For business owners who pay 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 a “captive” because it generally provides insurance to one or more related operating businesses. With captive insurance, the premiums paid by a company are retained in the same “economic family”, instead of being paid to a third party.
Two key tax benefits allow a structure containing 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 in premium payments annually tax-free. In other words, a business owner can shift taxable income from an operating business to the low-tax captive insurer. A CIC 831(b) pays taxes only on the income from your investments. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from your corporate stock investments.
Beginning about 60 years ago, the first captive insurance companies were formed by large corporations to provide insurance that was either too expensive or not available in the conventional insurance market.
Over the years, a combination of US tax laws, court cases, and IRS rulings has clearly defined the steps and procedures necessary for the establishment and operation of a CIC by one or more business or professional owners.
To qualify as an insurance company for tax purposes, a captive insurance company must meet the “risk shifting” and “risk sharing” requirements. This is easily done through routine CIC planning. The insurance provided by a CIC must actually be insurance, that is, a genuine risk of loss must be transferred from the operating business that pays the premium to the CIC that insures the risk.
In addition to tax benefits, the main advantages of a CIC include greater control and flexibility, which improve insurance protection and reduce cost. With conventional insurance, an outside company typically dictates all aspects of a policy. Certain risks often cannot be insured conventionally, or can only be insured at a prohibitive price. Conventional insurance rates are often volatile and unpredictable, and conventional insurers tend to deny valid claims by exaggerating small technicalities. Also, although business insurance premiums are generally deductible, once they are paid to a conventional third-party insurer, they are gone forever.
A captive insurance company efficiently insures risk in a number of ways, such as through customized insurance policies, favorable “wholesale” rates from reinsurers, and pooled risk. Captive companies are well prepared to insure otherwise uninsurable risks. Most businesses have conventional “retail” insurance policies for obvious risks, but remain exposed and subject to damage and loss from numerous other risks (ie, they “self-insure” those risks). A captive company can write custom policies for a company’s particular insurance needs and negotiate directly with reinsurers. A CIC is particularly suitable for writing commercial accident policies, that is, policies that cover business losses claimed by a company and that do not involve third-party claimants. For example, a business might insure against losses from business interruptions due to weather, labor problems, or computer failures.
As noted above, a CIC 831(b) is tax-exempt on up to $1.2 million of annual premium income. In practice, a CIC makes economic sense when your annual premium receipt is approximately $300,000 or more. In addition, a company’s total insurance premium payments must not exceed 10 percent of its annual income. A group of companies or professionals that have similar or homogeneous risks can form a multi-parent 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, finance, and capitalization requirements. It is organized as an insurance company, with procedures and personnel to administer insurance policies and claims. An initial feasibility study of a business, its finances, and its risks determines whether a CIC is appropriate for a particular economic family. An actuarial study identifies the appropriate insurance policies, corresponding premium amounts, and capitalization requirements. After the selection of a suitable jurisdiction, the application for an insurance license can proceed. Fortunately, competent service providers have developed turnkey solutions for the initial assessment, licensing, and ongoing management of captive insurance companies. The annual cost of such turnkey services is typically $50,000 to $150,000, which is high but is easily offset by lower taxes and higher investment growth.
A captive insurance company may be organized under the laws of one of several offshore jurisdictions or in a domestic jurisdiction (ie one of the 39 US states). Some captives, such as a risk retention group (RRG), must be licensed nationally. In general, offshore jurisdictions are more accommodating than domestic insurance regulators. In practice, most offshore CICs owned by a US taxpayer choose to be treated under IRC § 953(d) as a domestic business for federal taxes. However, an offshore CIC avoids state income taxes. The costs of licensing and running a CIC abroad are comparable to or less than doing so at home. More importantly, an offshore company offers better asset protection opportunities than a domestic company. For example, an offshore irrevocable trust held by an offshore captive insurance company provides asset protection against creditors of the company, the grantor, and other beneficiaries, while allowing the grantor to enjoy the benefits of the trust.
For American business owners who pay substantial insurance premiums each year, a captive insurance company efficiently reduces taxes and builds wealth and can be easily integrated into asset protection and estate planning structures. Up to $1.2 million of taxable income can be transferred as deductible insurance premiums from an operating business to a low-tax CIC.
Warning and Disclaimer: This is not legal or tax advice.
Internal Revenue Service Circular 230 Disclosure: Pursuant to Treasury regulations, the advice (if any) relating to federal taxes contained in this release is neither intended nor written for use, and is not may be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to a third party any transaction or matter addressed in this document.
Copyright 2011 – Thomas Swenson