The Use of Captive Insurance Companies for Closely Held Businesses

Transcription

1 The Use of Captive Insurance Companies for Closely Held Businesses Presented by: Michael F. Amoia, J.D., LL.M., CFP, CLU, ChFC CRUMP LIFE INSURANCE SERVICES Senior Vice President, Advanced Planning and Life Product Bethesda, MD

2 Disclosure This material contains references to concepts that have significant legal, accounting, and tax implications. It is not intended as legal, accounting or tax advice. Clients should always consult their own attorney and/or tax advisor for advice regarding application of these concepts to their particular situation. CIRCULAR 230 DISCLAIMER To ensure compliance with requirements imposed by the IRS, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

3 TODAY S DISCUSSION Insure risks otherwise not insurable Managing insurance exposures and expenses Current income tax considerations Estate tax benefits Key employee incentives

4 INSURANCE OPTIONS Captive Insurance Companies Allow Successful Companies to Shift Risk

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6 Identifying Risk INSURED RISK UNINSURED RISK 6

7 To Insure Or Not Insure Balancing between Commercial Insurance and Self Insuring Commercial Insurer Unacceptable Risk Business Manageable Risk Cash Reserve Deduct When Pay Premiums No Deduction Until Claim Paid

8 Analyze the Inefficiencies Pertaining to Your Firms Risk Management Strategy How commercial insurance premiums are calculated 50% of Premium Expected Loss Administration Insurance companies typically price property and casualty insurance at a 50-60% loss ratio Up to 50% is allocated for claims administration, overhead, and profit for the insurer Overhead and Profit 8

9 Captive Insurance Programs How does a captive reduce the net cost of risk? Carefully analyze risk exposure Transfer unacceptable levels of risk to others (via commercial insurance) Incorporate safety and loss prevention measurers Participate in underwriting profits Shareholder Commercial Insurer Unacceptable Risk Sponsor Manageable Risk Captive

10 What is a captive? 10 Private insurance company structured to provide insurance or reinsurance to related entities Captive History First captive believed to have been formed in 1922 (Guernsey) Approximately 10,000 captives in operation Offshore Jurisdictions (Cayman, British Virgin Islands, Bermuda) 1 st On-shore Jurisdiction (Colorado Captive Insurance Act of 1972) Majority of States allow Captive formation Case Law (Humana/Harper Group/UPS) Harvard Medical school was the first domestic captive to manage their med-mal risks IRS guidance Revenue Ruling Safe Harbors

11 Potential Insurance Benefits Insurance Costs: Reduced premiums for P&C coverage. Reduced funding for self-insured risks. Adjustment of risk retention levels as needed. Take Advantage of Good Loss Experience Allow Control of the Claims Process Allow Control of Investment of Reserves Access to the Reinsurance Market Estate Planning Opportunities

12 Industries to Consider Builders / Contractors Manufacturers Trucking Franchisees Hotel Chains Private Equity Healthcare

13 What they are and are not Must have a business purpose to it Is not just a tax strategy Is not quick it takes time Is not tax deductible life insurance

14 What is a Captive? Captive Insurance for Qualified Businesses Private Insurance Company Pure captive Association captive Group captive Agency captive Rent-a-captive Protected cell captive Domestic or International 14

15 Captive Insurance Programs Captive Insurance Company (Pure Captive) Shareholder Business Premiums Captive Insurance Policies

16 Income Taxation: Income Tax Issues Deductibility of Premiums. Premiums paid to an insurance company, including a captive, are deductible. Corporate Status. For Federal income tax purposes, an insurance company is a per secorporation. It must pay a corporate level tax and will not receive flow-through or disregarded-entity treatment. Insurance Tax Accounting. If a company qualifies as an insurance company, insurance-tax accounting (under Subchapter L) applies. Favorable Tax Treatment. Insurance tax accounting may provide certain tax benefits to a captive, including: Acceleration of Tax Deductions. A captive can take a current income tax deduction for amounts needed to fund future claims. Self-insured businesses can only deduct claims when paid.

