Captive Insurance Companies and the Closely-Held Business

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Captive Insurance Companies and
theClosely-Held Business
Feld, Hyde, Wertheimer, Bryant Stone, P.C. 2000
SouthBridge Parkway, Suite 500 Birmingham, AL
35209 Phone [phone] Fax
205.802.7550 Web site http//www.feldhyde.com

• James J. Coomes, Esq.
• FELD HYDE WERTHEIMER BRYANT STONE, P.C.
• ATTORNEYS AT LAW

Birmingham Estate Planning Council
October 1, 2009
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What is a Captive Insurance Company?

• A Captive insurance company is an insurance
  company formed primarily or exclusively to insure
  the risks of one or more affiliated businesses.
• There are many types of captives, however, the
  materials contained herein focus on captive
  insurance companies that insure property and
  casualty risks of affiliated closely held
  businesses (i.e., business risk insurance)
  through the issuance of insurance policies in
  return for premium payments and
• The Captive insurance company is owned by one or
  more of the owners of the affiliated closely held
  business (and/or the heirs of the owners).

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Who Else is Doing It?
It is estimated that more than 80 of Fortune 500 companies benefit from captive insurance companies. In fact, Allstate Insurance was founded as a captive insurance company for Sears. Other examples Wal-mart UPS Exxon - Mobil Starbucks Delta Airlines Microsoft Coca-Cola
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Lets Talk About Insurable Risks

• Some traditional risks
• General liability (includes property)
• Errors and omissions
• Directors and officers
• Employment practices
• Employee fidelity
• Construction defects
• Subcontractor default
• Workers compensation

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Lets Talk About Insurable Risks

• Some non-traditional risks

• Product recalls
• Loss of franchise agreement
• Subcontractor default
• Terrorism
• Earthquake
• Mold
• Kidnap, ransom
• Accounts Receivable
• Intellectual property

• Deductibles
• Administrative actions
• Data breach/cyber risk
• Loss of key customer
• Loss of key supplier
• Loss of key employee
• Litigation expenses
• Business interruption
• Tax audit

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Mariah Careys legs, 1 Billion
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Rod Stewarts voice, 6 Million
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Gene Simmons tongue, 1 Million
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Dolly Partons . 600,000
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Reasons to Form a Captive

• Underwrite risks that are presently being self
  insured (i.e., those that are not presently being
  insured by a third party)
• Underwrite risks that are presently being insured
  by third party insurance companies
• Underwrite risks that are difficult to obtain or
  are expensive
• Tailor insurance policies to specific needs
• Risk management incentives
• Greater control over claims
• Share in underwriting profits
• Tax benefits
• Asset protection benefits
• Estate Planning opportunities

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Taxation of Captives

• Captives are formed as C corporations and
  are subject to Chapter C and Chapter L of the
  Internal Revenue Code.
• Business risk insurance premiums paid by a
  business to a Captive are a deductible business
  expense. IRC Section 162. T.R. Section
  1.162-1(a)
• The premiums received by a Captive may be
  income tax-exempt.

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Did You Say Tax Advantage? -
continued

• The Internal Revenue Code provides a certain
  tax advantage to small property and casualty
  insurance companies depending on the amount of
  annual premiums it receives.
• Property and casualty insurance companies with
  annual premiums of 1.2 million or less can elect
  to be taxed only on net investment income under
  IRC Section 831(b).

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Did You Say Tax Advantage? - continued

• Income tax consequences of an 831(b)
  election
• Investment income earned on assets owned by
  the Captive is taxable at ordinary C Corporation
  rates.
• Premiums received by the Captive are income
  tax free.
• Only investment related expenses may be
  deducted by the Captive.
• So is the 831(b) election really a tax
  advantage?

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Some Ground Rules

• The Captive must be respected as a valid
  insurance company for federal income tax
  purposes.
• What ground rules must be followed?

