|Captive Insurance Companies - |
Creating Current & Recurring Revenue
|Volume 3, Issue 8
This issue of The Wealth Counselor examines Captive Insurance Companies, a topic that should be of interest to all business owners with
annual net profits of $500,000 or more, as well as all planners who serve them. Perhaps over-hyped at times, Captive Insurance Companies
(Captives) are a legitimate planning tool that offers significant benefits to clients, while also generating significant current and
recurring revenue to the planning professionals who understand, implement and maintain them. An understanding of Captives allows the
wealth planning team to distinguish and/or solidify itself as its clients' trusted advisors while providing unique and valuable client
From William Chandek
William J. Chandek & Associates, LLC
333 Bishops Way, Suite 150
Brookfield, WI 53005
What is a Captive Insurance Company?
A Captive Insurance Company is a subsidiary or an affiliate of a company or group of companies that serves to insure or reinsure some
or all of the risks of that company or group of companies. A company that pays reasonable premiums to a properly formed Captive may
deduct them just like any other insurance premiums paid.
The benefits of Captives include that they can:
A Captive has to be a real insurance company and that means being a true risk-spreading vehicle. This can be accomplished through
risk pooling and other means. A Captive cannot just insure the risks of its owner.
- Provide coverage for uninsurable risks
- Allow flexibility over claims management
- Create wealth in underwriting profit (potential estate planning opportunity)
- Protect assets and reserves
- Provide incentive for establishing "best practice" risk management procedures
Planning Tip: Captives can also provide income tax deferral and/or savings,
estate tax savings, wealth transfer, and asset protection.
The History of Captives
Some may believe that the benefits of Captives are simply too good to be true. To the contrary, the IRS has issued several Revenue
Rulings since 2001 that provide specific guidance for Captives, including Safe Harbor guidelines in Revenue Ruling 2005-40. (See
also Rev. Rul. 2001-31, 2002-89, 2002-90, 2002-91, and 2008-8.) These rulings have in fact created the opportunity for Captives
owned by mid-size, privately owned companies, as well as their use for estate and business planning purposes.
Planning Tip: Properly implemented and maintained, Captives are legitimate
and can provide significant client benefits.
What Risks Can a Captive Insure?
Companies form Captives to insure against both risks for which insurance coverage is available and those for which it is not. Some
examples of otherwise uninsurable risks are:
Companies form Captives if they believe that they can self-insure in a cost-effective way. Otherwise insurable risks against which
companies self-insure include:
- Loss of Key Customers
- Some Director & Officer Liabilities
- Punitive Damages
- Excess Errors & Omissions
- Construction Defects
- Contract Claims
- Intentional Acts
Tax Treatment of Captives
- Worker's Compensation
- General Liability
- Professional Liability
- Errors & Omissions
- Director & Officer Liability
- Builder's Risk
Under Internal Revenue Code Sec. 831(b), if a Captive receives premium payments of less than $1.2 million per year, there is no tax
on the premium income. However, Captives are C corporations and therefore pay tax on investment income at corporate rates.
Planning Tip: Business owners can use Captive profits to fund life insurance
more tax efficiently, either as a direct investment of the Captive or by using Captive dividends to pay insurance premiums. However,
clients should understand that the death benefit will be subject to tax, at a minimum, at long-term capital gain rates upon dissolution
of the Captive. Life insurance death benefits are also a preference item for corporate Alternative Minimum Tax, so owners of large
Captives should be mindful of that issue as well.
Estate Planning Opportunities with Captives
Captives provide numerous estate planning opportunities. In addition to owning a Captive outright or through an entity, business
owners can capitalize Captives owned by children (or better yet, inside a trust for children's benefit), or they can later gift or
sell the Captive to children or a trust for children's benefit. To the extent a business owner can deduct premium payments to a
Captive, those premium payments are not gifts and therefore are not subject to gift or generation-skipping transfer (GST) tax. If
claims against the Captive's reserves are less than the premium payments, the Captive will leverage the transfer to children or a
trust for children's benefit, while removing the Captive's assets from the taxable estate of the business owner.
Planning Tip: To the extent business owners can deduct premium payments to a
Captive, those payments are not gifts and therefore are not subject to gift or GST tax, even if someone other than the business owner
owns the Captive. However, premiums that are not deductible will be subject to estate and possibly GST tax. The initial capitalization
of a Captive may also be subject to gift and GST tax, depending upon ownership.
Business owners can also use equity buildup with a Captive to provide seed money to a grantor trust for that trust's future purchase
of estate assets.
Business Planning with Captives
Captives are also a useful tool for business planning. If key executives own a percentage of a Captive, the Captive can create very
powerful management incentives. For example, a Captive can incentivize key executives to improve risk management practices; the better
key employees manage risk, the more Captive profits remain after payment of claims. Because Captives are C corporations, owners can
grant key executives ownership interests in a Captive with preference rights that become more valuable as the executive hits certain
revenue targets or cost reduction targets. Such preference rights are not possible with an S corporation election, which many closely
held businesses have made, because there can only be one class of S corporation stock.
Additionally, Captives can be a part of a golden handcuffs plan. The business owner could also implement a deferred vesting schedule
for Captive stock to make it increasingly expensive for the executive to seek employment elsewhere.
Planning Tip: Captives offer significant business planning benefits,
particularly as an incentive and retention tool for key employees.
Formation and Administration
First year costs for Captives are generally $75,000 or more. Ongoing annual costs are $36,000 or more for management fees, plus
$20,000 or more for audit, tax, licensing fees, and actuarial fees. Where there are less than 12 insureds, third party risk costs
are typically 2.5% - 4% for risk pool insurance purchases plus loss of use of funds while held by the risk pool.
Planning Tip: Ideal clients are those with $500,000 or more in taxable profits
at the company level, and the business must face substantial risks that are not entirely within its control.
Captive Insurance Companies can offer significant benefits to businesses that face substantial risks not within their control. By
working together, the planning team can identify those businesses that might benefit from a Captive and explore with the client the
benefits of Captives generally and whether a Captive meets that client's unique planning goals and objectives. Captives provide
significant benefits to business owners and the planning professionals who understand them.
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter
was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may
be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer's particular circumstances.
For professionals' use only. Not for use with the general public.
You have received this newsletter because I believe you will find its content valuable, and I hope that it will help you to provide
better service to your clients. Please feel free to contact me if you have any questions about this or any matters relating to estate or wealth planning.
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William J. Chandek & Associates, LLC 333 Bishops Way, Suite 150 Brookfield, WI 53005 Website