158 J o u r n A l o f T A x A T I o n l o C T o b e r 2 0 1 6

EDITED BY PETER J. CONNORS, LL.M., ROBERY R. CASEY, LL.M.,AND LORENCE L, BRAVENEC, LL.M.

SPECIAL INDUSTRIESu

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Recent changes made by the PATHAct1 will force closely-held businessowners who have integrated captiveinsurance companies into their riskmanagement profile to revisit theeconomics, risk management, and es-tate planning goals of their designs.A new risk diversification require-ment added by the PATH Act willforce business owners to either in-crease their captives’ participation inrisk pools, or restructure existing es-tate planning designs. This article ex-plores the history of closely-held cap-tive insurance companies (referred toherein as “micro-captives”), discussesthe income tax requirements of in-surance arrangements, including therecently promulgated diversificationrequirements under the PATH Act,and suggests ways to deal with thenew law.

BRIEF HISTORY OF CAPTIVESHistorically, captive insurance compa-nies (including micro-captive insur-ance companies) have been used bybusiness owners for many reasons.First, captives help business ownerscover exposure from self-retainedrisks. These are risks that businessowners have determined not to coverthough traditional commercial carriersfor a number of reasons, including thecost may be too high relative to thepotential exposure, or they were sim-ply willing to take the risk. From anactuarial perspective, these self-insuredrisks do not require the same level ofreserves as commercial policies thatcover catastrophic losses related toproperty damage, general liability, au-tomobile, and umbrella coverage. Atypical risk managed through a self-insured retention program is one that,although is likely to occur, has less po-tential exposure. Typically, a self-in-sured risk retention program is imple-

Planning with Micro-Captive InsuranceCompanies After thePATH Act

CLAUDIO A. DE VELLIS

Although the PATH Act’s expansion of the Section 831(b) exclusion washelpful, it also added diversification requirements under Section 831(b)that made micro-captive planning more challenging.

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mented with a strong loss control pro-gram to mitigate the self-insured ex-posure. Depending on the type of cov-erage, some of these risks may still becovered through a commercial insurer,in conjunction with a high deductibleplan, with the deducible portion rep-resenting the self-insured risk.

Second, a captive can help businessowners reduce overall insurancecosts. By taking on greater self-insuredrisks, business owners who also en-hance their loss control programsmay reduce commercial insurancepremiums and losses associated withself-retained risks. This allows the in-sured to capture a portion of the un-derwriting profit in a commercial in-surance policy by better managing itsown risks. In addition, a larger self-insured retention program may in-centivize a commercial carrier to offerbetter pricing as a way to retain someof the lost premiums. Finally, a costsavings can be achieved by a businessenterprise that is a good actor with agood loss experience rating in an in-dustry experiencing significant currentlosses and increasing premiums. Thecaptive permits the business enterpriseto use its own experience rating ratherthan that of its industry.

Third, a captive can permit a busi-ness owner to obtain coverage thatmay not otherwise be available in thecommercial market. This can beachieved by having the captive un-derwrite policies that cover gaps andexclusions in the business owner’scommercial policies. It may also per-mit a business owner to underwritedirectly from a reinsurer, typicallyavailable only to a licensed insurancecompany. Buying insurance coveragethrough a reinsurer has the advantageof eliminating the middleman and gets

the business owner the wholesaleprice of coverage.2

Fourth, a captive can help a busi-ness owner control the timing of pre-mium payments and smooth out cashflow to better coincide with its busi-ness cycles. The timing and amount ofpremium payments made to a com-mercial carrier is not flexible beyondthe typical monthly, quarterly, semi-annual, or annual payment cycle.

Fifth, a captive gives the insuredbusiness greater control over the claimsprocess, including, timing and admin-istrative issues related to claims, selec-tion of lawyers to handle a lawsuit re-lated to a claim, and a greater say inwhether or not a claim is even coveredby the policy.

INSURANCE FOR INCOME TAX PURPOSESThe Code defines the term “insurancecompany,” in relevant part, as “anycompany more than half of the busi-ness of which during the taxable yearis the issuing of insurance or annuitycontracts.”3 While the Code sets forththis general definition of an insurancecompany, the definition of what con-stitutes insurance has been a matterleft to the courts. In fact, the SupremeCourt in Helvering v. LeGierse, 312 U.S.531, 25 AFTR 1181 (1941), articulatedin a single sentence what has becomethe primary definition of insurance forincome tax purposes. In LeGierse, theCourt declared that “[h]istorically andcommonly insurance involves riskshifting and risk distribution.” Each ofthese elements must be present for theinsurance relationship to be respectedfor income tax purposes. If either riskshifting or risk distribution is not pres-ent, the insurance arrangement will

not be respected and the insured’s pre-mium payment will be characterizedas a nondeductible reserve. Each ofthese two requirements is consideredin turn.

