What if there was a tool that allowed you to minimize your business insurance costs, control currently uninsured or underinsured risks and improve cash flow? What if, in addition to these benefits, you gained a (up to) $1.2 million annual tax deduction, and controlled the timing of the recognition of that money when you reclaimed it at capital gains tax rates? What if you simultaneously developed an asset protection and estate planning vehicle? If risk management, tax benefits, or asset protection are important to you at all, then you should consider a Captive Insurance Company (the "Captive").
The Captive Insurance Company
Fundamentally, a Captive is a privately held insurance company created by a parent company or its owners to provide insurance coverage exclusively for its operations. It is first and foremost a bona fide insurance company, and must be operated and present itself as one in every single respect. The Captive issues insurance policies, collects premiums, and pays claims, just like a commercial insurer, but it does not offer insurance to the public, solely to the parent company. It must also be respected and treated as a separate entity, and as such will require, among other things, separate books, records and accounts, and no comingling of assets with personal funds or funds of other entities.
Historically, the Captive represented a viable alternative risk transfer structure that was only used by large corporations due to restrictions, complexity, and capital requirements. However, today the Captive is available to any size company (Middle-market and family businesses, physicians, etc.), but they must be properly structured with the help of experts who are familiar with all of the intricacies relating to its formation.
Among other things, the Captive structure enables business owners to better manage insurance costs, coverage, service, and capacity. Additional benefits include, but are not limited to, pre-tax wealth accumulation, favorable distribution rules, asset protection, highly efficient estate planning/wealth transfer and superior retention of key employees:
1. Minimization of insurance costs to the business. The use of a Captive allows the business to pay actuarially calculated insurance premiums to the (wholly-owned) Captive based on the risk needs of the business. The profits inherent in the insurance premiums will now remain with the Captive and accrue over time, allowing for the investment of those profits at favorable tax rates. Likewise, the premiums will be stabilized and will not be subject to the market fluctuations so often seen in commercial insurance premiums. The flexibility remains with the business to transfer only those risks that can be borne with economic prudence.
2. The business can control its risk more efficiently. The business controls the claims process through its Captive, thus, eliminating delays, costly denials, and any outside influence on its risk management process. The business can structure its insurance program to provide only the coverage it needs in the amounts it desires without restrictions dictated by the marketing needs of commercial insurance companies. The Captive can avail itself of lower cost reinsurance if the risk in a particular area exceeds its risk tolerance.
3. The business can improve its cash flow. The premium payments made to the Captive by the business could be less than comparable insurance premiums payable to an outside insurance company.
4. Tax Benefits. Though a Captive is never structured for the tax benefits alone they are four-fold:
a. Insurance premiums are an expense to the parent company. Insurance premiums flow tax free to the Captive, where they collect on a pre-tax basis in anticipation of future claims. The cornerstone of favorable Captive tax provisions is Internal Revenue Code � 831(b). This provision, designed to encourage the formation of new insurance companies, provides for alternative taxation if a business's premiums do not exceed $1.2 million, and if the business makes a valid, qualifying IRC section 831(b) election.
Further, premiums are deductible to the parent and flow tax free to the Captive qualifying under � 831(b).
b. A Captive only pays federal income tax on its net investment income. Under the provisions of IRC � 832(b), the Captive will generally pay no federal income tax on its underwriting income (premiums earned, less losses incurred and expenses), thus, allowing for the rapid accumulation of profits and investment income. Only the net investment income of the Captive will be subject to tax at the regular corporate tax rates (regardless of the Captive's structure, it will be recognized as a corporation for tax purposes).
c. On and Off feature. Rather than profits that would have to pass through to the business owner's personal tax returns as ordinary income in the year the profits occur, profits and investment income of the Captive can remain in the Captive indefinitely. The business owner does not have to recognize any of the Captive's profits or investment income in his personal income tax until he/she so chooses; thus, the Captive structure promotes even greater accumulation of profits and investment income.
d. Dividends to shareholders receive favorable tax treatment. If prudently managed, the Captive could pay dividends or liquidate its capital to its shareholders, which in today's tax environment would receive favorable tax treatment by virtue of a top capital gains rate of 20%. This effectively creates an arbitrage between the business owner's federal marginal income tax rate on ordinary income (plus any state tax if applicable) and the capital gains tax rate.
5. Asset Protection. If managed properly, the Captive is an independent corporate entity and creditors of the parent company would find it very difficult to seize the Captive's assets.
6. Estate Planning. A family trust or other entity for the benefit of the future generations can own the Captive, allowing for wealth transfer without resulting gift or estate tax liability.
7. Retention of Key Employees. Giving key employees restricted ownership in the Captive can provide a foundation for retention. In addition, employees have an increased incentive to manage risk effectively.
In conclusion, as discussed above, there are benefits to forming a Captive, however, careful consideration must be given to scrupulous compliance with controlling legislation during both the formative and ongoing management stages and during the course of its existence.
This article was prepared in June 2013 as a general discussion on the subject matter presented, and is not to serve as, or to be relied upon, as legal advice. The views expressed in this article are those solely of the author.
Robert E. Feiger, J.D., L.L.M., is a Partner with Friedman & Feiger, LLP, Counselors and Attorneys At Law. For more information on this topic, please contact Robert at 972-450-7350 or email: firstname.lastname@example.org.