A captive insurance company (“Captive”) is a domestic or foreign insurance company formed by a business owner to insure the risks of the operating business. The owner of a business or a group of businesses can form a wholly owned Captive for the purpose of insuring his related companies. The insured businesses pay premiums to the Captive in exchange for insurance. The insurance premium paid is a deduction to the operating businesses income and, in many cases, the premium income received by the captive insurance company will be tax free.
A Captive can be owned by the business owner, his spouse, his relatives, a Trust, or any other entity. The operating business pays premiums to the Captive, and the Captive insures the risks of the operating business. A Captive not only allows a business to control its insurance costs and ensures hassle free payment when a claim is made, but also provides a highly tax efficient method to accumulate wealth. Businesses can also use captives to reduce their cost of insurance or improve their coverage at little to no cost.
This article summarizes many of the non-insurance benefits of Captive offers. These benefits include, but are not limited to, estate planning and wealth accumulation, retirement planning, and asset protection. This article is intended to be very broad and to merely draw your attention to this sophisticated and flexible tool.
History of Captives
Modern Captives began in Bermuda in the early 1960s, and were formalized in the late 1970s with a medical malpractice Captive for Harvard University. The growth of Captive insurance and related risk transfer mechanisms has boomed. The total number of pure Captives in the United States today is well over 1,500.World wide there are well over 5,000 pure Captives. Captives are not fly by night entities. Rather they are sophisticated tools that have been time tested and approved by the IRS.
Generally, Captives are taxed on all of their income as though they are C corporations. However, the Code permits property and casualty insurance companies certain deductions against taxable income, including premium income and investment income, that are not available to regular corporations. As a result, a carefully administered property and casualty Captive may have little or no taxable income from premiums received.
Code Sec. 831(b) provides a very powerful tax advantage for qualifying small Captives. If the Captive receives less than $1.2 million of premiums each year, it may elect to be taxed only on its investment income. Thus, premiums are not taxable income. Once the 831(b) election is made, it may not be revoked without prior written consent from the IRS. Fortunately, a Code Sec. 831(b) election does not affect the deductibility of premiums paid by the operating companies. The key advantage to making a Code Sec. 831(b) is that the Captive is able to accumulate surplus from underwriting profits free from tax. Assuming the Captive carefully chooses its risks, it can accumulate significant assets in a fairly short period of time.
If you imagine a Captive that goes five years without a significant claim and little appreciation the Captive can easily accumulate $6.0 Million in assets. If the Captive were structured to be owned by a trust or limited liability company for the benefit of your children and grandchildren then you would have effectively shifted $6.0 Million to your children free of income, gift, and generation skipping tax. In addition, you would have the added benefit of shifting the $6.0 Million while creating an income tax deduction for you without income to the children and grandchildren. In sum, if properly structured a Captive can create a significant income tax deduction while moving assets out of your estate free of gift taxes.
A Captive that makes a Code Sec. 831(b) election can also provide substantial retirement benefits for their owners. The profits a Code Sec. 831(b) Captive earns on its insurance premium is taxed when they are distributed to its shareholders as qualified dividends or as long term capital gains, both of which are currently taxed at 15%. This tax deferral feature provides substantial flexibility while Congress continually changes the tax rates. Since the shareholders control the timing and amount of distributions they receive from their Captive, they can choose to receive these distributions in the manner and time which provides them with the greatest tax benefits.
Depending on the structure, a Captive can provide significant creditor protection. In addition to the protection afforded by the corporate shield, some jurisdictions prevent premiums paid to a Captive from being attacked by creditors of the insured. Anguilla, for example, has legislation which provides that the premium paid to the Captive is protected from the creditors of the insured unless the payment of such premiums was made with the intent to defraud the creditor. In addition, the legislation also protects the insurer from actions against insurance premiums paid to it, providing it maintains such premium in accounts separate from every other account.
Captives are very flexible but sophisticated tools which can have significant noninsurance benefits. Despite the non-insurance benefits of Captives, they are not right for everyone. No one solution fits all. Let us help you determine if a Captive makes sense for you.