17 Small/Micro Captives 831(b) Captive If premiums less than $1.2 million/year, no tax on premium income However, not a panacea Tax is paid on investment income at corporate rates C-Corporations pay higher capital gains rate than individuals Real estate is generally a poor investment choice Corporate AMT may apply to death benefit paid to a C-Corp Caveat: Beware of captives promoted to buy tax deductible life insurance

18 Federal Income Taxation The IRS and Captives What constitutes insurance? IS NOT an off balance sheet self-insurance structure IS: Bona-fide business purpose Operates as an insurance company Risk shifting» Risk must be transferred Risk distribution» Risk must be spread» The law of large numbers must apply Reasonable premiums Adequate capitalization For Provider Use Only

19 Federal Income Taxation RISK DISTRIBUTION AND SHIFTING What is insurance? Testing for Risk Shifting and Risk Distribution Helveringv. Le Gierse, 312 U.S. 531 (1941) Uninsurable 80-year-old woman purchased a life policy and an annuity policy from the same insurance company one month before death Executor did not report death benefit on estate tax return Supreme Court found no risk shifted because of offsetting positions; this was just an attempted tax avoidance First case to set forth the standard for true insurance as required to have both risk shifting and risk distribution

20 Federal Income Taxation RISK DISTRIBUTION AND SHIFTING Case law developed two theories: Theory 1 (third-party theory): Sufficient third-party premium along with premiums from related entities Courts say 30% third-party insurance is adequate Theory 2 (balance sheet theory): Sufficient number of related party entities insured to create risk distribution and shifting

21 Federal Income Taxation RISK DISTRIBUTION AND SHIFTING Revenue Ruling , C.B Service determines it will no longer raise the economic family theory Explicitly acknowledged that no court had fully adopted the economic family theory set forth in Rev. Rul Analysis is now a case-by-case analysis Service promised more challenges based on facts and circumstances Focus is on risk shifting, risk distribution, inadequate capitalization, and parental guarantees

22 Significant IRS Rulings Rev. Rul Third -party Risk (Safe Harbor) Rev. Rul Balance Sheet Theory (Safe Harbor) Rev. Rul Disregarded Entities and More Rev. Rul Cell Captive Rev. Rul Reinsurance and Risk

23 What qualifies as risk shifting and risk distribution? Revenue Ruling Brother/Sister subsidiaries No single Brother/Sister subsidiary can constitute greater than 15% or no less than 5% of the risk Parent Company Each Sub Comprises 5-15% of Risk Sub Sub Sub Sub Sub Sub Sub Sub Sub Sub Sub Sub Captive

24 What qualifies as risk shifting and risk distribution? Revenue Ruling > 50% of risk exposure is derived from unrelated parties 49% of Risk 51% of Risk Parent Company Captive Unrelated Company

25 IRS Revenue Ruling Greater than 50% unrelated risk Parent Company Premium Independent Insurance Company 1 EPLI MGMT PROF LEGAL GEN L BUS CONST Reinsurance Premiums Captive 1 Each Line of Insurance is Pooled in order to Achieve Homogenous Risk Distribution and 3rd Party Risk; 2.5% Pooling Rate

26 IRS Revenue Ruling Low $ / high frequency claims (paid by captive) 49% of Risk / Premium Parent Company 1,000,000 Premium Independent Insurance Co 1 EPLI MGMT PROF LEGAL GEN L BUS CONST Reinsurance Contract for this part of risk 477,750 Reinsurance Premiums Captive 250, , ,000 1,000,000 1 net of 2.5% pooling rate

27 IRS Revenue Ruling Low frequency / high $ claims (paid by QS pool) 51% of risk / premium Parent Company 1,000,000 Premium Independent Insurance Co 1 EPLI MGMT PROF LEGAL GEN L BUS CONST Reinsurance Contract for pooled risk 497,250 Reinsurance Premiums Captive 250, , ,000 1,000,000 1 net of 2.5% pooling rate

28 Disregarded Entities Ruling Treatment of disregarded entities (i.e., LLC s) Rev. Rul indicates they are disregarded, risk of a single-member LLC is risk of the parent Inconsistent with the balance sheet theory Inconsistent with treatment IRS wants for partnerships Single member LLC s are respected by the IRS in other contexts 965 repatriation of profits; separate entities for liability for taxes Most importantly, disregarded entities are respected for liability and legal purposes That is what is being transferred in insurance transactions They have separate balance sheets Rev.Rul reads that, even if the insurer is adequately capitalized and completely unrelated, if there are an insufficient number of insureds, you may not have risk distribution, and thus no insurance

29 Other Guidance TAM IRS will not count limited partnerships with a common general partner as separate entities No logic to the IRS s argument that the common general partner bears all risk of loss Rev Rul protected cell captives -IRS requires risk distribution within each cell, not just within the overall organization, as cells are segregated from each other for liability purposes Rev. Rul to determine risk distribution regarding a reinsurance contract, one must look through to the risks of the ultimate insured the primary (underlying) insurance contract Rent-a-Center, 142 T.C. 1 (2014) distinguished cases finding parent guaranty of reinsurance risk results in no risk-shifting; where captive directly insures numerous brother-sister subs, a parent guaranty to the captive does not vitiate risk-shifting

