Businesses carry various types of insurance in order to provide protection from liabilities and reduce risks. Since coverage for certain types of risks is expensive or difficult to obtain, many business owners simply choose to not obtain this insurance.
Is there a better option?
“An innovative technique to address business risk is through a captive insurance company,” says Curtis Campbell, a partner at HMWC CPAs & Business Advisors in Tustin. “It is a great tool to consider for the insurance coverage and can provide additional tax, estate and asset planning benefits as well. We’ve found this to be very useful for many small and medium-sized businesses.”
Smart Business spoke with Campbell about how a captive insurance company can benefit Orange County businesses.
What is a ‘captive’?
A captive insurance company, or captive, typically refers to an insurance company that provides insurance to and is controlled by its owners. Its purpose is to provide insurance coverage for some or all of its owners’ risk. In the closely held business environment, it is most commonly used to write insurance policies for risks that are currently not insured at all by the owners. However, it can also create policies to replace existing coverages if the economics make sense.
How does it work?
A captive is a separate corporation established for the exclusive purpose of writing property and casualty insurance. It is a fully licensed insurance company under the jurisdiction of the Insurance Commissioner within the state it is established. As such, the captive must adhere to certain requirements to be respected, such as proper risk sharing, risk distribution and underwriting guidelines for the determination of the annual premium amounts. A wide variety of risks can be covered including workers’ compensation, liability, earthquake, mold, loss of a major client, etc.
Each year, the captive issues a policy, or multiple policies depending on the need of the operating business, in exchange for annual premiums. The operating business deducts the insurance premiums as a business expense and the captive records the premiums as income. However, the captive does not pay tax on the first $1.2 million of premiums received each year if a Section 831(b) election has been made. This election allows for some very unique planning opportunities not normally available.
What are the potential benefits a captive owner may realize?
Given the right fact pattern, there are many possible benefits. First the operating business can improve its cash flow by pre-funding potential future risks with pre-tax dollars. This saves on income taxes and provides peace of mind that some of the company’s risks are being addressed.
Second, if the captive is properly managed and experiences a positive claims history, it could generate annual profits for its owners, providing a secondary income source.
Third, the ownership of the captive is very flexible. Since it is a C corporation, it can be owned by any type of entity such as a trust or a partnership, or by relatives or business associates of the operating company. This flexibility adds some potential estate and asset protection planning possibilities to the mix.
What about some of the potential drawbacks?
As with most business decisions, there are things to consider before coming to a conclusion. First, set-up costs and annual operating costs need to be evaluated. Factors that impact the cost structure are the State of Jurisdiction in which you incorporate, the number of insurance policies written, the types of coverages involved and the number and types of captive owners.
Second, whenever you create a new business entity it can add complexity to your world.
Third, the IRS could change the rules down the road. These potential drawbacks may be mitigated by aligning yourself with qualified professionals who are knowledgeable in this area and who can guide and support you through the complexities and potential rule changes.
Who should consider a captive?
Generally, any profitable closely held business with at least $500,000 per year of discretionary income, current uninsured business risk and a desire to improve its bottom line should consider a captive. In the right situation, a properly established and well-run captive can accomplish the goals of many business owners, including reduced income taxes, better risk management, and the ability to take advantage of estate and asset planning opportunities.
This article is for general information purposes only and should not be construed as a professional opinion on any specific facts or circumstances. The tax advice contained in this article is not intended to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person.
Curtis Campbell is a partner at HMWC CPAs & Business Advisors (www.hmwccpa.com), one of Orange County’s largest local accounting firms. Contact him at (714) 505-9000 to discuss how your company or client could benefit from HMWC’s services.
