SMALL COMPANY TAX INFLATION ADJUSTMENT ACT

THE ISSUE IS… Preserving the tax-exempt status of small, mutual insurance companies.

IT'S IMPORTANT BECAUSE… Since 1921, small insurance companies have been exempt from paying federal taxes. The rationale behind this exemption was so that all available financial resources of the companies could be used solely for paying claims.

Under the current Internal Revenue Code (Section 501(c)(15)), a property/casualty insurance company with up to $350,000 in direct or net written premium, whichever is greater, is tax-exempt. In addition, Section 831(b)(2) allows companies with direct or net written premiums, whichever is greater, exceeding $350,000 but not exceeding $1,200,000 to elect to be taxed on their net investment income.

However, the tax-exempt level and the investment income election levels have not been increased since the Code was amended in 1986. For instance, what was once $350,000 in 1986 is now $575,000, and what was once $1.2 million is now $1.971 million. Thus, while a company’s annual costs have increased over the years with inflation, the tax-exempt and investment income election levels have not.

On March 27, 2003, Senators Christopher Bond (R-MO) and Tim Johnson (D-SD) introduced S. 735, the “Small Insurance Company Inflation Adjustment Act,” which would raise the threshold for tax exemption from $350,000 to $575,000, and the upper limit for election of tax basis from $1.2 million to $1.971 million. On April 1, 2003, Congressman Jim Nussle (R-IA) and five other Representatives introduced an identical version of this legislation known as H.R. 1530. Both bills provide for inflationary indexing of both levels.

However, concerns were raised that the exemption provided under 501(c)(15) have been used to improperly shelter investment income from federal income tax. Tax shelter promoters have marketed schemes to help taxpayers organize insurance companies that maintain premiums below $350,000 per year, but have investment income far in excess of that.

In an effort to address the loophole exploited by the tax shelter promoters, the Senate Finance Committee marked up S. 1637, the JOBS bill, on October 1, 2003. Included in the bill was the small company tax provision, which extends the tax-exemption to property/casualty insurance companies with gross receipts under $600,000 (if the premiums received are greater than 50% of its gross receipts).

The House Ways and Means Committee also addressed this issue in H.R. 2896, the American Jobs Creation Act. It mirrors the Senate language, except it also increases the 831(b)(2) limit to $1.89 million, to be indexed annually by the cost-of-living adjustment.

On April 10, President George W. Bush signed into law H.R. 3108, the Pension Funding Equity Act of 2004, which NAMIC was able to preserve the small p/c insurance company tax exemption. The provision modifies the section 501(c)(15) by requiring that a small property/casualty insurance company may be eligible for tax-exempt status if (a) its gross receipts do not exceed $600,000, and (b) the premiums received for the taxable year are greater than 50 percent of its annual gross receipts. This provision was a substantial improvement over the $350,000 gross receipts test proposed by the Bush Administration’s Budget proposal dated February 2, 2004.

An additional provision was added that provides that a small mutual property/casualty insurance company is eligible to be exempt from Federal income tax under Section 501(c)(15) if (a) its gross receipts for the taxable year do not exceed $150,000, and (b) the premiums received for the taxable year are greater than 35 percent of its gross receipts, provided certain requirements are met. Those requirements are that no employee of the company or member of the employee’s family is an employee of another company that is exempt from tax under Section 501(c)(15). The limitation to mutual companies and the limitation on employees were intended to address the concerns about the inappropriate use of tax-exempt companies to shelter investment income from Federal taxes.

The Pension bill also modifies Section 831(b) providing that a property/casualty insurance company may elect to be taxed only on taxable investment income if its net written premiums or direct written premiums (whichever is greater) do not exceed $1.2 million (without regard to whether such premiums exceed $350,000). For purposes of determining the amount of a company’s net written premiums or direct net written premiums under this rule, premiums received by all members of a controlled group of corporations (as defined in section 831(b)) of which the company is a part are taken into account.

May 11, after two previous attempts, the Senate passed the FSC/ETI “JOBS” Bill by an overwhelming 92-5 vote including a provision that further modifies the small property/casualty insurance company tax exemption.

The language included in the managers’ amendment offered by Senate Finance Committee Chairman Charles Grassley (R-Iowa) and Ranking Member Max Baucus (D-Mont.) addressing the small p/c company tax exemption states the following: A property/casualty insurance company is eligible to be exempt from Federal income tax if (a) its gross receipts for the taxable year do not exceed $600,000, and (b) the premiums received for the taxable year are greater than 60 percent of its gross receipts. The proposal also addresses Section 831(b) providing that a p/c insurance company may elect to be taxed only on taxable investment income if its net written premiums or direct written premiums (whichever is greater) do not exceed $1.89 million (without regard to whether such premiums exceed $350,000). Beginning after year 2004, the $1.89 million shall be indexed for inflation by multiplying the $1.89 million by the cost-of-living adjustment.

This represents a huge improvement from the recently enacted Pension legislation (Public Law No. 108-218) that maintained the 831(b)(2) test at $1.2 million with no indexation.

NAMIC POSITION… Any amendment to section 501(c)(15) should allow for the continued exemption for small p/c mutual insurance companies that have always been the intended beneficiaries of that provision. This exemption should also apply to those same mutuals that operate in a single state. The exemption limit should be annually indexed for inflation. Similarly, the limit to allow p/c insurance companies with $1.2 million or less in premium income to make the election under section 831(b) to be taxed on investment income should be increased to $1.89 million, and indexed annually for inflation.

Small mutual property/casualty insurance companies serve an important niche market in America, and with such limited financial resources, all of their assets must be preserved for paying consumers’ claims. Preserving, updating and indexing the small company tax provisions would accomplish that goal.

Posted: Wednesday, April 07, 2004 12:00:00 AM. Modified: Tuesday, May 18, 2004 8:36:55 AM.

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We are 1,400 property/casualty insurance companies serving more than 135 million auto, home and business policyholders, with more than $196 billion in premiums accounting for 50 percent of the automobile/homeowners market and 31 percent of the business insurance market. We are the largest and most diverse property/casualty trade association in the country, with regional and local mutual insurance companies on main streets across America joining many of the country’s largest national insurers who also call NAMIC their home. More than 200,000 people are employed by NAMIC members.