In general, Code Section 831a provides for the taxation of insurance companies to follow normal “C” corporation rules, with certain significant exceptions. These normal rules start with insurance premium earned plus investment income, less the losses incurred and other expenses.
One significant exception is a portion of unearned premium and certain loss expenses may be deferred until future years. A reserve is often held which reduces current year tax liability by an estimated amount of losses to be paid sometime in future years.
Under Code Section 831b there is an election for small insurance companies to change the way they calculate their taxable income. This election simplifies the calculation of taxable income and is only available for companies that receive annual premium of $1.2 million or less.
This 831b election is a tax accounting change; it does not change the captive’s status as an insurance company. With this election, a captive insurance company will not be taxed on its premium income, nor does it take a deduction for insurance losses. However, such electing company will only pay tax on investment income, less certain deductions. One of the trade-offs from making this election is that a company is not allowed to deduct insurance losses against investment income. The net result is that a captive may pay more income tax with an 831b election, than if it had opted for the default 831a treatment.
The effect of electing to be taxed as a small insurance company may be likened unto the change that a corporation goes through when electing “S“ corporation status. By default, a corporation is taxed as a “C“ corporation. However, certain corporations that have a small number of domestic shareholders may choose to make a special tax election to be an “S“ Corporation, which allows it to follow different tax accounting rules. The same general idea applies to an insurance company making the 831b election.
If you are considering a captive, please consult your own tax advisor as the 831b election may have certain advantages and disadvantages over the default 831a tax treatment.