BY KEVIN M. HEDLEY, MS, CPA, PFS
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
$1.2 million 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 CIC 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 CIC. The
operating company pays the premium to the
CIC 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
CIC is under $1.2 million, the CIC will pay no
tax on the receipt of the premiums. The CIC 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 million.
Your company pays and deducts the $1 million
business income thereby reducing your taxes. If
you had not deducted the $1 million, then your
business would have an additional $1 million
of income.
Therefore, you would be in the highest tax
bracket for federal purposes, which is 39.6 percent
(not including the effective rate increase
from various phase outs) or an effective rate as
high as 43.592 percent after taking into account
the effective costs of phaseouts; plus New York
taxes of anywhere from 6.85 percent to 8.82
percent.
These make an effective combined tax rate
with federal and state taxes of 50 percent or
greater. That $1 million deduction results in a
savings of $500,000. Remember that your CIC
does not pay tax on the $1 million 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 CIC 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 0.0 percent
to 20 percent, plus the 3.8 percent ACA tax.
So the tax cost of receiving the dividend in
current law may be 23.8 percent for a qualifying
dividend (exclusive of effective tax costs of
phaseouts) or 24.592 percent with effective costs
of phaseouts, plus the state rate of anywhere
from 6.85 percent to even 8.82 percent.
Therefore the tax paid on receiving the qualifying
dividend is approximately 30 percent. A
business can deduct the premium in one year,
save taxes at perhaps at rates of 50 percent or
higher and then several years later receive earnings
back from the CIC and pay taxes at a rate
of closer to 30 percent. 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 is a partner with Hedley & Co. PLLC.