Can Forming A Captive Insurance Company Trim $2.2 Million From Your Business’ Annual Tax Bill?

By: Steven Abernathy and Brian Luster

Captive insurance companies, self-insurers for businesses, provide owners with substantial tax advantages, the most attractive of which is an annual deduction of up to $2.2 million based on an actuarial assessment of your business.[1]  This effectively shifts business income from the top marginal tax rate of 39.6%, towards a more preferred dividend tax rate of 20%.  These cumulative savings can further benefit from the dividends-received deduction, which allows the captive to deduct 70% of the dividends that it receives from its stock portfolio investments.  Over time, as these premiums accumulate, they can be invested to generate additional income which can then be distributed back to the shareholder.  Owning an insurance company gives a business the opportunity to retain favorable, (i.e. profitable) risks within the captive, and transfer the less favorable risks to the traditional insurance marketplace.

To put this in perspective, a business owner that deducts $650,000 per year to fund a captive, can reasonably expect to accumulate over $7.8 million over 10 years, versus $3.8 million had they not used such a vehicle, for net savings of $4 million.  While this may sound too good to be true, if properly established and set up with the primary intent of filling a legitimate business need, these tax savings can be a welcomed benefit to the owner.  It’s no wonder this strategy is being incorporated into the tax and estate planning of high net worth business owners.  However this technique isn’t appropriate for all. If an advisor touts and wrongly employs a captive, the result is likely to be increased IRS attention.  Yet there are best practices that can be followed to greatly minimize the likelihood of such scrutiny and adverse outcomes.

What is a captive insurance company?  A captive is a real, operating insurance company that a business owner or business directly owns.  It processes and pays out its own claims, acquires reinsurance to protect itself against catastrophic claims, and is formed and licensed for the specific purpose of providing real insurance coverage.  The way it works is a business pays the wholly owned captive’s annual premiums, and profits left at the end of the year after paying claims are the business owner’s to keep.  The captive premium expense is tax deductible as an “ordinary and necessary business expense.”  There are an estimated 5,000 captive insurers worldwide, according to The Center for Insurance and Policy Research’s data from A.M. Best.  Yet, captive insurance companies’ existence is not always known to those who could benefit from them.

What type of businesses can employ a captive? If a business is generating over $2 million dollars of annual income, a captive, self-insuring model may be one worth considering to insure low to medium risks where there is likely to be unsubstantial claims activity.  Nearly any business of sufficient size across a wide range of industries can implement a captive to more effectively finance the risks of its operations.  While every business varies, there are scenarios with businesses generating over $3.5MM in revenue where a captive may be worth considering.

While many wealthy business owners consider forming a captive for its favorable investment opportunities (70% dividends-received deduction on investment income) it is imperative to understand that the captive’s primary intent must be non-tax related i.e., to fulfill a legitimate business need such as: cost reduction, risk management and/or risk control.  Businesses using an 831(b) captive are advised to be mindful as the IRS is likely to take notice when a company and its subsidiaries cite outlandish risks or pay premiums for insurance which has nothing to do with the actual business operations.  Likewise, the pricing of the policies need to be in line with commercially relevant rates.

To a degree most business owners are already self-insured.  For example they may already own explicit commercial insurance policies covering such risks as general liability, product liability, professional liability, and commercial property.  But this still leaves a bevy of risks off the table which business owners would not ordinarily pay out of pocket premiums to cover, yet are responsible for in the event of an adverse event.  In this respect forming a captive could make sense.  For example, business interruption, wrongful acts, loss of a key employee, supplier or customer, tax audit expense reimbursement, and computer data restoration are common examples of risks born by the business owner, yet not explicitly covered through commercial insurance.

So, what best practices can a qualifying business use to limit the likelihood of IRS scrutiny?

1) First, determine whether the business has particular risk that could be covered by a captive.  These risks could be based on gaps in existing commercial coverage or simply “self-insured” risk in which the business owner writes off the expense of what could otherwise be insured (i.e., supply chain interruption).  Everyone wants to save on taxes but not every business is poised to use captive insurance within their business.

