The Captive Audience

By forming its own insurance company, a business can legally dodge some taxes.


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Want to make a grown man cry? Find one who was thrilled to have had a great, profitable year, and tell him the amount of his income tax bill. For 2013, the tax rate was increased to an unbelievable 39.6 percent on taxable income of more than $400,000 if single or $450,000 if married.

A successful business owner like Joe is old enough to begin thinking about his estate tax liability as well, which will be at the top rate of 40 percent. Joe knows the numbers: for every $1 million he makes, the IRS takes $400,000, leaving him with just $600,000. After he dies, the estate tax monster strikes with a vengeance, taking another $240,000 bite and leaving Joe’s family with just $360,000.

Is there a way to legally avoid this double tax? Not entirely. But Joe can prevent as much as $1.2 million per year from being hit in this way by creating a captive insurance company for his business, Success Co.

Section 831(b) of the Internal Revenue Code specifically creates a tax incentive for businesses to form their own small insurance companies that can provide them with a broad range of risk management capabilities. Basically, the captive insures those risks that a typical property and casualty insurance company does not, such as the loss of a large customer or a key employee.

Joe’s Success Co. establishes a captive, typically a limited liability company (LLC) or a partnership, which, in turn, forms an investment LLC to hold its assets and invest its funds. The investment LLC can invest its funds in stocks, bonds, real estate or other entities, and Joe can manage the investments, if he wants to.

The big tax saving comes from the fact that premiums up to $1.2 million per year paid by Success Co. are 100-percent deductible but tax-free when received by the captive. The captive then invests those premiums. Earnings on the investments are taxed as if the captive is a C corporation, and the assets of the LLC are used to pay Success Co. on claims covered by the captive.

A law firm that specializes in captives explains the savings with this example: Success Co. pays $1.1 million in premiums per year to the captive. Claims are 5 percent of the cash available in the captive, while cash invested earns 3 percent. Current tax rates are used to pay required taxes and deduct all costs. At the end of three years, the captive is liquidated. Joe ultimately dies. The three-year example saves $1,198,815. Over five years, the savings jumps to $1,860,484.

Captives as Estate Planning Strategies
So, can a captive be used as an estate planning strategy? The following example, from an article in the June 6, 2010, issue of Accounting Today, explains how it can be:

The children of the business owner (Joe, in this case) are the beneficiaries of a dynasty trust, which owns 78 percent of the captive. Annual premiums are $1 million per year, while taxes, claims and operating expenses total $120,000. Investment assets grow at 8 percent per year. After 10 years, the captive has more than $14.6 million in investment assets. Of that amount, $11.4 million (78 percent) would be excluded from Joe’s estate for tax purposes. In addition, the captive distributes annual dividends to purchase a $10 million life insurance policy. Then the family wealth, which is held in the dynasty trust, (combining the insurance death benefit and the captive liquidation) is increased to more than $21 million—all estate-tax-free.

This begs the question: Can a captive be used to build a retirement fund? Again, the answer is “Yes.” If Joe owns the captive, when the time comes for him to retire, he simply liquidates the captive to capture its assets at low capital gains tax rates.

What Does the Captive Cover?
As touched upon earlier, a captive can be set up to insure risks that a typical property and casualty insurer does not cover. It also offers monetary benefits. Say you pay $500,000 in premiums to a property/casual company and have no claims. Obviously, you’ve given up 100 percent of that money. But if the same amount in premiums is paid to your captive without any claims, you still retain every penny of that $500,000 and get investment earnings.

The most common risks that a captive insures against include:
1. Everything a business currently self-insures, such as excess losses above coverage limits, construction defects, warranties and deductibles (property, vehicle accidents, workers compensation, general liability, product liability).
2. Loss of income due to loss of key employees or salespersons, key contracts (including government contracts) or major customers; a strike by employees; and weather, terrorism and other calamities.
3. Anything that could be considered a “Lloyd’s” risk. (If Lloyd’s of London would insure it, so could your captive.)

The right advisors can tailor your captive to fit your business and your circumstances perfectly.

Now the key question: Is a captive right for you? If costs were not an issue, the answer would be a resounding “Yes” for almost every business. Unfortunately, there are costs associated with creating and administering a captive. But the more profitable your business, the more the resulting savings and tax benefits make those costs well worth it. If you make $500,000 or more before taxes, a captive should be a top priority for your tax planning.