The Internal Revenue Code is not a friendly creature. It is designed to “taketh” your money; “giveth” is not in its vocabulary. Yet, there is a section of the Code [Section 831 (b)], dealing with captive insurance companies (captives) that when properly used, is primarily an income tax-saving machine for your business and can be structured to offer tax-advantaged benefits that create wealth for you (or even your heirs). A real tax winner.
About 80 percent of the Fortune 500 take advantage of the captive benefits. But much smaller businesses can join the tax-saving/wealth-building fun. If you own all or a part of a business, listen up, you’ll love what you are about to read.
Note: The Obama administration has made it clear: Income tax rates on high earners are going up. As you are about to learn, a captive is an especially welcome friend in a rising-tax-rate environment.
It’s difficult to find a CPA or lawyer who has even heard of captives. The few that know captives exist (like yours truly for many years) don’t have a clue of how to take advantage of the many benefits offered by captives for family owned businesses or small public companies.
Just what is a captive? First and foremost it is a bona fide insurance company, an insurer established to provide coverage for the company or people who founded it. An example is the easiest way to explain captives.
First, a simple example: Joe owns Success Co, which has some “uninsured risks” (explained in greater detail later) that his current property and casualty insurance (PCI) company will not insure. Joe creates New Co. (a captive), a corporation, which is an insurance company (covering Success Co.’s uninsured risks). The stock of New Co. is owned by Joe’s children.
Now for the fun part. Suppose the insurance premium for the uninsured risks are determined (professionally by a consulting actuary) to be $500,000 per year. Success Co. pays the $500,000 premium to New Co. The entire premium is immediately deductible by Success Co. like any other PCI. You’ll like this: Under the captive rules, all of the $500,000 is income tax-free to New Co.
Say Success Co. is in a 40 percent tax bracket (state and federal combined). Success Co. is only out of pocket $300,000 ($500,000 less $200,000 in tax savings). New Co. has the entire $500,000 to invest. A good start. But remember, New Co. is a captive and must hold the $500,000, plus earnings as a fund to pay potential claims for the risks it insurers.
Next, let’s explain “uninsured risks.” Every business has risks: Some insured, some uninsured. The most common risks — like workmen’s compensation, vehicle, property and general liability — are transferred to a third-party (your traditional property and casualty insurance carriers) and are insured risks.
Now let’s list some typical “uninsured risks,” the kind that you can’t buy coverage for in the traditional insurance market (as you scan down the list below, check off those that apply to your business):
- Litigation defense/asset protection;
- Loss of a key customer;
- Loss of a key supplier;
- Change in a law/regulation/ruling;
- Product warranty;
- Product liability;
- Professional liability;
- Strikes/labor problems;
- Traditional policy exclusion/deductible;
- Employment practices.
The list could go on and on. You probably have one or more uninsured risks peculiar to your business. Go ahead, add ‘em on.
Let’s face it, your business is self-insured for all of the above risks, either by choice or because the risk just can’t be insured commercially. A captive reduces the amount needed to fund such possible future losses. How? The premiums paid to your captive are immediately deductible.
There are many more ways that the use of a captive can save your business significant insurance costs. Following are two (of dozens of possible) examples:
- You own a new (or very up-to-date) building in an area with “zone coverage.” Your building is in total compliance with stringent building codes. Many older buildings in the zone are not complaint. Your building can obtain lower rates from your captive if you can show that your building is a better risk than the zone’s rating.
- Success Co. pays premiums to the captive to insure for litigation defense, strikes and product warranty. Remember with a commercial insurance company (CIC), if the insured has no losses, the CIC keeps the entire premium. No refunds.
Even though a captive cannot reduce (actuarial determined) premiums, a financial windfall results (unused reserve) if the insured’s actual losses are less than actuarial predicted. For example, suppose Joe’s captive (New Co.) has an unused reserve. A portion of the unused reserve can be (a) refunded to Success Co.; (b) reduce future premiums; or (c) paid to the
captive’s shareholders (Joe’s children) as a dividend. Three nice fringe benefits.
There are a number of other what I call “fringe benefits” to a captive structure. Following are a few:
- Someday liquidate your captive and take out the unused reserve at capital gains rates;
- Have the captive invest a portion of its reserve funds to pay premiums for life insurance on the captive’s founder or his family members (in effect, deducting the life insurance premiums);
- Use the captive as an estate planning strategy, passing the captive (and any life insurance proceeds) to your heirs.
Make no mistake, your captive must be formed and operated for a business purpose. The captive must demonstrate that it is, in fact, acting as a proper insurance company. Follow the rules and the IRS is not a problem. Try to fool the IRS by forming your captive to take advantage of only the tax-advantaged fringe benefits, without a real business purpose, is almost certain to cause the loss of the sought-after benefits.
No attempt is made in this article to explore all the rules, traps and opportunities in forming your own captive. It is essential that you work only with qualified, experienced advisors that specialize in captives. The right advisors can easily tailor your captive to fit you, your business and your circumstances perfectly.
Now the key question: Is a captive for you? If costs were not an issue, the answer would be a resounding ‘yes’ for almost every business. Unfortunately, costs are a factor. For a Fortune 500 company, it’s a slam dunk: The insurance cost savings and tax-benefits are well worth the required costs to create and administer a captive.
If you can answer ‘Yes’ to any of the following questions, you should strongly consider forming a captive:
1. Is your before-tax profit $1 million (or more) per year?
2. Are your traditional insured property and casualty expenses $1 million (or more) per year?
3. Is one (or more) of the “uninsured risks” listed above (or one you added) a significant factor in your business? And worth a premium of about $200,000 a year (or more)?
Logic tells you that the larger your business, the more likely a captive should be a top priority for your next year’s business plan (i.e. make $1 million — before-tax — or more, captive is a must). Costs are easily covered by captive benefits.
But what about smaller family businesses? The answer can be ‘Yes’ with a new strategy the experts have perfected, if your before-tax profits are in the $250,000 per year range. Benefits are the same as for a larger company but costs are substantially reduced.
What, you are even smaller? Well, we need your help. Show this article to the decision maker(s) of your trade association. Have your trade association adopt a captive program; then you and the other members can participate. The cost is minimal.
Finally, if you are lucky enough to be a Florida resident and your business is located in any other state there is a little known — legal — tax strategy that enhances your tax savings.
How can you learn if a captive will work for your business? Please fax the following (on your company letterhead) to 847-674-5299: Your name, title, type of business, total number of employees and any other information you think would be helpful. Also include all phone numbers where you can be reached (business, home, cell). If a trade association, please fax on your letterhead and include number of members and name of decision maker. Please mark “Captive” at the top of your fax.
Irv Blackman is a certified public accountant who lives part-time on Marco Island and specializes in estate planning, business succession and asset protection. E-mail him at email@example.com or call 417-9732. His Web site is taxsecretsofthewealthy.com.