“Take for example, a manufacturing company that produces consumer goods,” says attorney Peter Strauss of The Strauss Law Firm on Hilton Head, a boutique law firm specializing in risk management and insurance.  “They’re likely to require a lot of insurance across the board for product liability, worker’s compensation, and employment practices liability, to product recall, loss of inventory and theft.  However, other business owners such as a neurosurgeon would traditionally not need this breadth of insurance.”

2) Use an independent, third-party, fully credentialed underwriter to determine legitimate insurance needs for your business.  Appropriate underwriting allows for the business to be analyzed in an effort to understand the applicability and scope of each policy.  Additionally, an independent, third-party, fully credentialed actuary can price each policy appropriately.  At the end of the process, the actuary will produce a report illustrating what areas of risk are uninsured or under-insured and determine whether it makes sense to keep current coverage in place, or shift some of it to the captive.  Actuaries also help business owners understand what types of coverage can be underwritten by the captive and how much annual premiums for such coverage will cost.

3) Consider obtaining a private letter ruling from the IRS.  Consider this a blessing of sorts directly from the government granting approval to your company’s captive.  While these have largely fallen out of favor in recent years to do the well-known use of captives, the letters go a long way in providing a sense of peace of mind.

4) The captive must demonstrate regular claims activity.  While it needn’t be dramatic, if the company’s activity is perceived as too low it could be a red flag.  Mr. Strauss asserts, “Captive insurance companies are just that—insurance companies.  They need to be treated, interacted with and monitored as such.”  With heightened scrutiny and abusive practices only adding to the complexities of owning a corporation charged with the task of managing risk, it’s advisable to have legal counsel guiding business owners through the implementation process and monitoring their management activity each year.

Captive insurance companies provide tremendous value to businesses.  They have been prevalent for over half a century.  There are over 80 jurisdictions domestically, internationally and in the U.S. territories that provide for licensure.  Somewhere in the neighborhood of 90% of all Fortune 1000 companies use some form of risk management vehicle such as a captive.  With various Internal Revenue Codes, Revenue Rulings and now the PATH Act offering broad support, it is clear captives are here to stay.  However, while the captive insurance company model can hold tremendous allure, we advise business owners to proceed with caution when considering adding this to their business.  Considering a captive insurance company can be up and running in as little as three months, the substantial tax advantages available are impossible to ignore for qualified businesses.  If it’s worth doing—it’s worth doing right.

As with any business idea that sounds as if it’s too good to be true, conducting due diligence on the company you plan to hire to form your company’s captive insurance company before you hire them is recommended.  Jay Adkisson offers this: “The industry shakeout of “real captives” versus “tax shelter captives” has been a long time coming, and for the industry it will be a good thing in the long run.”

[1] *Premiums collected by the captive are currently tax-exempt up to $1.2MM per annum, per captive.  The Protecting Americans from Tax Hikes Act of 2015 (PATH ACT) was signed by President Obama in December 2015.  Tax exemption for premiums will increase to $2.2MM annually and the limit is indexed for inflation. The increase in the exemption will be effective January 1st, 2017.

Brian Luster is a Managing Member and Portfolio Manager of a long/short US event-driven value-oriented hedge fund. Founder and Chief Executive Officer of a Multi-Family Office. Portfolio Manager of discretionary shareholder activist Separately Managed Account strategy. Author of 50+ articles covering investing and multigenerational asset management featured in such publications as Forbes, Barron’s, The Wall Street Journal, The Huffington Post, Private Air Magazine, The American Association of Individual Investors, Family Wealth Report, Medical Economics, Physicians Money Digest, Chiropractic Economics, Medscape, Practice Link, Practical Dermatology, Physicians Practice, Dental Practice Management, Buyside Magazine, and The Bottom Line. For more information, visit www.abernathygroupfamilyoffice.com.

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