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 to any other insurance company in many ways. It is called “captive” because it generally provides insurance to one or more related business activities. With captive insurance, premiums paid by a company are kept in the same “economic family” rather than being paid to an outsider.
Two major tax benefits allow 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 in premium payments annually, tax-free. In other words, a business owner can shift the taxable income from an operating business to the low-tax captive insurer. An 831(b) CIC only pays tax on income from its investments. The “deduction of dividends received” under IRC § 243 provides additional tax efficiency for dividends received from company stock investments.
About 60 years ago, the first captive insurance companies started by big companies to offer insurance policies that were either too expensive or not available in the conventional insurance market.
Over the years, a combination of US tax laws, lawsuits, and IRS rulings has clearly defined the steps and procedures required for the establishment and operation of 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 allocation” requirements. This can be easily done through routine CIC scheduling. The insurance provided by a CIC must really be insurance, that is, 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 increased control and flexibility, which improve insurance protection and reduce costs. With conventional insurance, a third-party carrier typically dictates all aspects of a policy. Often, certain risks cannot be insured conventionally or only at an unaffordable price. Conventional insurance rates are often volatile and unpredictable, and conventional insurers tend to deny valid claims by exaggerating small technicalities. While business insurance premiums are generally deductible, once paid to a conventional third-party insurer, they are gone forever.
A captive insurance company efficiently insures risk in a variety of ways, such as through custom insurance policies, favorable “wholesale” rates from reinsurers, and pooled risks. Captive companies are very suitable for insuring risks that would otherwise be uninsurable. Most companies have conventional “retail” insurance policies for obvious risks, but remain exposed and subject to damage and loss from many other risks (ie they “insure themselves” those risks). A captive company can tailor policies for a company’s specific insurance needs and negotiate directly with reinsurers. A CIC is particularly suitable for issuing industrial accident policies, that is, policies covering business losses claimed by a company that do not involve outside claimants. For example, a company may insure itself against losses incurred through business interruption due to weather conditions, labor problems, or computer failure.
As noted above, an 831(b) CIC is tax exempt on up to $1.2 million in premium income annually. Practically speaking, a CIC makes economic sense when the annual premium receipt is about $300,000 or more. Also, a company’s total insurance premiums should not exceed 10 percent of annual revenue. A group of companies or professionals with similar or homogeneous risks may 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 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 proceed. Fortunately, competent service providers have developed “turnkey” solutions for conducting the initial evaluation, licensing and ongoing management of captive insurance companies. The annual cost for such out-of-the-box services is typically about $50,000 to $150,000, which is high, but easily offset by lower taxes and greater investment growth.
A captive insurance company may be incorporated under the laws of one of several offshore jurisdictions or in a domestic jurisdiction (ie in one of the 39 US states). Some captives, such as a risk retention group (RRG), must be licensed domestically. In general, offshore jurisdictions are more lenient than domestic insurance regulators. In practice, most offshore CICs owned by a U.S. taxpayer elect to be treated as a domestic corporation for federal tax purposes under IRC § 953(d). However, an offshore CIC avoids state taxes. The cost of licensing and managing an offshore CIC is comparable to or lower than inland. More importantly, an offshore company offers better asset protection opportunities than a domestic company. For example, an offshore irrevocable trust that owns an offshore captive insurance company provides asset protection from the company’s creditors, grantor, and other beneficiaries, while allowing the grantor to enjoy the benefits of the trust.
For U.S. 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 asset 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 Treasury regulations, any advice (if any) regarding federal taxes in this notice is not intended or written to be, and may not be, used for (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Copyright 2011 – Thomas Swenson