On March 28, 2022, President Biden sent his $5.8 trillion fiscal year 2023 (FY23) budget to Congress. Within the President’s budget are several proposed changes to the taxation of insurance companies.
Untaxed Income Account Regime for Certain Small Insurance Companies
Currently, under section 831(b) of the Internal Revenue Code (IRC) certain small non-life insurance companies may elect to be taxed under an alternative tax regime. Under the alternative tax regime, electing small insurance companies are taxed only on their taxable investment income (interest, dividends, capital gains, rents, royalties, certain non-insurance trade or business income, and similar items less, capital losses, the dividends received deduction, and certain allocable investment expenses). The election is irrevocable without the consent of the Secretary.
To qualify for the election, a non-life insurance company, along with any members of the same controlled group, cannot exceed the prescribed threshold of net written premiums (or, if greater, direct written premiums) for that taxable year. For tax years beginning after December 31, 2021, that limitation is $2.45 million and is indexed annually for inflation.
In addition to a limitation on the amount of premium income, insurance companies must also meet one of two ownership diversification requirements. The first requirement can be met if no more than 20% of its net written premium is attributable to any one policyholder. If the first diversification requirement is not met, the second requires that no person holding, directly or indirectly, an interest in the insurance company has a greater percentage interest in the insurance company than he or she has in the business or assets being insured.
Under the proposal, an electing insurance company that fails to meet the first diversification requirement, discussed above, would be considered a covered insurance company, and would be required to establish an Untaxed Income Account (UIA). As the name would suggest, this account would track the income (or loss) of the company that is sheltered by the section 831(b) election. Shareholder distributions, share repurchases, and any payments that are not ordinary and necessary costs incurred for the conduct of an insurance business would be deemed an unadjusted net distribution and would be subject to the highest corporate marginal tax rate (proposed to be 28%) and a penalty tax rate of 10%. The deemed unadjusted net distribution would be limited to positive UIAs and the resulting tax would be added to the corporation’s regular tax as calculated under section 831(b).
The Biden Administration has indicated in their general explanations to the FY23 budget that the proposed changes under section 831(b) are meant to target what are deemed to be micro-captive transactions which have received the attention in the press and Tax Court recently. See, for example, Avrahami v. Commissioner, 149 T.C. 144 (2017); Caylor Land & Development, Inc. v. Commissioner, T.C. Memo. 2021-30 (2021) (accuracy related penalty also sustained); and Syzygy Ins. Co. v. Commissioner, T.C. Memo 2019-34 (2019) (company also required to recognize the premiums it received as income). The proposed changes will create additional burdens for micro-captive companies while potentially also increasing tax liabilities, possibly significantly.
Policy Acquisition Costs
Section 848 requires insurance companies to capitalize, as policy acquisition expenses, a portion of their general deductions otherwise allowed. These capitalized amounts are generally amortized over 180 months. Capitalized policy acquisition costs are generally equal to a percentage of an insurer’s net premiums on specified contracts. Under the Tax Cuts and Jobs Act (TCJA) the specified capitalization percentages were increased from 1.75% to 2.09% on annuity contracts, 2.05% to 2.45% on group life insurance contracts, and 7.70% to 9.20% for other life insurance or noncancellable accident and health insurance contract. However, a statutory drafting error misidentified the appropriate language, so that only the percentage for annuity contracts could be implemented logically. This error could result in a reasonable reading of the law that could claim only the percentage for annuity contracts was changed by the TCJA, despite the intent of Congress to change the capitalization percent for all specified contracts.
The proposal would correct the statutory drafting error to remove this potential ambiguity and would be effective as if it had been part of the original TCJA.
Discounting of Unpaid Losses
Section 846 requires insurance companies to discount their unpaid loss reserves on contracts that may not be paid for several years. Certain lines of business are considered “short-tail” and have relatively small discount factors applied to those reserves. Other lines have longer payout patterns and are considered “long-tail,” resulting in much deeper discounts. Due to a drafting error within the TCJA, nonproportional reinsurance and international lines of business were inadvertently reclassified from long-tail lines, consistent with accounting rules promulgated by the National Association of Insurance Commissioners, to short-tail lines of business resulting in smaller discounts applied even though the payout pattern of these lines might be many years.
The proposal would correct this statutory drafting error to explicitly identify nonproportional reinsurance and international lines of business as long-tail. The proposal would be effective for tax years beginning after December 31, 2022, with new loss payment patterns determined as if they were promulgated for the 2022 determination year.
The proposed budget still needs to make its way through congress before its enacted and as we all know, the final may look very different. Our intent is to keep you informed of various measures that could have a significant impact on your business. If you have questions regarding the proposed changes, reach out to your MarksNelson advisor in insurance.
