A Tax Law That Cuts Business Costs

The Internal Revenue Code is not a friendly creature. It is designed to “taketh” your money—“giveth” is not in its vocabulary. Yet, there is a section of the code that deals with captive insurance companies (captives). When properly used, captives are income-tax-saving machines for your business and can be structured to offer tax-advantaged benefits that create wealth.


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A captive is first and foremost an insurer established to provide coverage for the company that founded it. Captives can be used to insure risks for which you can’t buy coverage from property and casualty insurance (PCI) companies and other traditional suppliers. Examples of these “uninsured risks” include loss of a key customer, product liability, litigation defense/asset protection, loss of a key supplier, strikes/labor problems and others. A captive reduces the amount needed to fund possible these future losses because premiums paid to the captive are immediately deductible.

For example, let’s say Joe, owner of Success Co., created New Co., a captive insurance company that covers Success Co.’s uninsured risks. The stock of New Co. is owned by Joe’s children. Now, suppose the insurance premium for the uninsured risks is determined to be $500,000 per year. Success Co. pays the $500,000 premium to New Co., and the entire premium is immediately deductible by Success Co., like any other PCI. Under the captive rules, all of the $500,000 is income-tax-free to New Co.

Now, say Success Co. is in a 40-percent tax bracket (state and federal combined). Success Co. is only out of pocket $300,000 ($500,000 minus $200,000 in tax savings), and New Co. has the entire $500,000 to invest. This is a good start, but remember, New Co. is a captive and must hold the $500,000 plus earnings as a fund to pay potential claims for the risks it insures.

With a commercial insurance company (CIC), if the insured has no losses, the CIC keeps the entire premium—no refunds. Even though a captive cannot reduce (actuarially determined) premiums, a financial windfall results if the insured’s actual losses are less than actuarially predicted. For example, suppose New Co. has an unused reserve. A portion of the unused reserve can be refunded to Success Co.; reduce future premiums; or paid to the captive’s shareholders (Joe’s children) as a dividend—three nice fringe benefits.

There are a number of other fringe benefits to a captive structure. You can someday liquidate your captive and take out the unused reserve at capital gains rates; have the captive invest a portion of its reserve funds to pay premiums for life insurance on the captive’s founder or his family members (in effect, deducting the life insurance premiums); and you can use the captive as an estate planning strategy, passing the captive and any life insurance proceeds to your heirs.

Make no mistake, your captive must be formed and operated for a business purpose. The captive must demonstrate that it is, in fact, acting as a proper insurance company. Follow the rules, and the IRS is not a problem. Try to fool the IRS by forming your captive to take advantage of only the tax-advantaged fringe benefits without a real business purpose and you are almost certain to lose of the sought-after benefits.

No attempt is made in this article to explore all the rules, traps and opportunities in forming your own captive. It is essential that you work only with qualified, experienced advisors that specialize in captives. The right advisors can easily tailor your captive to fit you, your business and your circumstances perfectly.

So, is a captive for you? If costs were not an issue, the answer would be a resounding “yes” for almost every business. Unfortunately, costs are a factor. For a Fortune 500 company, it’s a slam dunk: The insurance cost savings and tax benefits are well worth the required costs to create and administer a captive.

If you can answer “yes” to any of the following questions, you should strongly consider forming a captive: Is your before-tax profit $1 million or more per year? Are your traditional insured property and casualty expenses $1 million or more per year? Is one or more of the “uninsured risks” a significant factor in your business and worth a premium of about $200,000 a year?

Logic tells you that the larger your business, the more likely a captive should be a top priority for next year’s business plan. Costs are easily covered by captive benefits.

However, what about smaller family businesses? The answer can be “yes” if your before-tax profits are in the $250,000-per-year range. Benefits are the same as those projected for larger companies, but costs are substantially reduced.

What, you are even smaller? Well, we need your help. Show this article to the decision maker(s) of your trade association. Have your trade association adopt a captive program, then you and the other members can participate. The cost is minimal.