30 Implementation Feasibility study prepared by actuary Choice of domicile Domestic Offshore Corporate formation Underwriting process Policies written Regulatory application/license received Ongoing management costs

31 What Does it Cost?

32 BEYOND THE INSURANCE Creative Business Planning Opportunities

33 Captive Insurance Programs Captive Insurance Company (Pure Captive) Shareholder Business Premiums Captive Insurance Policies

34 Business Planning Opportunities S-Corporation Owners Captive is a C-Corporation, so it is possible to create multiple classes of stock, vesting schedule, liquidation preferences, etc. Key Employee Incentives May be used to help indirectly fund nonqualified deferred comp or Restricted Stock Program Ownership by key employees can be used to incentivize better risk management/create more of an owner mentality for key employees

35 Gross Estate Equals All Assets +Company +Captive "Death may be an avenue of escape from many of the woes of life, but it is no escape from taxes." Estate of Kahrv. Commissioner, 414 F.2d 621, 626 (2d Cir.1969).

36 Captive Insurance Programs Shareholder Shareholder s IDGT Business Premiums Captive Insurance Policies 36

37 Estate Planning Opportunities Potential Transfer Tax Benefits: Reasonable premiums paid by the insured to the captive should not create gift, estate or GST tax exposure to the insured s owner The premiums must constitute full and adequate consideration for insurance coverage (e.g., arm s length and determined in accordance with underwriting standards) When the insured s actual claims are less than actuarially predicted, the captive s reserves will grow If family members directly or indirectly own shares in the captive, they benefit from this increase in value without any transfer tax liability In addition, the captive can distribute unused reserves to the captive shareholders as a dividend (currently taxed at capital gains rates) or as a capital gain distribution on complete liquidation of the captive

38 LEVERAGE, IN A GOOD WAY Split Dollar Offers the Best of All Worlds

39 THE NEED FOR ADVANCED PLANNING TECHNIQUES Estate planning professionals often recommend alternate techniques to fund life insurance policies in ILITs instead of incurring and paying gift taxes. The strategies used most often are: loans from third party lenders, private loans from the client or other family members, or split dollar arrangements employer or client or other family members.

40 SALE OF BUSINESS OR INVESTMENT ASSETS 4/ Client Secured Promissory Note; 9-year interestonly with annual interest based on midterm AFR and a balloon repayment of principal at the end of year 9. (Disregarded for income tax purposes) Sale of Business Assets 6/ Partial Guaranty Independent Party 5/ Irrevocable Grantor Trust Guaranty Annual Fee: Promissory Note Initial Gift Business Assets 4/ The sale would take place after the beneficiary s (Client s) withdrawal right had lapsed 5/ May be an existing irrevocable trust, the creator of the trust, or any other unrelated party who or which has sufficient assets to satisfy the guarantee, if necessary 6/ If the value of assets sold is adjusted by IRS resulting in an unintentional gift, then the beneficiary s testamentary power of appointment would avoid treating that excess as a completed gift. The value is determined by a qualified appraiser. This illustration assumes a 30% discount which is generally considered relatively conservative.

41 Formation of Captive Insurance Company Irrevocable Beneficiary Grantor Trust What is a Captive? Private Insurance Company Types Single Parent / Pure Group Rent-a-Captive Approximately 80% of the S&P 500 Utilize Captives Pure captive: closely held insurance company Provides significant annual savings for qualified business Can lower the net cost of risk Many captives are domestically licensed, state regulated and file Federal tax returns Business Assets Annual deductible insurance premiums Cash flows net of expenses and claims (estimated $1,068,900 in Year 1) Captive 41

