The Ultimate Guide to 831(b) Plans
In today’s unpredictable global economy, alternative solutions to protect assets, mitigate risks, and ensure financial wherewithal have grown increasingly important. As business interruption claims were denied by insurance carriers throughout the COVID-19 pandemic, business owners recognized the need for elevated safeguards.
Therein lies the value of 831(b) plans. First introduced in 1986 under section 831(b) of the Internal Revenue Code, these plans empower businesses to set aside tax-deferred funds through the formation of a captive insurance program. In turn, these resources can help protect against both underinsured and uninsured risks.
Although advantageous, 831(b) plans are oftentimes misunderstood by business owners. As a result, an expert plan administrator is essential to compliantly navigate the complexities of these alternative risk financing tools. Without the proper structure and procedures, these plans could be classified as abusive by the IRS, leading to severe penalties.
To demystify 831(b) plans for eligible business owners, our team at SRA 831(b) Admin has outlined the need-to-know in the following guide. In practice, these principles can lead operating businesses toward greater risk mitigation than what’s possible from traditional insurance carriers alone. Best said by Van Carlson during an interview on the Dental Clinical Companion Podcast, “there is no policy out there that covers it all.” In turn, the value of a custom-tailored 831(b) plan cannot be understated.
What Are 831(b) Plans?
On a fundamental level, 831(b) plans are insurance companies owned by the entities they insure. For example, a property management company may face a multitude of unique risks not covered by traditional insurance. These could range from tenant behaviors to certain environmental hazards. As a result, self-insuring against these risks by forming a micro captive company can help weather tomorrow’s storms by creating a “tax-deferred war chest.”
In our example, the property management company can secure tailored coverage to mitigate financial losses from business interruptions. This is because the captive insurer is aligned more closely with the specific needs of the operating business. As with traditional insurance, the operating business would pay tax-deductible premiums. During years with low losses, the captive insurer can accumulate reserves to serve as a buffer when needed.
Given the modern threats of “cyber insurance exclusions, pandemic losses, supply chain disruptions, and bank collapses,” an 831(b) plan offers alternative protections that fill in the gaps of traditional insurance. From there, businesses can manage risks with greater flexibility while better preparing for the rapidly evolving risk landscape.
How Are 831(b) Plans Taxed?
Similar to how a 401(k) allows for tax-deferred retirement savings, an 831(b) plan allows for tax-deferred self-insurance against certain risks. Contrary to popular belief, however, there’s a substantial difference between “tax-deferred” and “tax-free” contributions. These terms are not equivalent. While underwriting profits are not taxed on an 831(b) plan, investment income is.
Additionally, per the IRS, annual premium contributions cannot exceed $2.65M as of 2023, a $200K increase from inflation from the 2022 limit. These are published in the IRS Revenue Procedure outlining tax on insurance companies.
Any investment income or realized gains from the plan reserves are taxed at the C-Corp rate. Meanwhile, “dividend distributions taken by shareholders” are subject to individual tax. Here, the qualified dividend rate is applied.
Which Rules and Regulations Must an 831(b) Plan Uphold?
When it comes to 831(b) plans, compliance is essential. When 401(k) plans were first introduced, participants underwent heavy IRS scrutiny. After years of tax court cases, clarifying tax code amendments, and IRS safe harbor rulings, however, clear 401(k) guidelines have been established. The same is true for 831(b) plans, which is why we recommend our four-part test.
Risk Transfer - there must be a clear contractual transfer of risk from the operating business to the third-party insurer in exchange for a premium.
Risk Distribution - the 831(b) must distribute risk according to the law of large numbers, thereby minimizing the likelihood of a single claim exceeding the total premiums collected.
Fortuitous Risk - the contractually transferred risks must be fortuitous in nature (i.e. unforeseen and unexpected), as opposed to ordinary business risks.
Insurance Principles - the 831(b) plan must operate as an ordinary for-profit insurance company, meaning that they contractually transfer risk, use the law of large numbers, leverage a clear method to determine premiums as well as a standardized claims process, and generate investment income by managing reserves.
Understanding how premium reserves are held is key for transparency and compliance. To stay in accordance with the principles of insurance, these investments would likely include bonds and equities while maintaining a high level of liquidity. Given increased IRS scrutiny, 831(b) plans must maintain strict adherence to these guidelines while avoiding any practices that could be labeled as abusive. In general, the tax benefits should come secondary to risk mitigation.
In the words of Van Carlson during an interview on the Insurance Nerds Podcast, “we are 30 years down the road and have a good pathway (for businesses) to own an insurance company. Case law has also given a roadmap to stay compliant. Many clients initially want the tax advantages then realize the broader benefits over time.”
Additional rules specify that a micro captive cannot be a life insurance company. This is because the tax benefits under section 831(b) are designed specifically for non-life insurance companies.
Key Benefits of 831(b) Plans
When set up and managed correctly, an 831(b) plan can offer a wealth of benefits for businesses. Previously only available to large Fortune 500 enterprises, these plans have become more accessible to small businesses and entrepreneurs in recent years. They allow businesses to take a proactive approach to managing their unique risks while offering a level of control and customization not found with one-size-fits-all insurance plans.
For tailored coverage, 831(b) plans allow businesses to protect against underinsured or uninsured vulnerabilities, such as certain types of cyberattacks. Another example could include a subcontractor defaulting on their work. This is particularly valuable for businesses that face non-traditional risks that standard insurance companies overlook.