Risk shifting involves shifting theeconomic risk of loss from one party(the insured) to another party (the in-surance company). In several Rev-enue Rulings, the IRS has stated that“risk shifting occurs if a person facingthe possibility of an economic losstransfers some or all of the financialconsequences of the potential loss tothe insurer, such that a loss by the in-sured does not affect the insured be-cause the loss is offset by the insur-ance payment.”4

Courts have considered differentfactors to determine whether an eco-nomic risk of loss has been shifted.Adequacy of the capitalization of theinsurance company is the most im-portant factor in this determination.5For example, depending on the risksinsured and the potential loss, if aninsurance company cannot sustainthe loss, the economic burden mayrest with the insured. In addition, ifthe insurance company’s risk of lossis contractually capped or indemni-fied by a party related to the insured(e.g., the parent of the insured), riskshifting has also not been achieved.6Assuming that risk shifting has beenmet, the insurance company must stillmeet the risk distribution requirement.

The focus of risk distribution is de-termining whether the insurance com-pany has spread its risk of loss amonga sufficient number of insureds. Thismeans that a micro-captive must in-sure third-party risks, that is, risks ofcompanies other than its parent andrelated brother-sister companies (withcertain exceptions for brother-sister

1 Protecting Americans from Tax Hikes Act of 2015, Pl. 12/18/15.

2 It should be noted that reinsurance companies typicallyunderwrite risks that involve significant premiums. Soit will not be practical for a micro-captive to access thereinsurance market until it achieves a greater level ofreserves that permit it to underwrite greater coverage.

3 Section 816(a). 4 rev. rul. 2002-89, 2002-2 Cb 984, rev. rul. 2002-60,

2002-2 Cb 985, and rev. rul. 2002-91, 2002-2 Cb 991.(The IrS found risk shifting to exist where a whollyowned subsidiary captive insurance company re-

ceived less than 50% of its total premiums from itsparent, the parent did not guaranty performance ofthe captive subsidiary, and the captive did not makeany loans to the parent).

5 Beech Aircraft Corp., 797 f.2d 920, 58 AfTr2d 88-5548 (CA-10, 1986) (This case involved a wholly ownedinsurance company that was thinly capitalized with$150,000 to cover potential excess losses of severalmillion dollars. In addition, the total exposure for theinsurance company was capped at the total amountof premiums received plus investment earnings onthe premiums. only the insured parent would haveborne a loss.).

6 Stearns-Roger Corp., 774 f.2d 414, 56 AfTr2d 85-6099(CA-10, 1985) (involving an indemnification agreementrunning from the parent to its captive insurance com-pany subsidiary); Malone & Hyde, Inc., 62 f.3d 835, 76AfTr2d 95-5952 (CA-6, 1995) (involving an undercap-italized captive insurance company subsidiary inwhich parent retained risk of loss under an agreementto hold subsidiary harmless from losses); CarnationCo., 71 TC 400 (1978) (involving a fronting arrange-ment in which commercial insurance carrier ceded90% of the risk of the insured to the wholly-ownedinsurance subsidiary of the insured), aff’d 640 f.2d1010, 47 AfTr2d 81-997 (CA-9, 1978).

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companies noted below). Through aseries of Revenue Rulings, the IRS hasdelineated the concept of risk distri-bution as follows: 1. Risk distribution incorporates the

statistical phenomenon known asthe law of large numbers

2. Distributing risk allows the insurerto reduce the possibility that a singlecostly claim will exceed the amounttaken in as premiums and set asidefor the payment of such a claim.

3. By assuming numerous relativelysmall, independent risks that occurrandomly over time, the insurermay smooth out losses to matchmore closely its receipt of premiums.

4. Risk distribution entails a poolingof premiums so that a potential in-sured is not in significant part pay-ing for its own risks.7So how much third-party risk is

necessary to achieve risk distribution?