42 Hypothetical Example For Discussion Purposes Only CONSOLIDATED CAPTIVE CASH FLOW YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 10 YR 10 TOTAL Prior Year Balance $0 $175,000 $1,243,900 $2,385,485 $3,604,698 $12,872,307 $0 Initial Capital Contribution (no change) 250, ,000 Formation Fee Expense (75,000) (75,000) Premium Collected (or Taxable Income) 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 12,000,000 Premium Fee Expense 0 (30,000) (30,000) (30,000) (30,000) (30,000) (300,000) General & Administrative Expense 0 (53,000) (53,000) (53,000) (53,000) (53,000) (530,000) Claims Occurred 0 (60,000) (60,000) (60,000) (60,000) (60,000) (600,000) Gains: Cash Equivalent Assets 0 1,750 12,439 23,855 36, , ,004 Gains: Alternative Investments 0 13,125 93, , , ,423 4,477,527 Income Tax on Realized Investments Gains 0 (2,975) (21,146) (40,553) (61,280) (218,829) (1,014,906) Income Tax NET CASH FLOW $175,000 $1,068,900 $1,141,585 $1,219,213 $1,302,119 $1,932,317 END OF YEAR BALANCE $175,000 $1,243,900 $2,385,485 $3,604,698 $4,906,818 $14,804,624 $14,804,624 COMPARATIVE CASH FLOW -W/O CAPTIVES YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 10 TOTAL Prior Year Balance $0 $250,000 $951,000 $1,699,668 $2,499,245 $8,577,077 $0 Initial Capital Contribution (no change) 250, ,000 Formation Fee Expense (Premium Collected or) Taxable Income 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 12,000,000 Premium Fee Expense General & Administrative Expense Claims Occurred 0 (60,000) (60,000) (60,000) (60,000) (60,000) (600,000) Gains: Cash Equivalent Assets 0 2,500 9,510 16,997 24,992 85, ,047 Gains: Alternative Investments 0 18,750 71, , , ,281 3,037,851 Income Tax on Realized Investments Gains 0 (4,250) (16,167) (28,894) (42,487) (145,810) (688,580) Income Tax 0 (456,000) (456,000) (456,000) (456,000) (456,000) (4,560,000) NET CASH FLOW $250,000 $701,000 $748,668 $799,577 $853,949 $1,267,241 END OF YEAR BALANCE $250,000 $951,000 $1,699,668 $2,499,245 $3,353,194 $9,844,318 $9,844,318

43 Option A: ANNUAL ADMINISTRATION OF SALE OF BUSINESS ASSETS AND PURCHASE OF LIFE INSURANCE POLICY Promissory Note Client Initial Gift Annual interest on promissory note (Disregarded for income tax purposes) Income on trust assets taxed to Client 7/ Annual Premiums 8/ Independent Party Guaranty Fee Irrevocable Grantor Trust Life Insurance Company Captive Business assets 7/ Payment of income tax by the beneficiary on trust income is not a gift for gift tax purposes. Additionally, it reduces Client s estate by the amount of income taxes paid, providing a substantial estate tax reduction benefit. 8/ This is not an illustration or a contract for insurance. Costs are estimated and may change based on underwriting.

44 Option B: ANNUAL ADMINISTRATION OF SALE OF BUSINESS ASSETS AND PURCHASE OF LIFE INSURANCE POLICY Promissory Note Annual Premium 8/ Client Initial Gift Annual interest on promissory note (Disregarded for income tax purposes) Income on trust assets taxed to client 7/ Split Dollar loan repayment Death Benefit (less Split Dollar loan) 8/ Independent Party Guaranty Fee Irrevocable Grantor Trust Life Insurance Company Captive Business assets 7/ Payment of income tax by the beneficiary on trust income is not a gift for gift tax purposes. Additionally, it reduces client s estate by the amount of income taxes paid, providing a substantial estate tax reduction benefit. 8/ This is not an illustration or a contract for insurance. Costs are estimated and may change based on underwriting.

45 COMPLETION OF SALE OF BUSINESS INTERESTS AFTER NOTE TERM (END OF YEAR NINE) Captive Client Repayment of outstanding principal of promissory note and any accrued interest paid in cash and in kind (Disregarded for income tax purposes) Satisfaction of promissory note ( Paid in Full ) Irrevocable Grantor Trust Income Principal and interest payments after 9 years: Total Interest Principal Cash Principal In Kind (shares of Captive Ins. Co.) Initial Gift Business assets

46 FOLLOWING COMPLETION OF SALE OF ASSETS Captive Client Income on trust assets continues to be taxed to Client for life Annual Premium Death Benefit Irrevocable Grantor Trust Income Initial Gift Business assets Life Insurance Company

47 FOLLOWING DEATH OF BENEFICIARY Client s Estate Life Insurance Company Death Benefit Irrevocable Grantor Trust Separate Trusts for Descendants for Life 9/ 9/ (i) Protected from all estate, gift, and GST taxes. (ii) Protected from the trust beneficiaries creditors, including divorcing or dissident spouses, for as long as the property is owned by the trust.

