A very wide range of companies employ Captive Insurance Company (CIC) as a means of preparing for risks and remaining solvent in the event of disasters and unforeseen events that traditional insurance won’t cover. Imagine a cancer diagnosis for a company owner or the key employee critical to company function? Or a pandemic that shuts down the supply chain. It’s really not hard to imagine a scenario that can quickly spell the end for a small or mid-sized business.
A CIC can help insure against those risks and help a company survive disasters of all kinds. They’re employed by a wide range of companies, from financial institutions and manufacturing, to education, construction, retail, agriculture, real estate and more.
**Tax Considerations of a CIC**
While a CIC can provide tax benefits to a company, it is not, by any means, a tax shelter. It’s intended by Congress to help businesses remain competitive in difficult times. And it’s heavily regulated by the IRS to insure it’s functioning as any insurance company is intended: paying claims to cover business losses and generating a reasonable return on its investments.
Virtually all CICs making an 831(b) election to file form 8886 and submit additional paperwork as a “Transaction of interest,” is required if the CIC has combined claims and administrative costs below 70% of its premiums; is supposedly required because the IRS needs more information on small CIC; and the original filing deadline was Jan. 30, 2017. It also requires “material advisors,” those compensated $10,000 or more on the CIC transaction, to file as well.
If the IRS determines the CIC is a “sham,” and that its main purpose is a tax shelter and not to act as an insurance company, the premium payments made to it will not be considered a bona fide business expense and the IRS will disallow them as a deduction.
So what is a “legitimate business purpose” of a CIC?
1.) Insuring risks presently insured via third-party arrangements
2.) Insuring risks presently self-insured via after-tax reserves
3.) Insuring risks presently uninsured or underinsured
4.) Insuring risks with unavailable coverage through commercial markets
5.) Reducing premium costs vs. third-party insurance costs
6.) Access to reinsurance markets
7.) Increasing loss control measures
8.) Balancing coverage
Since the IRS doesn’t actually provide a specific definition for the term “insurance,” a company will know if it qualifies as a insurance company only by the actions it takes.
Those actions include:
- insuring risks that have potentially measurable and economically feasible damages associated with them, typically determined by a. Third party Actuary.
- shifting risk of loss from the insured to the Captive, i.e., when the Captive issues policies to the insured, and
- transferring a portion of the underwritten risk to an unrelated party or an adequate number of related parties.
**Formation of a CIC**
A CIC’s domicile can be within the United States or Offshore. There are 30+ states who allow for the formation of CICs. The most popular of these are Vermont, Delaware, North Carolina, Hawaii, Utah, Montana, Tennessee, Kentucky and Nevada.
Offshore jurisdictions were originally the preferred choice for most CIC owners, with historically low capitalization requirements and more relaxed regulatory environments and desirable locations such as the Caribbean. The most popular options include Bermuda, Cayman Islands, Barbados, St. Kitts, Anguilla and the British Virgin Islands.
**Ten steps for proper CIC Formation**
1. Determine legitimate business purpose (or purposes) for forming a Captive Insurance Company.
2. Hire a Captive Management Company who will provide access to Actuaries, Attorneys, Risk Distribution Pools and Tax Professionals.
3. Engage a Captive Attorney to help determine the appropriate jurisdiction, type and ownership structure of the Captive being contemplated.
4. Feasibility Study to be performed by an independent Actuary to determine the types of coverage and premiums to be charged.
5. Make a decision whether to proceed based on the Feasibility Study
6. Have the Captive Attorney form the Captive in the jurisdiction chosen, and obtain the proper Insurance License.
7. Capitalize the Captive as required by the jurisdiction (letter of credit or $250K)
8. Utilize the Actuary to develop, underwrite and issue the policies; pay the requisite premiums to the Captive.
9. Arrange for risk distribution requirements to be met through the Pool (or related entities).
10. Consider options for the investment of any Captive profits.
Ancillary Benefits of CIC Ownership
A CIC can be owned by the owner of the business it’s set up to provide insurance for, a family member of the business owner, or its key employees. The owner(s) of the CIC can reap benefits beyond the stability of insuring the company they have some stake in.
**Captive Profits:**
If claims paid are less than premiums received, business owners can capture the insurance profits instead of a third party insurance provider. Those profits can be used to reinvest in the business, or pay dividends, often at favorable tax rates, to the CIC’s owners.
A key component of establishing a CIC is developing appropriate investment and exit strategies to maximize the economic benefits of the CIC arrangement.
**Stronger Business Model:**
Businesses who use CICs to plan for unforeseen risks stand a much better chance of surviving and passing the business resources to the next generation.
Assets of a properly organized and managed CIC enjoy a very high degree of protection from both the business’s and the business owner’s creditors.
And CIC profits can accumulate over time, sometimes to significant sums, when can contribute to a retirement plan, late stage health care and a myriad of other life cycle needs.
**Alternative to Non-Qualified Deferred Compensation Plans:**
Key employees can be made co-owners of the CIC, allowing them access to some of the insurance company’s benefits.
**Business Transition:**
A CIC can facilitate buyout or buy-sell agreements. Selling party can own the Captive and provide insurance coverage to the business owned by the purchaser.
**Accessing CIC’s Wealth**
Accessing the wealth of the CIC while it exists can be done through dividends paid to its owners. These dividends are taxed at current rates, possibility Qualified Dividends Rates. Keep in mind, a CIC deemed a “sham” by the IRS may result in any dividends paid to the owner seeing double taxation.
An investment partner may also be able to access the CIC’s wealth via an investment in the insured business or venture. A loan from the CIC may also be made, in domiciles that approve of loans — not all do.
When an owner wants to exit a company, the steps may be different. The CIC can be dissolved, with all capital gains taxed at long term capital gain rates. Or the CIC can be converted to an S Corp, with the same CIC ownership. This may not trigger taxation.
Want to know more? Get in touch with us to learn more about Captive Insurance and other ways to mitigate risks and ensure a stable future for your business.
