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Captive Insurance Company – Reduce Taxes and Build Wealth
For business owners who pay taxes in the United States, captive insurance companies reduce taxes, build wealth and improve insurance protection. A captive insurance company (CIC) is similar to any other insurance company in many ways. It is called a “captive” because it typically provides insurance to one or more related operating businesses. With captive insurance, the premiums paid by the business are kept within the same “financial family” rather than paid to an outsider.
Two key tax advantages enable a CIC incorporation structure to efficiently build wealth: (1) insurance premiums paid by the business to the CIC are tax deductible; and (2) under IRC § 831(b), CIC receives premium payments of up to $1.2 million annually income tax-free. In other words, a business owner can shift taxable income from operating a business to a low-tax captive insurer. An 831(b) CIC pays tax only on its investment income. The “dividend deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.
Beginning about 60 years ago, the first captive insurance companies were formed by large corporations to provide insurance that was either too expensive or unavailable in the traditional insurance market.
Over the years, a combination of US tax laws, court cases and IRS decisions have clearly defined the steps and procedures required for the establishment and operation of a CIC by one or more business owners or professionals.
To qualify as an insurance company for tax purposes, a captive insurance company must meet the “risk shift” and “risk distribution” requirements. This can easily be done through a regular CIC scheme. Insurance provided by a CIC must be de facto insurance, i.e., the actual risk of loss must be transferred from the premium-paying operating business to the CIC insuring the risk.
In addition to tax benefits, the key benefits of CICs include increased control and increased flexibility, which improves insurance protection and lower costs. With traditional insurance, an outside carrier usually dictates all aspects of the policy. Often, some risks cannot be insured conventionally, or can only be insured at a prohibitive cost. Traditional insurance rates are often volatile and unpredictable, and traditional insurers are prone to denying valid claims by exaggerating minor technicalities. Also, although business insurance premiums are generally deductible, once they are paid to a traditional outside insurer, they are gone forever.
A captive insurance company efficiently insures risk in a variety of ways, such as customized insurance policies, favorable “wholesale” rates from reinsurers, and risk pooling. Captive companies are ideal for insuring risks that would otherwise be uninsured. Most businesses have traditional “retail” insurance policies for obvious risks, but remain open and subject to damage and loss from many other risks (ie, they “self-insure” those risks). A captive company can write customized policies for the specific insurance needs of the business and negotiate directly with reinsurers. A CIC is particularly well suited to issuing business casualty policies, that is, policies that cover business losses claimed by the business and do not cover third-party claimants. For example, a business can insure itself against losses through business interruptions caused by weather, labor problems or computer failures.
As noted above, an 831(b) CIC is exempt from tax on premium income up to $1.2 million annually. As a practical matter, a CIC makes financial sense when its annual premium receipts are around $300,000 or more. Also, a business’s total payment of insurance premiums should not exceed 10 percent of its annual revenue. A group of businesses or professionals with the same or similar risks may join a Risk Retention Group (RRG) to form a multi-parent captive (or group captive) insurance company and/or to pool resources and risks.
A captive insurance company is a separate entity with its own identity, management, finance and capitalization requirements. It is organized as an insurance company, has procedures and personnel to manage insurance policies and claims. A preliminary feasibility study of the business, its finances and its risks determine whether a CIC is suitable for a particular economic family. An actuarial study identifies suitable insurance policies, related premium amounts and capitalization requirements. After selecting the appropriate jurisdiction, the application for an insurance license can proceed. Fortunately, competent service providers have developed “turnkey” solutions to handle the initial assessment, licensing, and ongoing management of captive insurance companies. Annual costs for such turnkey services are typically $50,000 to $150,000, which is high but easily offset by lower taxes and enhanced investment growth.
A captive insurance company can be incorporated under the laws of one of several offshore jurisdictions or under the laws of a domestic jurisdiction (ie, in one of the 39 US states). Some captives, such as the Risk Retention Group (RRG), must be licensed domestically. Generally, offshore jurisdictions are more appropriate than domestic insurance regulators. As a practical matter, most offshore CICs owned by a U.S. taxpayer elect to be treated under IRC § 953(d) as a domestic corporation for federal taxation. An offshore CIC, however, avoids state income tax. The costs of licensing and managing an offshore CIC are comparable or lower than doing so domestically. More importantly, an offshore company offers better asset protection opportunities than a domestic company. For example, an offshore irrevocable trust owned by an offshore captive insurance company provides asset protection against the business’s creditors, the grantor and other beneficiaries while allowing the grantor to enjoy the benefits of the trust.
For U.S. business owners who pay substantial insurance premiums each year, a captive insurance company efficiently reduces taxes and builds wealth and can be easily integrated into asset protection and estate planning structures. Up to $1.2 million of taxable income can be shifted from an operating business to a low-tax CIC as deductible insurance premiums.
Warning and Disclaimer: This is not legal or tax advice.
Internal Revenue Service Circular 230 Disclosure: As provided in Treasury regulations, the advice (if any) regarding federal taxes contained in this communication is not intended or written to be used, and may not be used, for purposes of (1). avoid penalties under the Internal Revenue Code or (2) promote, market or recommend to another party any transaction or matter addressed herein.
Copyright 2011 – Thomas Swenson
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