HR1314’s Changes to the Section 831(b) Election Rules
This guide to the revised Section 831(b) rules explains the legislative shift from a simple premium threshold to a more complex analysis of a captive's structure.
An election under Section 831(b) of the Internal Revenue Code offers a tax advantage to small insurance companies, often called “micro-captives.” These entities, owned by the businesses they insure, can choose to be taxed on their net investment income alone, excluding their underwriting income from taxation. This allows a business to self-insure certain risks while gaining a tax benefit. The Protecting Americans from Tax Hikes (PATH) Act of 2015 introduced modifications to the qualification standards to address concerns about how these entities were being used.
The 831(b) Election Prior to Legislative Changes
Before the legislative changes, the framework for the Section 831(b) election was more straightforward. The qualification requirement was a limit on the amount of annual written premiums the insurance company could receive, set at $1.2 million. If a property and casualty insurance company’s premiums did not exceed this amount, its underwriting profit was exempt from federal income tax. The company’s tax liability was calculated solely based on its net investment income.
The focus for qualification was adherence to this premium cap and ensuring the entity operated as a legitimate insurance company. This involved demonstrating adequate risk distribution, risk shifting, and the presence of common notions of insurance. As long as these principles were met and premiums were below the $1.2 million ceiling, the benefits of the election were available.
Key Changes from the PATH Act of 2015
The Protecting Americans from Tax Hikes (PATH) Act of 2015 implemented reforms to the Section 831(b) election, effective for taxable years starting after December 31, 2016. A modification was an increase in the annual premium limit from $1.2 million to $2.2 million, which is indexed for inflation. For taxable year 2025, this limit is $2,850,000.
The legislation also introduced new diversification requirements to address concerns that some captive arrangements were being used for purposes other than genuine insurance. To qualify for the election, an insurance company must now satisfy one of two alternative tests each year. These tests ensure that the captive either insures a sufficiently diverse set of risks or has an ownership structure that is closely aligned with the business it insures.
The first of these alternatives is a risk diversification test. This requirement stipulates that no single policyholder can be responsible for more than 20% of the captive’s net written premiums for the taxable year. For the purpose of this test, related parties are treated as a single policyholder. This rule compels the captive to spread its risk exposure across multiple sources.
The second alternative is an ownership test, designed to prevent the use of captives as an estate planning tool. This test is met if the ownership of the captive by a spouse or lineal descendants is not disproportionately larger than their ownership in the insured business. The law states that the ownership of the captive by these family members cannot be greater, by more than a two percent margin, than their ownership of the insured operating business. This provision ensures a “mirror ownership” structure.
Qualifying Under the New Rules
Navigating the Section 831(b) election under the current rules requires a more detailed and ongoing analysis. Companies must perform specific annual tests to confirm their continued eligibility. To satisfy the risk diversification test, a captive insurer must conduct a careful review of its entire book of business each year. This involves calculating the percentage of total net written premiums that originates from each policyholder. Because attribution rules treat related entities as a single policyholder, this analysis must look through the corporate structure of the insureds to avoid any single group exceeding the 20% premium concentration threshold.
Meeting the alternative ownership test requires an analysis focused on shareholder ledgers. The company must compare the ownership percentages of the captive with the ownership percentages of the operating business it insures. This comparison must be made for the spouse and lineal descendants of the primary owners. The captive must document that the ownership stake of these specified heirs in the insurance company does not exceed their ownership stake in the insured business by more than two percentage points.