Case law had set different percentagesbased on the specific facts of severalcases, with the lowest amount ofthird-party risk reported at approxi-mately 30%.8 This means that 70% ofthe total risk insured by a captive in-surance company could be that of arelated party, with the remaining 30%from unrelated parties. Notwithstand-ing that 30% of unrelated third-partyrisk was generally accepted as indus-try norm to achieve risk distribution,the IRS has established a safe-harborof 50% for third-party risk.9

Assuming that a captive insurancecompany can achieve an acceptablelevel of third-party risk, there are twoways to insure third-party risk. Oneway is for the captive insurance com-pany to participate in a risk reinsur-ance pool. Under this arrangement, acaptive enters into a reinsurance, orrisk-sharing agreement with other

captives through a captive insurancecompany manager. Under the ar-rangement, each captive in the riskreinsurance pool agrees to insure therisk of the affiliated owners of theother captives in the pool. By way ofexample, assume a micro-captiveearns $2 million of premiums andneeds to achieve a 50% level of third-party risk. It would issue policies hav-ing aggregate premiums of $1 millionto the companies owned by its affili-ated closely-held business owner.These are “direct policies” because theyare issued by the micro-captive di-rectly to its affiliated insured busi-nesses (not third-party risk). It wouldalso enter a risk reinsurance poolthrough which it insures the risks ofhundreds of other companies. These“indirect policies” (or “pooled policies”)would generate aggregate premiumsto the micro-captive of $1 million.Through the risk pool, the micro-cap-tive insures a portion of each policyissued to a company in the pool. Byinsuring hundreds of companies, noone claim will wipe out the reservesof the micro-captive because the risk

Typical Third-Party Insurance Pool

EXHIBIT 1

ClAudIo A. de VellIS is a partner at Kleinberg, Kaplan, Wolff & Cohen, P.C. in new York City. Mr. deVellis is Co-Chair of the firm’s estate planning and administration group, where he represents individualand charitable organizations in connection with their income tax and wealth preservation issues. Hecan be reached at cdevellis@kkwc.com. Mr. de Vellis would like to acknowledge the assistance of hispartner James r. ledley for his careful review and comments on this article. Copyright © 2016 ClaudioA. de Vellis.

is dispersed among many insurancecompanies. This is the third-party riskthat achieves risk distribution. (Exhibit1 illustrates a typical risk pool arrange-ment, in which each micro-captive in-sures the risks of several insured busi-nesses.)

An alternative to risk pooling is the“brother-sister” arrangement wherebya micro-captive insures only the risksof its sister companies, that is, com-panies owned by the common parentof the captive. There is no third-partyrisk in the brother-sister arrangementbecause the micro-captive and the in-sured businesses are owned by a

common parent. Notwithstanding thelack of third-party risk, risk shiftingand risk distribution will be achievedunder this paradigm if there are a suf-ficient number of insureds and therisks are reasonably distributedamong all of the insureds.10 Initially,the IRS had successfully argued thatthere could be no risk shifting and riskdistribution when the economic riskof loss remains on the balance sheetof entities within the same affiliatedgroup. This economic family doctrinewas first espoused by the IRS in Rev.Rul. 77-316, 1977-2 CB 53.11 The eco-nomic family doctrine made good

sense when the captive insurancecompany was a subsidiary of the in-sured because the economic risk ofloss was never removed from the par-ent’s balance sheet. However, when acaptive insurance company and theinsured are owned by a commonparent, the risk of loss may be shiftedas between the subsidiary insurancecompany and the insured, eventhough the common parent remainseconomically neutral. After severaltaxpayer victories in the brother-sistercaptive insurance company arrange-ment,12 the IRS abandoned the eco-nomic family doctrine13 and published

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Risk Distribution Under Brother-Sister Safe Harbor

EXHIBIT 2

7 rev. rul. 2002-89, 2002-2 Cb 984 and rev. rul. 2002-90, 2002-2 Cb 985 (both citing Clougherty PackingCo., 811 f.2d 1297, 59 AfTr2d 87-668 (CA-9, 1987) andHumana Inc., 881 f.2d 247, 64 AfTr2d 89-5142 (CA-6,1989)).

8 The ninth Circuit approved 29% in Harper Group, 979f.2d 1341, 70 AfTr2d 92-6053 (CA-9 1992), aff’g 96 TC45 (1991). Amerco Inc., 979 f.2d 162, 70 AfTr2d 92-6048 (CA-9, 1992) (approving third-party coverageranging between 52%-74%). See also Ocean Drilling &Exploration Co., 988 f.2d 1135, 71 AfTr2d 93-1184 (CA-f.C., 1993) (approving third-party coverage rangingbetween 44%-66%). In practice, it is not absolutelyclear whether the percentages refer to total premiumsreceived or total losses covered. These figures tend

to be proportional in any event, and it is common tomeasure the risk distribution percentages in terms oftotal premium dollars.

9 rev. rul. 2002-89, 2002-2 Cb 984 (The IrS found riskdistribution present where a wholly-owned-subsidiarycaptive insurance company received less than 50%of its total premiums from its parent and more than50% of total premiums from unrelated insureds.).