In terms of financial efficiency, 831(b) plans can provide coverage at a lower cost than traditional insurance, especially for businesses with a favorable loss history. At the same time, businesses should ask their captive manager how they price their premiums as one of the ten standard questions we recommend asking. Here, the third-party underwriter should ensure that the premiums are reasonable, do not exceed those of commercial insurers with similar coverage, and maintain a set schedule. From there, operating businesses can stabilize their insurance costs based on their own loss history as opposed to industry-wide factors.
Under Section 831(b) of the IRC, these plans may exclude premium income from their taxable income, lending way to significant tax savings.
Beyond these, 831(b) plans also offer strategic benefits in the form of risk management by allowing businesses to identify, assess, and address their risks systematically. These plans can also have direct access to reinsurance markets for even greater cost-effectiveness. This is when “multiple insurance companies share risk by purchasing insurance policies from other insurers to limit their own total loss in case of disaster.”
Furthermore, an 831(b) plan’s underwriting profit can generate additional income through investment activity. These investments utilize the premium income after deducting any claims and operating costs. As a summary of these advantages, 831(b) plans lend themselves to:
Tailored risk coverage
Financial efficiency
Cost stabilization
Significant tax benefits
Improved risk management
Reinsurance access
Additional income
Potential Drawbacks of 831(b) Plans
While 831(b) plans can provide significant benefits, they also include potential drawbacks that must be taken into consideration. These include:
Regulatory Scrutiny - 831(b) plans are subject to greater scrutiny than businesses utilizing traditional insurance, particularly from the IRS. This is due to concerns about potential misuse of the 831(b) tax benefits. As a result, choosing a reputable plan administrator with a keen eye for compliance is essential.
Tax Risks - as a byproduct of the additional regulatory scrutiny, certain 831(b)-related transactions have been designated as transactions of interest by the IRS after 10 years. These apply to situations that could be considered tax avoidance or evasion. As is the case with regulatory scrutiny, an experienced plan administrator can help keep your business in compliance.
Complexity - operating a captive insurance program requires expertise in insurance, tax law, and business management, adding an extra layer of complexity to a business operation. This further necessitates the experience of a plan administrator.
Eligibility Requirements for 831(b) Plans
When contemplating an 831(b) plan, understanding the eligibility requirements is paramount. These requirements are dictated by Section 831(b) of the IRC. Unsure if your business is eligible for an 831(b)? Here is a summary of the eligibility requirements.
Type of Insurance Provided - as previously mentioned, to qualify for the benefits of an 831(b) plan, a company must provide property and casualty insurance as opposed to life insurance. In keeping with our four-part test, the risks insured should be fortuitous in nature while meeting the criteria of insurance risk, risk transfer, and risk distribution.
Gross Premium Income - to be eligible for the tax benefits under Section 831(b), the insurance company must have an annual gross premium income of no more than $2.65M, which does not include premiums ceded to a reinsurer.
Ownership Structure - the ownership structure of the captive insurance company should not lead to a concentration of benefits in which the owners of the insured operating business and the captive insurance company are not closely aligned. In turn, careful planning for the ownership structure through a meticulous plan administrator is crucial.
Compliance with Insurance Regulations - the captive insurance company must comply with the insurance regulations in its jurisdiction of domicile, as 831(b) plans are subject to U.S. state regulations, including capital and solvency requirements, corporate governance standards, and financial reporting obligations.
Operating in Good Faith - a key element for eligibility is that the captive insurance company must be operating in good faith as an insurance company. This means that the captive is set up and managed for genuine risk management purposes, not merely to achieve tax benefits.
While an 831(b) can be beneficial for many businesses, it is not suitable for everyone. Likewise, these plans may be better suited for certain industries. Here’s one such example from Clay Ogden during an interview on The Massive Passive Cashflow Podcast. “The industry that has used these programs the most and done so efficiently is the auto industry… we are making this available to various types of risks faced by small to mid-market businesses.”
This highlights the flexibility and adaptability of 831(b) plans, showing how they can be effectively used across various industries to address high-risk exposure.
Getting Started with SRA 831(b) Admin
The journey to establish an 831(b) plan can be daunting due to its complexity as well as the regulatory scrutiny it attracts. By partnering with a seasoned plan administrator, you can enjoy the peace of mind that comes with experience.
That’s where our seasoned team at SRA 831(b) Admin can help. We bring extensive industry knowledge and experience to the table through a vetted process that takes the intricacies of 831(b) plans into consideration. Along the way, we walk hand-in-hand with small to mid-market business owners as we navigate potential challenges, make informed decisions, and build a robust risk management strategy into your plan.
Meanwhile, we are committed to ensuring that your 831(b) plan is compliant with all IRS regulations, mitigating potential tax risks and the high penalties of non-compliance. Moreover, we understand the importance of maintaining liquidity with standard investments that align with the principles of insurance. Additionally, we keep you abreast with evolving regulatory landscape, including the most recent proposed rules affecting captive insurance programs.
In closing, setting up and managing an 831(b) plan can be a complex endeavor, but with the right support, it becomes a manageable and beneficial aspect of your business strategy. By partnering with our SRA 831(b) Admin team, you can accelerate the path toward your risk management goals. For interested small to mid-market businesses, we invite you to get in touch via our contact page to start the process. Thank you for reading.
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