There are several tax-related issues that should be considered when deciding to form or expand a reinsurance or captive program.
- Insurance Company Accounting
- IRC Section 831(b) Election
- Controlled Group
- IRC Section 953(d) Election
Insurance Company Accounting
Insurance company accounting provides some unique advantages for federal income tax purposes. When a non-insurance company receives a payment for a good or service, the full amount is generally recognized as income in the period the payment is received. However, if the company qualifies as an insurance company for tax purposes, the company is permitted to amortize the payment (premium income) over the life of the contract via the establishment of unearned premium reserves. Additionally, an insurance company may also deduct as an expense reserves set aside to pay future claims on contracts in force.
IRC Section 831(b) Election
The IRC Section 831(b) election allows a non-life insurance company to exclude underwriting gain or loss from its taxable income. A company making this election is effectively taxed only on its investment income or other non-insurance income, which may generate significant tax savings. The election is only available to corporations that qualify as non-life insurance companies for federal income tax purposes, have net written premium or direct written premium (whichever is greater) that does not exceed the annual premium threshold level ($2.3 million for 2018) AND passes at least one of the two diversification tests (not more than 20% of net written premium can be attributed on any one policy holder OR the ownership of the reinsurance company is essentially the same as the ownership of the entity insured with respect to any spouses or lineal descendants of the owners of the entity insured). Once the election is made, the electing company must continue to meet the qualification criteria annually to continue to receive the benefits of the election.
A controlled group is two or more corporations which are owned (directly or indirectly) by the same interests. Controlled groups present concerns and planning opportunities for companies. Among the key concerns, members of a controlled group are required to allocate corporate income tax brackets and combine premium for purposes of the IRC Section 831(b) election annual premium threshold testing. There are four basic types of controlled groups: parent-subsidiary, brother-sister, combined (which includes both parent-subsidiary and brother-sister related companies) and certain life insurance companies. The most common controlled group with captive and reinsurance structures are brother-sister controlled groups. A brother-sister controlled group is a group of corporations where five or fewer individuals own (directly or indirectly) more than 50% of the vote or value of the stock in each company. When establishing a multi-company group, it is important to monitor ownership to ensure the desired controlled group outcome.
A (re)insurance company or captive can be formed in most US States. As a domestic (re)insurer or captive, the company would be subject to premium tax and/or income tax in each state that the company does business. If the company qualifies as an insurance company for tax purposes, it would file an annual federal income tax return as a US insurance company (Form 1120-L or Form 1120-PC).
An NCFC reinsurance program is a non-controlled foreign corporation domiciled in an offshore country. Typically, these structures are reinsurance companies with multiple stock classes owned by many unrelated participating shareholders. In order to maintain its federal income tax classification as an NCFC, US shareholders cannot own or control 25% of more of the voting rights of the company. Since a US shareholder is defined as a shareholder that owns 10% or more of the voting rights OR the value of the entity, these structures have at least 11 unrelated US shareholders with equal voting. NCFC structures are set up to allow shareholders to participate in the underwriting profit they produce, with some risk sharing between the parties. The company is typically controlled by the administrator and/or insurance company whose products are reinsured into the NCFC. The participating shareholders do not individually direct the operations of the company or any of the investments. The entity is not subject to federal income taxes, but does pay a federal excise tax (typically 1% of net written premium). No state income tax return is required. However, premium taxes are paid by the ceding insurer and reimbursed as part of the reinsurance arrangement.
A properly structured NCFC program should be able to utilize the active insurance exception under the Passive Foreign Investment Company (“PFIC”) rules. This requires the foreign insurance company to qualify as an insurance company under the Internal Revenue Code and have applicable insurance liabilities (excluding unearned premium reserves) which are more than 25% of the total assets of the company.
A CFC reinsurance program is a controlled foreign corporation domiciled in an offshore country that is 25% or more owned by US shareholders. A US shareholder is defined as a US shareholder who controls 10% or more of the voting rights OR the value of the CFC. CFCs typically make an election under Internal Revenue Code Section 953(d) to be taxed as a U.S. insurance company. The entity files an annual federal income tax return as a US insurance company (Form 1120-L or Form 1120-PC). No state income tax return is typically required.
IRC Section 953(d) Election
Internal Revenue Code Section 953(d) allows a CFC that would otherwise qualify for insurance tax treatment under the Internal Revenue Code if it were a domestic corporation to elect to be treated as a domestic insurance company for all purposes of the Internal Revenue Code. This allows an offshore reinsurer to receive all the benefits of a domestic insurer (i.e. insurance company accounting and special federal income tax elections and provisions) while still having the operational and regulatory benefits of their offshore domicile.