10 Hosp. Corp. of Am., TCM 1997-482 (This case involvedthe common parent of an affiliated group of compa-nies that owned and operated hospitals and formeda wholly owned captive insurance company. The pre-miums paid by the insured subsidiaries to their sisterinsurance company met the test for risk distributionbecause a loss by the insurance company would not

affect the balance sheet of the separate insured.);Kidde Industries Inc., 81 AfTr2d 98-326 (fed. Cl. Ct.,1997) (involving the same reasoning for a broad basedconglomerate with 100 subsidiaries that requiredproducts liability coverage during a products liabilityinsurance crisis in the 1970s).

11 rev. rul. 77-316 was declared obsolete by rev. rul.2001-31, 2001-1 C.b. 1348.

12 Humana Inc. supra note 7; Kidde, supra note 10; Hosp.Corp. of Am., supra note 10. The courts finally acceptedtaxpayers’ argument articulated in Moline PropertiesInc., 319 u.S. 436, 30 AfTr 1291 (1943) that a corpora-tion will be considered a taxable entity separate fromits owner so long as it has a valid business purpose.

13 rev. rul. 2001-31, 2001-1 Cb 1348.

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a safe-harbor test for the brother-sis-ter arrangement.14 Under the safe-har-bor, risk shifting and risk distributionare present when the micro-captiveinsures at least 12 other sister sub-sidiaries with no one insured repre-senting less than 5% or more than15% of the total insured risk.15 (See Ex-hibit 2 for an illustration of thebrother-sister arrangement.)

Even if risk shifting and risk distri-bution are met, courts have added athird element requiring that an insur-ance arrangement must have “com-monly accepted notions of insurance.”

In addressing this last requirement,courts have examined whether the insurance company was properly or-ganized, whether it respected corpo-rate formalities, whether it was ade-quately capitalized, whether it wasregulated by state law, and whetherpolicies and premiums are marketcomparable.16

Taxation of Insurance Companies.Every non-life insurance company issubject to federal income taxation un-der Subchapter L of the Code (Part II,Sections 831 through 835), and willbe treated as a corporation for entityclassification purposes, regardless ofthe actual type of entity it is.17 Insur-ance companies are subject to incometax like every other corporation, butwith certain statutory modifications.

The taxable income of an insurancecompany is its gross income (definedunder Section 832(b)(1)) less deduc-tions (defined under Section 832(c)).The most significant modification isthe permissible deduction for losses“incurred but not reported,” often re-ferred to as IBNR. This is an actuarialcalculation that permits an insurancecompany to deduct the present valueof its estimated reserves, or futureamounts set aside to pay claims.

Micro-captives, on the otherhand, are not taxed based on thegeneral rules applicable to insurance

companies; instead, they are taxedunder the alternative treatment af-forded to small insurance companiesunder Section 831(b). Under this sec-tion, an insurance company that re-ceives less than $2.2 million18 a yearin net premiums can elect to be taxedon its net investment income only,with a complete exclusion for thepremiums received.19 This incentivewas put in place by Congress in 1986to encourage the creation of new in-surance companies at a time wheninsurance markets were extremelytight. It is important to note that themicro-captive is still a C corporationand therefore, will be taxed on its in-vestment income.20 In addition, dis-tributions from the micro-captive aretreated either as qualifying dividendsor liquidating distributions, both tax-able to the owner (currently at pref-erential income tax rates). Most sig-

nificant is that the election under Sec-tion 831(b) does not affect the currentdeductibility of the premiums paidby the related insured business. As-suming that a micro-captive is prof-itable, there can be tremendous taxsavings by deferring the premium in-come, as well as the tax arbitrage be-tween the premium deduction at or-dinary income tax rates and thecaptive dividend at preferential in-come tax rates.

For the closely-held businessowner who has multiple lines of busi-nesses with a sufficient amount of in-

surable risk and insurance premiumspossibly in excess of the Section831(b) limit, use of multiple micro-captives may provide a solution. It ispossible for a closely-held businessowner to create two or more captivesto cover the risks of its affiliated busi-nesses. In such cases, careful attentionshould be given to the controlledgroup rules under Section 1563(a),which are made applicable to micro-captives by Section 831(b)(2)(B). Theserules are designed to prevent closely-held business owners from gamingthe system and claiming multiple ex-clusions under Section 831(b)(2).21 Toforeclose this abuse, the Code appliesvarious attribution rules to limitclosely-held business owners to oneexclusion under Section 831(b).Notwithstanding these limitations, itis still possible to create multiple mi-cro-captives if there are a sufficient

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An alternative to risk pooling is the “brother-sister”arrangement whereby a micro-captive insures only therisks of its sister companies, that is, companies owned bythe common parent of the captive.

