831 (b) Micro-captive Insurance
In an attempt to maximize the client’s after-tax income, the owner’s financial planning consultant may recommend an 831(b) captive insurance company. By setting up an 831(b) captive insurance company and issuing insurance policies naming the business and/or the business owner as the named insured, the owner can deduct up to $1.2 million in premium payments as business expenses and retain 100% of the underwriting profit if no claims are paid. At the end of the day, the business owner will have saved as much as $420,000 in taxes per year which can be used to fund future risk exposures or taken as profit distributions in the form of capital gains. Further, the captive insurance company structure affords the additional benefits of protecting assets from creditors and efficiently transferring wealth to future generations.
Although the results of the financial planner’s research is all factual, there’s another saying that goes, “If it sounds too good to be true, it probably is.” In fact, the business of insurance is a highly regulated industry under the watchful eyes of interested parties including the National Association of Insurance Commissioners, the Federal Trade Commission, the Securities and Exchange Commission, and the Internal Revenue Service (IRS) as well as several industry trade and consumer protection groups. Specifically, the IRS is very interested in transactions just like the one described above for obvious reasons. Despite working with the labyrinth of tax laws that make up the Code, few financial advisors are well-versed on the business of insurance and its unique set of laws and regulations. Furthermore, there are many insurance advisors that would be hard pressed to define the fundamental principles of an insurance transaction from the IRS’ perspective.
For starters, the term “831(b) captive insurance company” refers to a closely held, special purpose company in the business of insurance that qualifies and has elected to be taxed as a U.S. corporation under Section 831(b) of the Internal Revenue Code. This section of the code provides that certain “small” insurance companies writing between $350,000 and $1,200,000 in annual premium can elect to be taxed solely on the basis of the investment income earned during the tax year. To illustrate the impact of this election, consider a company that writes $1,200,000 in annual premium, has $200,000 in expenses, $100,000 in investment income, no claims, and generates $1,000,000 in underwriting profit. Assuming a 35% tax rate, the company (and its owners) can save $350,000 in federal income taxes annually by making the Section 831(b) election. That is, the company will be taxed only on the $100,000 investment income as opposed to the sum of its underwriting profit and investment income earned during the tax year.
As captive insurance companies gain in popularity with non-insurance advisors, one should anticipate that the IRS’ scrutiny of such vehicles will also become more frequent and comprehensive. So, while a properly constructed captive insurance company can afford its owner with a valuable tool for optimizing risk management strategies and operating efficiencies, “the devil is in the details.” Essentially, one must be prepared to:
- demonstrate that the captive is formed for a legitimate business purpose other than optimizing tax efficiencies
- justify that the insurance contract(s) issued transfer a real risk of economic loss and that premiums are commensurate with the risk transferred and the benefits provided
- clearly establish compliance with the IRS’ standards for risk distribution
In short, if you want your captive insurance company to perform at its optimal efficiency and exceed all scrutiny from regulatory oversight, then you must PICK THE RIGHT ADVISERS AND MANAGER. Selecting competent advisers and service providers is critical to all successful captive programs, any sophisticated business development initiative for that matter, and this is especially true of 831(b) programs. In order not to run afoul of tax regulation trouble, it is important that your 831(b) captive program be well documented, maintain timely books and records, write legitimate lines of coverage, and price the coverage fairly. For many US based owners, domiciling onshore with a US state approving the captive as an insurance company could be worth the extra cost of operating the captive onshore.
Nonetheless, establishing a captive insurance company is not without meaningful risk to all involved. First and foremost, as previously noted, a small captive insurance company is an insurance company. Corporate Risk Management is therefore paramount; tax benefits and estate planning must be secondary though it can certainly be a significant incidental benefit. There must be a valid non-tax purpose for the formation of the captive. The IRS is acutely sensitive to how captive insurance is marketed and the motivations for its use, both legitimate and more suspect. Risks being insured must truly apply to the business (for example, flood insurance on the top of Mount Washington might not be appropriate), and the premium must reflect the likelihood of an insurable event. There must be adequate risk shifting and risk distribution.
Traditionally the 831 b is used to develop an insurance program that is currently either uninsured and or self insured by the prospective client. Such as everything a business currently self-insures:
- Deductibles, Excess losses above coverage limits, and Environmental Liability
Or coverages where the prospective client is uninsured such as:
- Professional liability Gap Coverage
- HIPAA/Billing Audit Liability
- Contractual Liability
- Cyber Liability
- Environmental Liability
- Excess Environmental Liability
- Labor Shortage/Strike Loss Reimbursement
- Employment Practices
- Employee Dishonesty
- Patent Infringement/Intellectual Property
- General Liability Gap
- Property Management Professional
- Professional Misconduct
- Product Recall
- FDA Administrative Actions Liability
- Product Liability Gap
- Directors and Officers Liability
- Punitive Damages
- Loss of Key Employee
- Wind Deductibles on Property
Similarly, in setting up a captive program, failure to engage in an actuarial study supporting the premiums to be made might be suggestive of a tax shelter rather than a business-driven arrangement, as would the failure to analyze the cost and availability of commercial insurance in a non-captive context. If the captive does not satisfy the requisite requirements, the IRC Section 831(b) election will not be able to be made, or, if already made, could subject the captive, the operating company and their principals to unpleasant IRS scrutiny.
In exchange for this investment, if you select qualified service providers such as the Gaudreau Group, you will get tax advantaged loss reserve accumulations that are protected from creditors and out of your estate while retaining investment control. In fact millions more in loss reserve assets you would not have otherwise had but for owning your own captive insurance company (assuming of course you implement effective loss control and do not experience any devastating enterprise risk event which would have cost you more without a captive).
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