who directly or indirectly owns an interest in an entity (or entities) (insured) conducting a trade business;
- An entity (or entities) directly or indirectly owned by A, insured, or persons related to A or insured (captive) enters into a contract (or contracts) with insured that captive and insured treat as insurance, or reinsures risks that insured has initially insured with an intermediary, company C:
- Captive makes an election under §831 (B) to be taxed only on taxable investment income;
- A, insured, or one or more persons related (within the meaning of §267 [b] or 707 [b]) to A or insured directly or indirectly own at least 20 per cent of the voting power or value of the outstanding stock of captive; and
- One or both of the following apply:
- The amount of the liabilities incurred by captive for insured losses and claim administration expenses during the computation period (defined in section 2.02 of this notice) is less than 70 per cent of the following:
- Premiums earned by captive during the computation period, less
- Policyholder dividends paid by captive during the computation period; or
- Captive has at any time during the computation period directly or indirectly made available as financing or otherwise conveyed or agreed to make available or convey to A, insured, or a person related (within the meaning of §267 (b) or 707 (b)) to A or insured (collectively, the “recipient”) in a transaction that did not result in taxable income or gain to recipient, any portion of the payments under the contract, such as through a guarantee, a loan, or other transfer of captive’s capital.
Also, per section 2.02, Notice 2016-66, the computation period is (a) the most recent five taxable years of the captive or (b) if the captive has been in existence for less than five taxable years, the entire period of captive’s existence. For purposes of the preceding sentence, if the captive has been in existence for less than five taxable years and the captive is a successor to one or more captives created or availed of/about a transaction described in this notice, taxable years of such predecessor entities are treated as taxable years of the captive. For purposes of section 2.02, a short taxable year is treated as a taxable year.
There have been many associations as well as state domiciles such as North Carolina and Utah whose senators, Burr and Hatch, were key in getting the Path Act passed. The senators wrote to their legislature(s) and to the IRS expressing how extremely burdensome and negative this notice is on all parties involved, which includes owners and managers of 831(b) captives. Moreover, this notice includes virtually all firms involved with these 831(b) captives. Generally, the concession between the states and associations push back has to deal with the harm to the economy of these states with captive laws, due to the loss of jobs and premium tax that is collected that would go away if this notice stays. Further, the cost compliance burden, redundancy, and overbroad issues have been brought up as this notice, as stated above in the article, is retroactive as well as prospective.
With these factors listed above, Notice 2016-66 will have the effect of nullifying the Path Act by causing current and potential people to either not participate or withdraw from their 831(b) captives. The reason is that these forms must be turned into the office of Tax Shelter Analysis. That is like putting a red flag on your personal or business tax return.
I know that most captives that are managed by reputable firms are operating correctly, but who wants to get audited? Clients are not going to want to take that chance and their certified public accountants will most likely advise them to either not go ahead with an 831(b) captive or come out of their existing entity. Again, if you have people coming out or not participating, then the states will not have as many to manage, which means less state premium tax as well as the captive managers, who may not need as much staff since they have less clients. Therefore, less jobs will exist within all states that have active captive rules and reduced revenue.
Most 831(b) captives are not abusive, but why have almost all 831(b) captives, which is what this notice encompasses, provided all of this additional information to the IRS, when most of it is already on the captives’ income tax returns?
There was even a lawsuit filed against the IRS, but later dropped, based on the IRS offering an extension to 1 May 2017 to comply with their new reporting rules. The lawsuit was based in part on a potential violation of the Administrative Procedures Act (APA) for not fully and technically adhering to the requirements of the APA.
A more efficient route would be to have the IRS withdraw the notice, review people’s comments that were turned in earlier this year and have hearings take place on this matter. This would allow a determination about how to balance the public and government’s interests. Right now, the IRS is putting the cart before the horse because they have failed, after many attempts, to identify the problem they are trying to resolve.
In conclusion, it is important that all captive associations, as well as the states in the captive industry, continue to work together to get this unjustified notice withdrawn, so that the Path Act will not be nullified and allow for an orderly expansion and growth in this important industry.
Jeremy Colombik, CPA
Jeremy Colombik is an experienced, licensed financial professional. He is a graduate of Western Illinois University, having obtained a bachelor of business degree with a major in finance. Jeremy is a licensed CPA and a member of the American Institute of Certified Public Accounts, and the North Carolina Association of Certified Public Accountants. Furthermore, he has been in the captive industry for over 10 years and is a member of the Captive Insurance Companies Association and the North Carolina Captive Insurance Association. In addition, he serves as Chairman for the North Carolina Captive Insurance Association. Jeremy is the President of Management Services International (MSI). MSI currently manages over a hundred businesses that are utilising a captive insurance company structure. MSI currently is one of the largest captive managers in the state of North Carolina. Jeremy specialises in IRC Sec. 831(b) captives. He is a sought-after speaker for professional groups, such as; CPAs, lawyers and financial advisers, on how a captive structure works and could be a great benefit to their clients.