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14 rev. rul. 2002-90, 2002-2 Cb 985 (The IrS deter-mined risk distribution was present where an insur-ance company was formed to insure the professionalliability risks of 12 sister companies owned by its com-mon parent, such that no one subsidiary was bearingits own loss.).

15 for purposes of the 12-entity rule, single-member llCsare disregarded. See rev. rul. 2005-40, 2005-2 Cb 4.

16 Ocean Drilling & Exploration Co., supra note 8; AmercoInc. supra note 8.

17 Section 7701(a)(3). The entity classification of an in-surance company is not binding for federal income

tax purposes. See reg. 301.7701-1(a)(1). even a non-in-corporated entity will be classified as a corporation ifits predominant business activity is issuing insurancecontracts. rev. rul. 83-132, 1983-2 Cb 270.

18 The limitation under Section 831(b) had previouslybeen $1.2 million from 1986 through the end of 2015.It was increased to $2.2 million by the PATH Act.

19 Section 831(b)(1). 20 In managing the investments of a micro-captive,

thought should be given to investments that producedividends to take advantage of the dividends re-ceived deductions applicable to C corporations. It is

also important to remember that C corporations donot enjoy the benefit of preferential rates on long-term capital gains. The good news is that the exemptpremium income is not an add-back for the alterna-tive minimum income tax.

21 under the attribution rules, a micro-captive is treatedas receiving premiums from all companies that arepart of the same control group. Therefore, if multiplemicro-captives are created by the same persons andeach micro-captive receives $2.2 million of premi-ums, the micro-captives would be deemed to receivetotal dividends in excess of the Section 831(b) limi-tation.

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number of different owners of the mi-cro-captive.22

Although the taxation of insurancecompanies, and specifically micro-cap-tives, is clear from a statutory perspec-tive, the implementation of micro-cap-tives has come under greater scrutinyfrom the IRS in recent years. In fact,micro-captives made news when theywere identified by the IRS on its DirtyDozen tax scam list for 2015.23 Byadding micro-captives to the list of taxscams it is targeting, the IRS has sent amessage that it will seek to invalidatebogus micro-captives and the promot-ers that push them as a tax dodge. Thisdoes not mean that every micro-cap-tive will be invalidated or that there isno room for legitimate micro-captivesestablished for valid business reasons.Rather, the IRS is targeting micro-cap-tives that have been used to push taxdeductible premium dollars into a taxdeferred vehicle with very little eco-nomic substance and a small likeli-hood of ever paying out a claim. Theabusive cases identified by the IRS in-clude micro-captives that overcharge

premiums for policies, or insure risksfor which there will never be a claim.In addition, the IRS is concerned aboutinsufficient underwriting and actuarialsubstantiation, as well as captive man-agers that seem to match premiumpricing with the desired level of tax de-duction sought by the operating busi-ness. The Dirty Dozen list should notpreclude business owners from con-sidering a micro-captive as part of alegitimate risk management structure.However, it is a reminder that a micro-captive, like every business venture,must be engaged in for a true businesspurpose.

PATH ACT CHANGESThe PATH Act had a significant impacton the creation and use of micro-cap-

tive insurance companies. On onehand, it expanded some of the bene-fits afforded to micro-captive insur-ance companies. On the other hand,additional qualification requirementsmade the use of existing and newerstructures more difficult to manage.

The expanded benefits increasedthe Section 831(b) limit from $1.2 mil-lion to $2.2 million for net written pre-miums received in tax years beginningafter 12/31/16. This means that a mi-cro-captive making a Section 831(b)election can receive almost twice asmuch insurance premiums as it didin the past and still maintain its qual-ification to be taxed only on its netinvestment income. This change waslong overdue. The original Section831(b) limitation had not been in-creased since it was first enacted in1986, despite many attempts to in-crease the limit by various membersof Congress over the last ten years.The increased threshold is also in-dexed for inflation starting in 2016.24

Other changes made by the PATHAct affect the qualification require-

ment for Section 831(b) and werepromulgated primarily to addressperceived abuses by some taxpayers.A new “diversification” requirementqualitatively affects the ownershipand risk distribution decisions ofevery micro-captive owner. The di-versification requirement can be sat-isfied through either a “risk diversifi-cation test” or a “relatedness test,”25

each of which requires careful analy-sis and planning.