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Some Ground Rules -
continued

• The Captive must be operated as a bona-fide
  insurance company.
• The Captive must be respected and treated as
  a separate entity (i.e., separate books, records
  and accounts, no commingling of assets with
  personal funds or funds of other entities, etc.).
• Insurance policies issued by the Captive
  must be commercially reasonable with respect to
  their terms (including premiums).
• The Captive must comply with capitalization,
  surplus, investment and other regulatory
  requirements of the jurisdiction in which the
  Captive is domiciled.

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Some Ground Rules -
continued

• Risk distribution must be present.
• The Captive must insure a sufficient number of
  insureds
• Revenue Rulings 2002-90 and 2005-40
• 12 insureds is enough.
• Case Law
• 8 insureds is enough.
• Third party risk pools are available for those
  Captive insurance companies that do not meet the
  safe harbor ruling.

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Jurisdiction Onshore vs. Offshore

• Fees (both startup and ongoing)
• Capitalization requirements
• Margin of solvency requirements
• Investment restrictions
• Degree of regulation
• Premium taxes
• Income taxes
• Federal excise tax
• (offshore only but does not apply if IRC
  Section 953(d) election is made)
• But arent there income tax advantages to
  forming offshore?
• NO , NO and NO!!!
• Captive will elect to be treated as a U.S.
  Corporation for
• federal tax purposes. IRC Section
  953(d)

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Typical Ownership Structures

Publicly Held Company
Parent Corporation
Captive Insurance Company
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Closely Held Companies
Individual Owners Jack and Joe
Individual Owners Jack and Joe
400,000 in premiums
Closely Held Business
Captive Insurance Company
Insurance policies/claims paid

• Business receives 400,000 ordinary business
  deduction.
• Captive insurance company receives 400,000
  income tax free.

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Closely Held Companies
Jack and Joe
Children of Jack and Joe (or trust FBO children)
400,000 in premiums
Closely Held Business
Captive Insurance Company
Insurance policies/claims paid

• Business receives 400,000 ordinary business
  deduction.
• Captive insurance company receives 400,000
  income tax
• free.
• Premium payment should not represent a gift
  to heirs for gift
• tax purposes.

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Closely Held Companies
Jack and Joe
GST Trust FBO heirs of Jack and Joe
400,000 in premiums
Closely Held Business
Captive Insurance Company
Insurance policies/claims paid

• Business receives 400,000 ordinary business
  deduction.
• Captive insurance company receives 400,000
  income tax
• free.
• Premium payment should not represent a gift
  to heirs for gift
• tax or generation skipping tax purposes.

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Closely Held Companies
Jack and Joe
Key Employees of Closely Held Business
400,000 in premiums
Closely Held Business
Captive Insurance Company
Insurance policies/claims paid

• Business receives 400,000 ordinary business
  deduction.
• Captive insurance company receives 400,000
  income tax
• free.

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How are assets of the Captive Insurance Company
Invested?

• Recall that the Section 831(b) captive insurance
  company is taxed on its investment income at C
  corporation rates.
• Subject to applicable regulatory restrictions,
  the captive insurance company may invest in the
  following
• Money market funds, CDs, etc.
• Stocks/Bonds
• Real Estate
• Closely held Businesses
• Life Insurance

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How do the owners of the insurance
company benefit from the profits
earned by the insurance company?

• Dividends
• Taxed at 15 federal rate. IRC Section 1(h)
• Liquidation
• Taxed at 15 federal rate plus C corporation tax
  rates on the net appreciation of the assets owned
  by the insurance company. IRC Sections 331 and
  336

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THANK YOU
Under requirements imposed by the IRS, any advice
concerning one or more U.S. federal tax issues
contained in this communication is not intended
or written to be used, and cannot be used, for
the purpose of (1) avoiding penalties under the
Internal Revenue Code or (2) promoting, marketing
or recommending to another party any transaction
or tax-related matter addressed herein.
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