For entrepreneurs paying taxes in the United States, captive insurance companies reduce taxes, build wealth, and improve insurance protection. A captive insurance company (CIC) is similar in many ways to any other insurance company. It is called “captive” because it generally provides insurance to one or more related operating companies. With captive insurance, the premiums paid by a company remain in the same “economic family,” rather than being paid to an outsider.
Two major tax advantages enable a structure with a CIC to efficiently build wealth: (1) insurance premiums paid by a company to the CIC are tax deductible; and (2) under IRC § 831(b), the CIC receives up to $1.2 million annually in premium payments tax-free. In other words, a business owner can shift taxable income from an operating business to the low-tax captive insurer. An 831(b) CIC only pays taxes on income from its investments. The “deduction for dividends received” under IRC § 243 provides additional tax benefits for dividends received from investments in company stock.
About 60 years ago, the first captive insurance companies started by large corporations to offer insurance that was too expensive or unavailable in the conventional insurance market.
Over the years, a combination of U.S. tax laws, court cases, and IRS rulings have clearly defined the steps and procedures required for establishing and operating 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 shifting” and “risk sharing” requirements. This can be easily done through routine CIC planning. The insurance provided by a CIC must really be insurance, that is, a real risk of loss must be shifted from the premium-paying business to the CIC insuring the risk.
In addition to tax benefits, the main benefits of a CIC include greater control and greater flexibility, which improves insurance protection and reduces costs. In conventional insurance, a third-party carrier typically dictates all aspects of a policy. Often certain risks cannot be insured conventionally, or only at a prohibitive price. Conventional insurance rates are often volatile and unpredictable, and conventional insurers tend to deny valid claims by exaggerating petty technicalities. Even though business insurance premiums are generally deductible, once they’re paid to a conventional third-party insurer, they’re gone forever.
A captive insurance company efficiently insures risk in several ways, such as through tailor-made insurance policies, favorable “wholesale” rates from reinsurers, and pooled risk. Captive companies are well suited for insuring risks that would otherwise be uninsurable. Most companies have conventional “private” insurance policies for obvious risks, but remain exposed to and subject to damage and loss from numerous other risks (ie, they “insure” those risks themselves). A captive company can write custom policies for a company’s peculiar insurance needs and negotiate directly with reinsurers. A CIC is particularly suitable for issuing business casualty policies, i.e. policies that cover business losses claimed by a business and do not involve third party claimants. For example, a company can insure itself against losses due to business interruption due to weather conditions, labor problems or computer failures.
As noted above, an 831(b) CIC is tax exempt on up to $1.2 million in premium income per year. In practice, a CIC makes economic sense when annual premium receipts are approximately $300,000 or more. Also, a company’s total payments of insurance premiums cannot exceed 10 percent of annual sales. A group of companies or professionals with similar or homogeneous risks can form a multi-person 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 like an insurance company, with procedures and staff to manage insurance policies and claims. An initial feasibility study of a company, its finances and its risks determines whether a CIC is suitable for a particular economic family. An actuarial study identifies appropriate insurance policies, associated premium amounts and capitalization requirements. After selection of an appropriate jurisdiction, the application for an insurance license can be continued. Fortunately, competent service providers have developed “turnkey” solutions for conducting initial evaluation, licensing, and ongoing management of captive insurance companies. The annual cost for such turnkey services is typically around $50,000 to $150,000, which is high but easily offset by lower taxes and improved investment growth.
A captive insurance company may be incorporated under the laws of one of several offshore jurisdictions or of a domestic jurisdiction (ie, in any of the 39 US states). Some inmates, such as a risk retention group (RRG), must be licensed in their own country. In general, offshore jurisdictions are more accommodating than domestic insurance regulators. In practice, most offshore CICs owned by a US taxpayer elect to be treated as a domestic corporation for federal tax purposes under IRC § 953(d). However, an offshore CIC avoids income taxes. The cost of licensing and operating an offshore CIC is comparable to or less than domestic. More importantly, an offshore company offers better asset protection options than a domestic company. For example, an offshore irrevocable trust that owns an offshore captive insurance company provides asset protection against company creditors, the grantor, and other beneficiaries, while allowing the grantor to enjoy the benefits of the trust.
For US business owners who pay significant insurance premiums each year, a captive insurance company efficiently reduces taxes and builds wealth and can be easily integrated into wealth protection and estate planning structures. Up to $1.2 million in taxable income can be shifted as deductible insurance premiums from an operating company to a low-tax CIC.
Warning & Disclaimer: This is not legal or tax advice.
Internal Revenue Service Circular 230 Disclosure: As provided in the Treasury Rules, advice (if any) related to federal taxes contained in this notice is not intended or written to be used, and cannot be used, for the purposes of (1) avoiding fines under the Internal Revenue Code or (2) promoting, marketing, or recommending to any other party any transaction or matter addressed herein.
Copyright 2011 – Thomas Swenson
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