The risk diversification test is met ifno more than 20% of net written pre-miums to the micro-captive are attrib-utable to any one policyholder.26 Inessence, this increases the risk distri-bution requirement (discussed above)from 50% to 80%. This new require-ment will force micro-captives to takeon additional third-party risk, presum-ably through a risk reinsurance pool.It is not clear whether the Service willlook through a risk reinsurance poolto the underlying insureds to deter-mine who is a policyholder for pur-poses of the risk diversification test. TheService has looked though risk rein-surance pool arrangements in the pastto analyze whether risk distributionexisted.27 If the IRS were to lookthrough a risk reinsurance pool, no in-sured in the pool could pay premiumsin excess of 20% of the total premiums.In addition, for purposes of determin-ing the identity of the payors of pre-miums, the new law attributes premi-ums to all policy holders who are

related or are members of the samecontrolled group.28 To the extent a con-cern exists that one or more insuredsmay pay greater than 20% of the totalpremiums of the risk pool, the micro-captive may have to participate inmultiple risk reinsurance pools, eachwith different participating insuredbusinesses. Alternatively, the risk poolcould limit premium payments by all

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Micro-captives are not taxed based on the general rulesapplicable to insurance companies; instead, they are taxedunder the alternative treatment afforded to small insurancecompanies under Section 831(b).

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22 This may be less of a planning concern given the in-crease in the Section 831(b) exclusion. Practicallyspeaking, if a business can write insurance premiumsof $2.2 million, it must have significant risks and mostlikely will have a substantial business enterprise. Inthe author’s personal experience with businesses writ-ing premiums in excess of the historical Section 831(b)limit, the operating businesses have been in industrieswith significant justifiable risks (e.g., manufacturing,construction, and transportation) and had significantoperations generating gross revenues in the multiplehundreds of millions of dollars.

23 Ir-2015-19, 2/3/15.

24 The Section 831(b) limit increases in increments of$50,000 with a base year of 2013 for calculating in-flation adjustments.

25 The names of these tests are not identified as suchin the statute. These are the monikers identifyingthem in the Technical explanation of the PATH Actpublished by the Joint Committee of Taxation.

26 Section 831(b)(2)(b)(i)(I). 27 rev. rul. 2009-26, 2009-38 Irb 366. 28 Section 831(b)(2)(C)(i)(II). (for this purpose, “related” is

defined by reference to Sections 267(b), 707(b), and1563).

NOTES

participants to 20% of total premiums.It will be incumbent on the closely-heldbusiness owner to discuss the risk rein-surance pool arrangement with thecaptive insurance company managerthat runs the risk pool to assess the im-pact upon the risk diversification test.More significant is that a micro-captivethat previously achieved risk distribu-tion without use of a risk reinsurancepool, that is, through a brother-sisterarrangement, cannot meet the risk di-versification test because there is nothird-party risk in that structure. Theseowners will be forced to satisfy the re-latedness test.

The relatedness test requires theownership of the micro-captive tomirror the ownership of the insuredbusiness, except for a de minimis dif-ference of no more than 2%.29 The testmust be satisfied whenever the ownersof the micro-captive are the spouse orlineal descendants of the owners of theinsured business. This test was de-signed to prevent a perceived estate

planning abuse whereby a taxpayerwould make a relatively small up-front gift to form the micro-captivethat was owned by the next genera-tion and then transfer millions of dollars of income tax deductible pre-miums into the micro-captive. (SeeExhibit 3 for typical estate placingstructure.) Thus, if the micro-captiveis owned 100% by junior generationfamily members, these family mem-bers must also own at least 98% of theinsured business. If the micro-captiveis owned 100% by senior generationfamily members, the ownership of theinsured business is irrelevant for pur-poses of the relatedness test becausethe statute requires matching owner-ship whenever the junior generationowns the micro-captive. In addition,if the micro-captive is owned by col-lateral relatives of the owner of the in-sured business (e.g., siblings, nephews),the relatedness test will not have to bemet. The relatedness test may be pre-ferable for a business owner who doesnot want additional third-party expo-sure presented by the risk diversifica-tion test.

The statute has left some unre-solved issues with the relatedness test.For instance, the statute requires own-ership of the micro-captive to mirrorthe ownership of the “specified assets”of the insured.30 These are defined asthe assets of the insured business fromwhich premiums are paid. It is notclear, however, how the ownershippercentages of the insured businessare to be calculated. By way of exam-ple, if a child owns 25% of a micro-captive that is receiving premiumsfrom three different insured busi-nesses, does the child also have toown 25% of each insured business? Isit sufficient for the child to own 25%of the aggregate assets of all three in-sured businesses? For instance, if thechild owns 90% of business 1 and25% of businesses 2 and 3, but thevalue of the assets of business 1 rep-resents 25% or more of the value ofthe assets of all three businesses. It isnot clear that this ownership wouldsatisfy the test.