48 Prepared For: Client Trust Values* Prepared By: Agent (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) Nominal Beg Yr Beg Yr Cash Asset Captive Loan Interest Loan Loan Repay Insurance EOY Loan Asset Cash Insurance Growth Income Cash Guar. Fee Payment Repay Cash Fund In Kind Death Trust Value Yr Age Payable 2% Gifts 5.5% 3% of 1.01% Cash Balance (Nom. Val.) Benefit Net of Loan 1 54 (7,000,000) 10,200,000 0 (827) (8) 550,000 1,068,900 (42,000) (70,700) 0 1,505, ,000, ,705, (7,000,000) 10,404,000 0 (1,051) 15, ,000 1,141,585 (42,000) (70,700) 0 3,109, ,000, ,513, (7,000,000) 10,612,080 0 (1,361) 31, ,220 1,219,213 (42,000) (70,700) 0 4,817, ,000, ,429, (7,000,000) 10,824,322 0 (1,751) 48, ,664 1,302,119 (42,000) (70,700) 0 6,637, ,000, ,461, (7,000,000) 11,040,808 0 (2,212) 66, ,338 1,390,664 (42,000) (70,700) 0 8,574, ,000, ,615, (7,000,000) 11,261,624 0 (2,715) 85, ,244 1,485,229 (42,000) (70,700) 0 10,637, ,000, ,899, (7,000,000) 11,486,857 0 (3,230) 106, ,389 1,586,224 (42,000) (70,700) 0 12,833, ,000, ,320, (7,000,000) 11,716,594 0 (3,777) 128, ,777 1,694,088 (42,000) (70,700) 0 15,171, ,000, ,887, ,950,926 0 (4,416) 151, ,413 1,809,285 (42,000) (70,700) (7,000,000) 10,659, ,000, ,610, ,189,944 0 (6,500,000) 41, , ,858, ,000, ,048, ,433,743 0 (650,000) 42, , ,920, ,000, ,354, ,682,418 0 (650,000) 42, , ,997, ,000, ,679, ,936,066 0 (650,000) 43, , ,088, ,000, ,024, ,194,788 0 (650,000) 44, , ,194, ,000, ,389, ,458,683 0 (650,000) 45, , ,315, ,000, ,774, ,727,857 0 (650,000) 46, , ,452, ,000, ,180, ,002,414 0 (650,000) 48, , ,605, ,000, ,607, ,282,462 0 (650,000) 49, , ,774, ,000, ,057, ,568,112 0 (650,000) 51, , ,961, ,000, ,529, ,859,474 0 (650,000) 53, , ,166, ,000, ,025,622 * All values are end of year unless otherwise indicated. Not valid wthout Disclosure page.

49 Summary of Results End of Year 1 (Includes Life Insurance Death Benefit) Estate Trust Estate Net to Value Value Taxes Heirs Current Situation 26,875,000 NA (10,750,000) 16,125,000 Proposed Strategy 17,676, ,510,700 (7,070,700) 120,116,750 Difference (9,198,250) - (3,679,300) 103,991,750 End of Year 9 (Includes Life Insurance Death Benefit) Estate Trust Estate Net to Value Value Taxes Heirs Current Situation 46,204,781 NA (18,481,913) 27,722,869 Proposed Strategy 19,448, ,696,208 (7,779,578) 142,365,576 Difference (26,755,836) - (10,702,334) 114,642,707

50 What are the issues to pay attention to DOING IT THE RIGHT WAY

51 Unofficial IRS Captive Audit Considerations 1. Consider whether the risks are garden-variety insurance risks or unique risks that require further investigation into whether the risks are insurance risk. 2. Was a feasibility study performed showing business benefits? The IRS is more likely to find an adjustment with a taxpayer that does not follow good business practice. 3. Assess whether the assuming company has the capacity to assume the risk. Look at the premium to surplus ratio. Are there any parental guarantees? What is the maximum single risk exposure compared to surplus. 51

52 Unofficial IRS Captive Audit Considerations 4. Consider whether the insured is in substantial part paying for their own losses, by comparing the relationship of the largest insured as measured by premiums to total premiums. 5. Consider whether there are sufficient exposure units for risk to be reasonably predictable (law of large numbers). 6. Assess whether the Captive is operating as an independent entity and whether there is insurance in its generally accepted sense. Part of this is the question; could the Captive still function if its largest investment failed? 52

53 Unofficial IRS Captive Audit Considerations 7. Is there a loss portfolio transfer and is there a significant chance of a significant loss as required for GAAP under FASB 113? 8. If parent premiums are deducted, determine whether there is a sufficient amount of unrelated risk assumed by the Captive. 9. Is the taxpayer taking a consistent position by paying excise tax for risk ceded to an offshore insurance company that is not taxed as a U.S. taxpayer? 53

54 Unofficial IRS Captive Audit Considerations 10.Did the Captive enter into a finite risk contract with an offshore reinsurance company that is a non-controlled Foreign Corporation? If so, review the transaction to determine whether there is significant tax avoidance. 11. Are Captive assets used as security or as compensating balance for the liabilities of another entity? 54