Private Client Services Update – Estate Planning With Small Captive Insurance Companies
The use of captive insurance companies has ballooned in recent years. The reasons are many, including traditional insurance companies narrowing the areas of risk they are willing to cover, ever increasing premiums charged by traditional carriers, a desire of insureds to have more control over policy terms, cost efficiencies available through the use of captive insurance companies, and wider recognition of the substantial tax and estate planning benefits associated with captives. Further contributing to the growth of captive insurance companies is the growth of a cottage industry of consultants touting the benefits of captives, most being competent and scrupulous but some operating on the margins pushing questionable schemes.
At its most basic, a captive insurance company is a company formed by one or more individuals or operating businesses to insure the risks of its owners and related or unrelated businesses. Like any other insurance company, it issues policies, collects premiums, and pays claims as they arise. A captive insurance company can be formed as a Virginia entity, a domestic entity located outside of Virginia, or an off-shore entity. Depending on the jurisdiction, a captive can take various forms, including a corporation with a single owner that is one of the insureds, a corporation with multiple owners who are the insureds, a “cell” company, or a “series” limited liability company. A cell company is a corporation with separate divisions called “cells.” The assets and liabilities of each cell are segregated from those of the other cells, but the cells are not separate entities. The captive owner may own interests in just the cell, rather than the entire entity. A series limited liability company is similar to a cell company, except that the entity is a limited liability company rather than a corporation, and the captive owner owns interests in a “series” rather than a “cell.”
While captive insurance companies should always be formed primarily for non-tax business purposes, there are also particular tax benefits associated with small captive insurance companies. Under Section 831(b) of the Internal Revenue Code, insurance companies (other than life insurance companies) receiving annual premiums of up to $1.2 million can elect a special tax regime. Unlike traditional insurance companies, an insurance company making this election is not taxed on the premiums received. Instead, it is only taxed on its investment income.
A small captive insurance company can offer significant wealth transfer opportunities. For example, if the owners of the captive are the children of a business owner, or a trust or trusts for the benefit of children and more remote descendants, premium payments by the business are valid business expenses that are deductible for income tax purposes and not treated as gifts. As long as the captive satisfies its reserve requirements, it can make periodic distributions to its owners. If the captive experiences few losses, over time a substantial amount of wealth can accumulate for the benefit of family members. Because the business owner does not own the captive, the captive is not included in his or her estate at death.
Aside from complying with the various regulatory requirements applicable to insurance companies, in order to take advantage of the available tax benefits, the captive must be a true insurance company – it must cover bona fide risks, there must be risk shifting (in exchange for premiums, the company assumes the liability of making payment if the covered risk develops into a loss), and there must be risk distribution (the pooling of independent risks of unrelated parties). Case law and IRS rulings provide guidance concerning the acceptable structuring of captive insurance companies.
A small captive should be considered for profitable businesses (for example, $500,000 or more in annual pre-tax profits) that enjoy stable cash flow but have low frequency, potentially high loss risks that are currently self-insured or underinsured. A wide range of industries are good candidates for creating captive insurance companies, such as contractors, developers, farmers, retailers, physicians and other health care providers, hotels, restaurants, manufacturers, and car dealers. Any number of risks might be covered by a small captive, including business interruption, reputational risk, regulatory risk, and loss of a key supplier, customer or employee.
Because of the complicated framework of laws that apply to insurance companies, the formation and maintenance of a captive insurance company requires great care. So assembling a strong professional team – attorney, CPA, insurance consultant/manager, and investment manager – is critical. – David Kamer
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2019.