Business owners are generally more concerned with day to day business matters and may not realize some of the opportunities that may arise from solving problems. You may be concerned about the loss of key employees, vendors or major clients, legal expenses, or a myriad other concerns. All of these can result in a catastrophic loss if they occur and are the types of items that can keep you up at night. When dealing with all of this it isn’t often that a single solution can be found to solve multiple problems facing business owners, but there is such a solution available in the tax law.
One potential solution is known as a Captive Insurance Company (CIC).
The key difference with the insurance to be discussed here and insurance you obtain from your local insurance carrier is you own the insurance company. The Internal Revenue Code Section 831(b) effectively allows a business to claim a deduction of up to $2,200,000 in a calendar year and have that premium go to an insurance company that is owned by the business owner. The added benefit of the self owned insurance company is you do not pay any tax on the receipt of the insurance premium. Yes, you read that correctly, you deduct the premium from one company you own and exclude the income in another company you own.
So how can a Captive Insurance Company help your business?
Specifically, there are risks in your business that are uninsured or under insured. First you will need to determine the risks, the actuarial cost of the risk and determine a premium that an operating company will pay to the Captive Insurance Company. The operating company pays the premium to the Captive Insurance Company to cover those risks that are needed. It is important to note that the risks must be real, as an example you could not insure your local business facility against a tidal wave because no such risk of a tidal wave exists in upstate New York. As long as the annual premium paid to the Captive Insurance Company is under $2,200,000 the CIC will pay no tax on the receipt of the premiums. The Captive Insurance Company has certain obligations and liquidity needs to pay any claims that arise but it is also allowed to invest its assets. The income from its earnings is taxable.
What is this worth to you and your company?
Assume after doing the analysis we determine a premium for the series of risks is $1,000,000. Your company pays and deducts the $1,000,000 business income thereby reducing your taxes. If you had not deducted the $1,000,000 then your business would have an additional $1,000,000 of income. Therefore, you would be in the highest tax bracket for Federal purposes which is 39.6% (not including the effective rate increase from various phase outs) or an effective rate as high as 43.592% after taking into account the effective costs of phaseouts plus New York Taxes of anywhere from 6.85% to even 8.82%. These make an effective combined tax rate with federal and NYS taxes of 50% or greater. That $1,000,000 deduction results in a savings of $500,000. Remember that your CIC does NOT pay tax on the $1,000,000 of revenue as illustrated n the example. At this point you have saved $500,000 or more in tax. Furthermore you have protected yourself against claims and liabilities which, up to this point, have not been covered.
As you fast forward a few years and insure your risks, pay claims from your CIC as claims arise and after a few years the company has sufficient reserves on hand to pay claims. At this point the Captive Insurance Company can distribute the funds as long as it does not jeopardize its reserves. These distributions would be taxable to the individual owners at the long term capital gains rate as a qualifying dividend. Currently the qualifying dividend rate ranges from 0% to 20% plus the 3.8% ACA tax. So the tax cost of receiving the dividend in current law may be 23.8% for a qualifying dividend (exclusive of effective tax costs of phaseouts) or 24.592% with effective costs of phaseouts plus the NYS rate of anywhere from 6.85% to even 8.82%. Therefore the tax paid on receiving the qualifying dividend is approximately 30%. A business can deduct the premium in one year, save taxes at perhaps at rates of 50% or higher and then several years later receive earnings back from the CIC and pay taxes at a rate of closer to 30%. This is a 20 percentage point benefit to the owner.
The CIC needs to be properly structured, designed for risk transfer, and managed as an insurance company to be acceptable. The CIC may be owned by the owners of the operating company or may be owned by others as well. CICs have expenses separate from the current operating company to maintain and operate on an annual basis. It is safe to assume the operating costs of the CIC can be $50,000 to $70,000 annually but if you have saved $500,000 in taxes you are still ahead $430,000, this I argue is an expense well worth having.
Hedley & Co Certified Public Accountants can help you determine if the Captive Insurance Company is right for you and help you protect your business, solve the problems that concern you and even save money.