When are dividends from an insurance company subsidiary deductible in California?

Why the dividend is taxable in the first place

Under the California Constitution, insurers pay a gross premiums tax that is in lieu of the corporate franchise tax (Cal. Const. art. XIII, § 28). Because an insurance company is not subject to the franchise tax, it cannot be a member of a combined reporting group, no matter how unitary its operations are with the rest of the enterprise. That exclusion has a sharp consequence for distributions. The rule that spares most intercompany dividends, the elimination for dividends paid from unitary earnings and profits between combined group members (RTC 25106), requires the payor to be in the group. A dividend from an insurer to its noninsurer parent starts life fully includible in the parent's apportionable income, even though the same cash moving between two general corporations in the group would have been eliminated. The same is true where a federal consolidated return includes a life group and a nonlife group side by side: the federal consolidation does nothing for California, and only the members of the California combined report get elimination treatment.

Section 24410 is the legislature's answer to that structural inclusion. The current version dates from 2004, after the courts struck down its predecessor as unconstitutional discrimination in Ceridian Corp. v. Franchise Tax Board (2000) 85 Cal.App.4th 875. Former section 24410 failed on two independent grounds, and it is worth keeping straight which party each one ran to. The court held first that the deduction could not be conditioned on the recipient's California commercial domicile, a condition that favored recipient corporations domiciled in the state over otherwise identical recipients domiciled elsewhere. It held separately that the deduction could not be prorated by reference to the paying insurer's California property, payroll and receipts, a proration that pegged the benefit to the payor's California-source income. The modern statute applies without regard to either, and in exchange it polices what kind of insurer, and what kind of earnings, can generate a deductible dividend.

The basic deduction: 85 percent, 80 percent ownership

For taxable years beginning on or after January 1, 2008, a corporation may deduct 85 percent of qualified dividends received from an insurance company if the recipient owns, directly or indirectly, at least 80 percent of each class of the insurer's stock (RTC 24410(a)). The ownership test is per class, so preferred stock held outside the group can break qualification even where common ownership is complete. The remaining 15 percent of even a fully qualified dividend stays in income, a permanent inclusion that belongs in any model of a distribution up from the insurance side of the house.

The overcapitalization phase-out

The statute's central anti-abuse device measures whether the group's insurers are in the insurance business or are an investment company wearing an insurance license. The test compares the five year average net written premiums of all insurance companies in the commonly controlled group to their five year average total income (RTC 24410(c)). If premiums are at least 70 percent of total income, the dividends are fully qualified. If premiums are 10 percent or less of total income, nothing qualifies. Between those lines, the qualified percentage is prorated: the dividend qualifies in the proportion the premium ratio bears to the 70 percent benchmark. An insurer whose balance sheet has swollen with investment earnings relative to its underwriting can therefore see the deduction shrink well before it disappears, and a fact often recited in distribution planning, that the dividend represents funds in excess of the needs of the insurer's business, is not itself the test. The statute asks about the composition of the insurer's income over five years, not the purpose of the particular distribution, and the two questions can produce different answers on the same facts.

The captive rule: intercompany premiums poison the well

Separately from overcapitalization, no deduction is allowed for dividends attributable to premiums received or accrued by the insurance company from members of its commonly controlled group (RTC 24410(d)). The disallowed portion is computed as the total dividend multiplied by the greater of the intercompany share of net written premiums or a risk-based ratio, the underwriting risk borne for group members for a property and casualty company or the corresponding reserve measure for a life company, with exceptions for reinsurance of risks that originated outside the group. At the far end of the spectrum the rule is absolute: an insurer that derives all of its premiums from members of its own group generates no deductible dividends.

Two features of the captive rule deserve emphasis. First, the attributable portion is set by formula, not by tracing: all dividends from the paying insurer are multiplied by the greater of that insurer's own intercompany premium ratio or its risk or reserve ratio (RTC 24410(d)(1)), so even a predominantly third party insurer loses that share of its dividends. Second, the statute has no rule for tiered structures and measures each paying insurer on its own ratios, so a distribution routed from a captive through an intermediate insurer should be modeled at each tier and documented for its substance.

The section 24455 backstop

Keeping earnings inside the insurer is not a complete answer either. Section 24455 authorizes the Franchise Tax Board to include in the parent's gross income its pro rata share of an insurer's current earnings and profits, capped at the insurer's investment-income net income less its net written premiums for the year, where the insurer is a member of the commonly controlled group and two further conditions coincide. The first is the same group-wide ratio the phase-out uses, at a lower threshold: the five year average net written premiums of all insurers in the commonly controlled group, measured against their five year average total income, is 15 percent or less, or 40 percent or less for a predominantly captive insurance group (RTC 24455(a)(2), (b)). The quantity measured is premium writing relative to income, not capitalization in the balance sheet sense, so a practitioner who builds an equity-to-assets schedule has tested the wrong thing. The second condition is purpose: a substantial purpose of the accumulation must have been the avoidance of income tax in California or any other state (RTC 24455(a)(3)). The provision has no implementing regulations, and how often the FTB has invoked it is not publicly visible, but it sits in the statute as the counterpart to the overcapitalization phase-out: the deduction rules police distributions out of overcapitalized insurers, and section 24455 polices the decision never to distribute. A structure that parks earnings in thinly premium-supported insurance entities should be documented with both provisions in view.

Practice notes

The analysis runs in a fixed order, and each step needs its own workpaper. First, establish the baseline: confirm the payor is an insurer under the constitutional definition and therefore outside the combined report, because if the payor is not an insurer the entire framework changes, elimination may be available, and Section 24410 is beside the point. Second, test ownership class by class against the 80 percent requirement, including indirect holdings. Third, build the overcapitalization schedule: five years of net written premiums and total income for every insurance company in the commonly controlled group, computed consistently (RTC 24410(c); FTB Schedule H (100) instructions), because the qualified percentage is arithmetic once the inputs exist and contestable forever if they do not. Fourth, compute the payor's own intercompany premium and risk or reserve ratios, and apply the greater-of formula rather than assuming the premium ratio controls. Fifth, because the statute does not address tiering, a multi-step distribution is modeled at each paying insurer and documented as a whole before any step is papered (RTC 24410(d)). G&G State Tax Group provides California analysis of insurance company dividends and combined reporting for insurance holding company groups alongside its state and local tax practice.