For most business owners, taxes chew up half of their profits. Real estate taxes, payroll taxes, income taxes, franchise taxes, sales taxes, ad valorem and other taxes deplete most of the cash generated from a typical business. As if taxes aren’t enough, rising insurance costs and increasing self-insured risk are additional and expensive challenges.
With the certainty that taxes are rising in 2011, what is the solution to combat the erosion of taxes, while also protecting your assets, mitigating insurance risk and passing on assets to your heirs? For many businesses, the answer is captive insurance companies (CICs).
Smart Business learned from Robert N. Greenberger at Habif Arogeti & Wynne, LLP about how CICs can be a viable way for businesses to save on insurance costs through tax deductions.
What is a captive insurance company?
CICs have been around since the late 1970s; more than 80 percent of Fortune 500 companies take advantage of some sort of CIC arrangement. Recent years have seen more growth to include small and medium-sized companies. CICs are corporations formed in the United States or a foreign jurisdiction that write property and casualty insurance to a small group of insureds. CICs seldom replace conventional insurance, but are formed to assume risk that is currently self-insured for items not covered by traditional policies. Items such as medical malpractice, natural disaster, high deductibles, credit default, construction defects, disability, loss of key customers and suppliers, policy exclusions, and types of insurance unavailable in commercial markets are currently self-insured by businesses.
How does a business save money with a captive insurance company?
The cost of ‘self-insurance’ outside of a valid CIC structure is not tax deductible. With a properly formed CIC, the insurance premiums are deductible so that claims are paid with pretax dollars. If no claims are made, the CIC retains the premiums for future business risks or distribution. CIC policies may replace current coverage to cover copyright infringement, errors and omissions, employment practices and property damage.
IRS rules allow businesses to deduct property and casualty insurance premiums paid to their CIC that is established to insure or reinsure the risks of the business, while the premium income to the CIC may be tax free.
For example, a business could pay $1.2 million of property and casualty insurance premiums to its affiliated CIC and receive a tax benefit of almost $500,000. If properly structured, the premium income received by the CIC would not be taxable. If the business has insurance claims, the claims can be paid by the CIC. The remaining funds in the CIC can eventually be utilized by the business owner during retirement by having the CIC pay taxable dividends or utilizing other methods. With proper planning, the funds could also be passed to heirs with no gift or estate tax consequences. CIC ownership may also be structured to provide incentives for key management and business succession.
The IRS has issued Revenue Rulings and other guidelines that provide specific ‘safe harbor’ rules. Following these guidelines properly will ensure that the CIC is entitled to the benefits of Code Section 831(b), which provides that the first $1.2 million of insurance premiums received by the CIC each year are tax-free. CIC insurance premiums are ‘annually renewable’ and can increase and decrease each year to meet the business’s needs.