In addition, the statute determinesownership of the micro-captive andthe insured business both directly and

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Typical Estate Planning Structure

EXHIBIT 3

29 Section 831(b)(2)(b)(i)(I). 30 See supra note 21.

NOTES

indirectly through attribution appliedto trusts, estates, partnerships, and cor-porations. However, there is no guid-ance on how to apply the attributionrules to determine indirect ownership.For instance, are grantor trusts disre-garded for this purpose so that thegrantor is the deemed owner? Thatmakes sense because this is an incometax statute, but the result would nullifythe relatedness test. Are partners ofpartnerships counted by capital orprofits interests? For clarification, theIRS could issue regulations incorpo-rating the attribution rules of Section1563 (the controlled group rules) be-cause these rules are currently used todetermine both ownership under the

risk diversification test and the totalamount of premiums received by amicro-captive for purposes of the Sec-tion 831(b) limit. Taxpayers will haveto await further guidance for answersto these questions.

IMPACT ON EXISTINGARRANGEMENTSThe PATH Act does not change thecommon law elements of risk shiftingand risk distribution necessary for avalid insurance arrangement. How-ever, its new requirements create asecond layer of qualification underSection 831(b) for micro-captives.While the new requirements certainlyaffect the planning of any new micro-captive, they have a greater impact onexisting micro-captives that wereformed and operated prior to the newlaw.

Unfortunately, the PATH Act doesnot grandfather existing micro-captiveownership structures for purposes ofthe relatedness test. So a micro-captivethat has been operating for severalyears and which was incorporated

into a business owner’s estate plan-ning could be in violation of the re-latedness test as of 2017. For example,if a business owner used a trust toown 100% of the micro-captive, butretained ownership of the insuredbusiness, the business owner wouldfail the relatedness test. Because thePATH Act did not exempt preexistingownership structures from the relat-edness test, the business owner mayhave to modify or unwind some orall of the previous estate planning. Thereallocation of ownership interests re-quires careful consideration of the taxconsequences, valuation issues, andalso limitations imposed by existinglegal structures.

Consider the following conse-quences for a business owner whosemicro-captive is owned 100% by atrust for the benefit of the businessowner’s spouse and descendants. Thetrustee can make distributions of themicro-captive shares only to a bene-ficiary of the trust. Since the businessowner’s spouse is a beneficiary of thetrust, the trustee could distribute themicro-captive’s shares to the spouse-beneficiary, who could in turn makea gift-tax-free transfer to the businessowner. Although this series of transfersis without gift tax consequences, itdoes add a significant asset to the busi-ness owner’s estate.31 If the businessowner’s spouse were not a beneficiaryof the trust and a similar strategy wereused with a descendant-beneficiary ofthe business owner, the ultimate trans-fer to the business owner would be ataxable gift. Gift tax will be payable if

the value of the shares exceeds thebeneficiary’s available gift tax exemp-tion. It may be possible to have a de-scendant-beneficiary appoint the mi-cro-captive shares to the businessowner (or to the business owner’sspouse) through the exercise of abroad limited power of appointment.Such exercise is generally not a taxablegift, provided the beneficiary does nothave a fixed income interest in thetrust and the trustee has full discretionover the trust income and principalrather than discretion based on an as-certainable standard.32

Both of the described distributionsreallocate micro-captive shares to thebusiness owner to solve the related-

ness test, but at a significant estate taxcost. The shares of the micro-captiveare also likely to be worth a lot morethan when the micro-captive was firstestablished and should continue toincrease in value over time. The trust,however, would be left with very littlevalue after the transfer. The estate taxcost could be mitigated in part byhaving the business owner purchasethe micro-captive shares from thetrust at fair market value. Althoughthe trust and the business owner willexchange equivalent value, an estateplanning opportunity will still be lostif the growth in the assets of the trustunderperforms the growth on theshares of the micro-captive in thebusiness owner’s estate. For incometax purposes, if the trust is a grantortrust, this transfer would be incometax free.33 If the trust is not a grantortrust, the transfer would result in an

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The PATH Act does not change the common law elements ofrisk shifting and risk distribution necessary for a validinsurance arrangement. However, its new requirementscreate a second layer of qualification under Section 831(b)for micro-captives.

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31 Query: Would the trustee be in breach of his or her fi-duciary duty to the beneficiaries of the trust if thetrustee knowingly participates in a plan to move own-ership of the micro-captive shares to the grantor?

32 If the trust does not grant a beneficiary a broad limitedpower of appointment, it may be possible to decant

the trust (distributing assets from an old trust to anew trust with more favorable terms) to grant such apower.

33 If the grantor trust has a grantor trust substitutionpower under Section 675(4)(C), a swap of assets isthe likely scenario.

