Jan. 18, 2016
By Joe Magyar and Kevin Gilbreath
On Dec. 18, 2015, tax extender legislation under the Protecting Americans From Tax Hikes Act of 2015 (PATH) was signed into law. One provision of the act, which is effective for tax years beginning after Dec. 31, 2016, raises the current Internal Revenue Code Section 831(b) annual premium limit from $1.2 million to $2.2 million with inflation adjustments.
The provisions of Section 831(b) most frequently are used by dealers in certain finance and insurance (F&I) arrangements that allow participation in the underwriting profit on products such as service contracts. The structure of these arrangements can take many forms, though the most common are arrangements referred to as controlled foreign corporations (CFCs). In this context, a CFC is a reinsurance entity formed in a foreign jurisdiction by a dealer in order to minimize regulatory and compliance costs and that elects to be taxed as a domestic corporation for federal income tax purposes. Under Section 831(b), the CFC can elect to be taxed only on the investment income from the company, thereby exempting the underwriting profits from current taxation. The CFC owners receive their cash as dividends or liquidating proceeds, which then are taxed at favorable capital gains tax rates. The advantage of the new legislation is that beginning in 2017 a dealer will be able to reinsure an additional $1 million of service contracts or other qualified F&I products into a CFC under this preferential tax regime. This change may expand the availability of this structure to more dealers or make existing CFCs and other F&I entities using Section 831(b) more beneficial to dealers.
The Section 831(b) provisions also are used by some dealers who have established enterprise risk management captive insurance companies to provide related-party insurance coverage for risks of the dealership and related business that otherwise are not covered by commercial insurance.
The legislation also adds a new diversification requirement for Section 831(b) captives. The new requirement is designed to prevent a captive from being used as an estate planning tool. A number of ambiguous provisions in the law could be problematic to all captives depending on guidance that has yet to be issued by those who drafted the legislation or by the U.S. Department of the Treasury. Updates will be provided as guidance becomes available.
Dealers with an F&I captive using Section 831(b) should stay on top of additional information as it becomes available. Dealers who form a captive to cover the risks of the dealership and related business should review their structure now with their tax adviser to make sure they comply with the diversification requirement.