Many successful small and midsized businesses are discovering the benefits of captive insurance companies, and are pursuing the guidance of financial advisors with experience in this arena.
Captives can reduce insurance costs, reduce taxes, protect assets, diversify wealth outside of the business and help transfer business value and family wealth to future generations. Legislative changes in the last seven years have made this one of the most advantageous strategies for business owners today. As a financial advisor working in the business market, you should become knowledgeable about this form of planning. Whether your business owner client moves forward with a captive program or not, you do not want to lose an opportunity to further differentiate yourself from your peers.
CAPTIVE 101
A captive is a property and casualty insurance company established by a business or individual to provide a broad range of risk management capabilities to affiliated companies. For example, a group of doctors can form and own a captive to insure against the exclusions of and deductibles within their primary medical malpractice coverage, or even against risks unrelated to malpractice, such as the loss of a key employee, a wrongful termination or the loss of electronic medical records or medical licenses. Another example is a firm establishing a captive to insure against the risk of intellectual property theft by employees.
Captives established under Internal Revenue Code Sec. 831(b) are often referred to as wealth captives. There are restrictions placed on these captives regarding deductibility and the amount of premiums that can be paid. They can be formed in the U.S. (currently approved in 39 states) or in a foreign jurisdiction, depending on the needs and concerns of the captive's shareholders
Whether domiciled domestically or offshore, captives are required to file a U.S. federal corporate tax return and pay corporate income taxes on any taxable gains each and every year. Therefore, the premiums received by the captive, along with its reserves, must be managed both to meet the liquidity needs of the insurance company and also to mitigate current taxable income.
Captives are designed to manage business risk exposure. Once the risk is identified, a policy must be designed and underwritten in order to provide legitimate coverage. Policy underwriting and policy limits are determined by the company underwriters, and premiums are set by independent actuaries following ISO standards.
Ownership structure is a critical decision that must be made early in the decision process. Who will own the captive and in what form are key elements that will ultimately impact both the short-term and long-term effectiveness of this strategy. The shareholders of the captive can be the business owner, key employees, spouses or other family members, charitable trusts, limited liability companies, or estate planning trusts. The flexibility of ownership structure creates significant planning opportunities, depending on the owner's personal goals and objectives.
TAX BENEFITS
Sec. 831(b) captives offer additional benefits through favorable tax treatment on receipt of premiums. Tax exemptions on current premiums are allowed for small insurance companies receiving up to $1.2 million per year, and larger insurance companies can take current deductions for estimated future losses. Both provisions make owning an insurance company an excellent investment. For example, a business owner or company paying $1 million in premiums to a captive will receive a business deduction for the insurance payment under IRC 162, but the captive will not pay current income tax on the premium received. This can result in $400,000 to $500,000 in savings on annual income tax alone.
Many business owners unknowingly self-insure a tremendous amount of business risks, including general business liability, legal and malpractice deductibles, professional liability, employment practices, accounts receivable concentration, administrative actions (such as Medicare or HIPAA), disability, loss of business license or professional license, and business interruption. Self-insurance, whether funded out of company reserves or personal after-tax savings, is not tax-deductible. However, with a properly structured captive, self-insurance through a captive structure can create substantial tax deductions, resulting in tremendous tax savings.
ASSET PROTECTION VALUE
Captives may very well be the best asset-protection tool available to business owners. Assets in a captive are not exposed to creditors and plaintiffs, and are only available to pay valid claims - claims approved by the captive company and its owners. A captive also allows the use of customized policies that are often too pricey or unavailable through large insurers, allowing greater flexibility and reduced exposure.
Typically, when a business owner invests both personal and business assets, the assets stay in their name, or the name of the business, leaving these investments potentially subject to lawsuit claimants, creditors, divorce settlements or bankruptcy trustees. Using a captive, a business owner can transfer monies as a business expense into an independently operating, fully licensed insurance company. Any lawsuit, claim, divorce, tax or other action against the business owner or the business is completely separate from the captive, meaning the investments held and owned by the captive are fully protected against litigation risks.
ESTATE-PLANNING TOOLS
Captives can be an effective way to transfer family net worth to future generations with or without the use of life insurance. At the time a captive is established, the business owner can transfer ownership at time of capitalization to a limited liability corporation. The LLC limited interest can be gifted to the owner's children or a trust to benefit the children. All future premiums paid by the business and received by the captive are held and owned by the LLC. If claims are effectively managed and the captive is maintained and continues operations for many years, a significant amount of value can be moved outside of the business and outside of the business owner's net worth free of estate taxation.
For example, let's assume that a business creates a captive and premiums are set at $1 million per year. The business owner has three children and the capitalization of the insurance company was $100,000 at inception. An LLC is established at the time of capitalization and both parents gift $13,000 apiece of LLC limited interest to each of their three children. The children own 78 percent of the LLC and not a single penny of either party's lifetime exclusion was used.
Let's further assume that the insurance company operated for 10 years and assets grew at 8 percent per year. Let's also assume that taxes, claims and operating expenses totaled $120,000 per year. After 10 years, the insurance company would have in excess of $14.6 million, of which 78 percent or $11.4 million would be outside of the estate of the business owner and excluded from estate taxes. If, on the other hand, the business owner distributed annual dividends from the captive to the LLC and used these dividends to purchase a $10 million life insurance policy, the estate-tax-free distribution to the children, including both the insurance death benefit and the captive liquidation, would be increased to more than $21 million.
SUMMARY
If you have a client or prospect who has insurance premiums for current business liability coverage in amounts exceeding $300,000 per year, or one that has risks that are uninsured or self-insured and business income of $1 million per year, you may want to explore how a captive insurance company can help your client improve risk management, reduce taxes and protect assets.
Even if your client's premiums are not as large, smaller businesses or groups of individuals can form captives to cover the hidden risks of operating a business, reduce the inherent risks caused by these litigious times and receive the benefits of owning an insurance company. Other options are available for those requiring even smaller premiums. There are a number of exit strategies for captives, such as dividends, loans, salaries or even wind-downs of the captive itself, which can easily be accomplished in a matter of months at favorable tax rates.
Captives are specialized risk and business management tools, which require special management expertise. The structure must be properly created and maintained by experts in the field. If it is not, the insurance, asset protection and tax benefits may be lost.
Rick A. Jaye is the chief financial strategist for First Allied Securities Inc.