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immediate gain on sale to the trustbecause the current value of the mi-cro-captive shares is likely to be sig-nificantly greater than its cost basis.An alternative strategy may be to liq-uidate the micro-captive and form anew micro-captive with permissibleownership under the new legislation.This may be more costly from an in-come tax perspective than the sale bya non-grantor trust because of thedouble-tier tax system for C corpo-rations. Obviously one has to con-sider the built in gains on assets aswell as state level tax consequences ofeach of these options.

Whatever strategy is used to trans-fer the micro-captive shares to thebusiness owner, a fair market valueappraisal of the micro-captive is re-quired. Once operational, the micro-captive will have millions of dollarsin surplus and reserves, not to men-tion enterprise value for the profits asan ongoing business. A businessowner would be well served by hiringa competent appraiser to determinethe value of the micro-captive sharesso as to avoid additional gift tax con-cerns if the transaction is later deter-mined by the IRS to have been forless than fair market value.

Of course, if a business owner doesnot want to unwind the existing own-ership structure of the micro-captive,but still wants to satisfy the relatednesstest, he or she could make a gift of hisor her interest in the insured businessto the trust or other owners of the mi-cro-captive. Apart from the obviousgift tax cost, if the business owner haspreviously given away 100% of themicro-captive, he or she may not bewilling to also part with 100% of thebusiness. It may be possible for thebusiness owner to part with the busi-ness without making a gift and withthe ability to direct the ultimate dis-position of the business if he or shegifts the business interest to a trust ina transfer that is an incomplete gift for

federal gift tax purposes. The businessowner would retain lifetime and tes-tamentary powers of appointmentover the trust to make the transfer in-complete for gift tax purposes. Thebeneficiaries of the trust would be thesame individuals who own the micro-captive. For income tax purposes, thetrust could be designed to be a non-grantor trust. Assuming application ofthe same attribution rules used to de-termine controlled group status (seefootnote 21), the assets of the trustwould be attributed to the beneficiar-ies of the trust and relatedness testcould be satisfied. Unfortunately, theIRS has not issued regulations that ad-dress how attribution will be appliedthrough trusts.

If the foregoing restructurings arenot feasible or otherwise acceptable tothe business owner, he or she couldforego the relatedness test in favor ofthe risk diversification test. As dis-cussed earlier, this test basically in-creases the risk distribution require-ment of the micro-captive from 50%to 80%. Thus, instead of unwindingthe existing ownership of the micro-captive, the micro-captive has to as-sume additional third-party risk. Thismeans increasing the micro-captive’sparticipation in a risk reinsurance pooland putting more of its assets at risk.This is an economic and risk manage-ment decision that will be informed inpart by the historical claims made inthe risk reinsurance pool used by themicro-captive. If the risk reinsurancepool has low recurring losses (as apercentage of premiums received), theanticipated economic losses sustainedmay be less than the estate tax im-posed by undoing the prior owner-ship structure. Based on a current es-tate tax rate of 40% (federal only), atypical risk reinsurance pool shouldbe a safer bet. As discussed above, thisalso assumes that no one insured inthe risk pool has written more than20% of the total premiums; otherwise,

the micro-captive may have to partic-ipate in multiple risk pools.

Notwithstanding the foregoing, abusiness owner who has imple-mented a brother-sister arrangementto satisfy risk distribution may find itmore difficult to satisfy the new riskdiversification test if he or she has alsodone significant estate planning. Al-though technically no third-party riskis required to achieve common lawrisk distribution in the brother-sisterarrangement, such arrangement failsthe risk diversification test under thePATH Act. A business owner who hasused a brother-sister arrangement toachieve risk distribution must eithersatisfy the relatedness test by possiblyunwinding existing estate planningarrangements, or forego the brother-sister arrangement and convert to arisk reinsurance pool to satisfy riskdistribution as well as the risk diver-sification test.

CONCLUSIONSimilar to many federal tax statutesaimed at curbing perceived abuses,the government giveth and the gov-ernment taketh away. The increasedSection 831(b) exclusion was a wel-come and much-needed change, butthe additional diversification require-ments have made planning with mi-cro-captives more difficult to navigate.Owners of new micro-captives willhave to deal with more stringent re-quirement for qualification under Sec-tion 831(b), but they will still have aneasier path than the owners of exist-ing micro-captives. The lack of grand-fathering for existing ownership andrisk reinsurance pool structures willrequire a lot of work by most micro-captive owners and their captive in-surance advisers. Unless further guid-ance is issued soon, owners of existingmicro-captives will have to make dif-ficult decisions to restructure theirarrangements. l

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