For business owners paying taxes in the United States, captive insurance companies reduce taxes, build wealth and enhance insurance protection. A captive insurance company (CIC) is similar in many ways to any other insurance company. It is referred to as “captive” because it generally provides insurance to one or more related operating businesses. With captive insurance, premiums paid by a business are retained in the same “economic family”, instead of being paid to an outsider.
Two meaningful tax benefits permit a structure containing a CIC to build wealth efficiently: (1) insurance premiums paid by a business to the CIC are tax deductible; and (2) under IRC § 831(b), the CIC receives up to $1.2 million of premium payments yearly income-tax-free. In other words, a business owner can shift taxable income out of an operating business into the low-tax captive insurer. An 831(b) CIC pays taxes only on income from its investments. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.
Starting 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 situations and IRS rulings has clearly defined the steps and procedures required for the formation 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 satisfy “risk shifting” and “risk dispensing” requirements. This is easily done by routine CIC planning. The insurance provided by a CIC must really be insurance, that is, a genuine risk of loss must be shifted from the premium-paying operating business to the CIC that insures the risk.
In addition to tax benefits, principal advantages of a CIC include increased control and increased flexibility, which enhance insurance protection and lower cost. With traditional insurance, an outside carrier typically dictates all aspects of a policy. Often, certain risks cannot be insured conventionally, or can only be insured at a prohibitive price. traditional insurance rates are often volatile and unpredictable, and traditional insurers are inclined to deny valid claims by exaggerating petty 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 various ways, such as by customized insurance policies, popular “wholesale” rates from reinsurers, and pooled risk. Captive companies are well suited for insuring risk that would otherwise be uninsurable. Most businesses have traditional “retail” insurance policies for obvious risks, but keep exposed and unprotected to damages and loss from numerous other risks (i.e., they “self insure” those risks). A captive company can write customized policies for a business’s disinctive insurance needs and negotiate directly with reinsurers. A CIC is particularly well-appropriate to issue business casualty policies, that is, policies that cover business losses claimed by a business and not involving third-party claimants. For example, a business might insure itself against losses incurred by business interruptions arising from weather, labor problems or computer failure.
As noted above, an 831(b) CIC is exempt from taxes on up to $1.2 million of premium income yearly. As a functional matter, a CIC makes economic sense when its annual receipt of premiums is about $300,000 or more. Also, a business’s total payments of insurance premiums should not go beyond 10 percent of its annual revenues. A group of businesses or professionals having similar or homogeneous risks can form a multiple-parent captive (or group captive) insurance company and/or join a risk retention group (RRG) to pool resources and risks.
A captive insurance company is a separate entity with its own identity, management, finances and capitalization requirements. It is organized as an insurance company, having procedures and personnel to administer insurance policies and claims. An initial feasibility study of a business, its finances and its risks determines if a CIC is appropriate for a particular economic family. An actuarial study identifies appropriate insurance policies, corresponding premium amounts and capitalization requirements. After selection of a appropriate jurisdiction, application for an insurance license may proceed. Fortunately, competent service providers have developed “turnkey” solutions for conducting the initial evaluation, licensing, and current management of captive insurance companies. The annual cost for such turnkey sets is typically about $50,000 to $150,000, which is high but freely offset by reduced taxes and enhanced investment growth.
A captive insurance company may be organized under the laws of one of several offshore jurisdictions or in a domestic jurisdiction (i.e., in one of 39 US states). Some captives, such as a risk retention group (RRG), must be licensed domestically. Generally, offshore jurisdictions are more accommodating than domestic insurance regulators. As a functional matter, most offshore CICs owned by a US taxpayer elect to be treated under IRC § 953(d) as a domestic company for federal taxation. An offshore CIC, however, avoids state income taxes. The costs of licensing and managing an offshore CIC are comparable to or less than doing so domestically. More importantly, an offshore company offers better asset protection opportunities than a domestic company. For example, an offshore irrevocable trust owning an offshore captive insurance company provides asset protection against creditors of the business, grantor and other beneficiaries while allowing the grantor to enjoy benefits of the trust.
For US business owners paying substantial insurance premiums every 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 as deductible insurance premiums from an operating business to a low-tax CIC.
Warning & Disclaimer: This is not legal or tax advice.
Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Copyright 2011 – Thomas Swenson