Micro Captives: The Insurance Company You Keep

Micro Captives: The Insurance Company You Keep Dallas Bar Association April 4, 2016 Cindy L. Grossman 100 CONGRESS AVENUE, SUITE 1440 AUSTIN, TEXAS 78701 phone 512.767.7100 fax 512.767.7101 WWW.GSRP.COM 2015 Giordani, Swanger, Ripp & Phillips, LLP. This report has a been prepared for informational purposes only. It does not constitute an offer or solicitation for the purchase or sale by our firm to you or to any other person to acquire a life insurance product. The information contained herein has been obtained from sources believed to be reliable, but our firm cannot guarantee its accuracy or completeness.

What Is a Captive Insurance Company? Captive: Property and casualty insurance company formed by a business or its owners to provide coverage to the business or its affiliates Business or Business Owner Operating Business Deductible Premiums Policies 100% of stock Captive (C corp.) required capitalization 2

What Is a Micro Captive? 831 of the Code provides for two types of captives - 831(b) election micro captives Premiums deductible by insureds Taxed only on investment income, not on premium income Annual premiums $2.2 million - 831(a) large captives Any non 831(b) elected captive Premiums deductible by insureds Taxed on underwriting (insurance) income and investment income Annual premiums likely > $2.2 million 3

Why Should I Care? Heavily promoted to small and mid size business owners Why? 4

Sample Captive Economics Income Statement Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Underwriting revenue Written Premium 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Total Underwriting Revenue 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Underwriting Expense Risk Pool Losses (15,300) (15,300) (15,300) (15,300) (15,300) Administration Expenses (64,100) (52,300) (52,300) (52,300) (52,300) Total Underwriting Expense (79,400) (67,600) (67,600) (67,600) (67,600) Net Underwriting Profit 920,600 932,400 932,400 932,400 932,400 Investment Income 53,530 102,735 154,296 208,342 264,807 Federal Corporate Income Tax Estimate * (1,832) (3,917) (5,767) (11,455) (13,273) Net Income 972,298 1,031,218 1,080,929 1,129,288 1,183,933 Opening Retained Earnings - 972,298 2,003,516 3,084,445 4,213,733 Closing Retained Earnings 972,298 2,003,516 3,084,445 4,213,733 5,397,666 Balance Sheet Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Assets Cash & Investments 150,000 1,122,298 2,153,516 3,234,445 4,363,733 5,547,666 Total Assets 150,000 1,122,298 2,153,516 3,234,445 4,363,733 5,547,666 Liabilities Unearned Premium - - - - - Total Liabilities - - - - - - Capital and Surplus Capital Contribution 150,000 150,000 150,000 150,000 150,000 150,000 Retained Earnings - 972,298 2,003,516 3,084,445 4,213,733 5,397,666 Total Capital and Surplus 150,000 1,122,298 2,153,516 3,234,445 4,363,733 5,547,666 Total Liabilities, Capital and Surplus 150,000 1,122,298 2,153,516 3,234,445 4,363,733 5,547,666 * ASSUMES THE INVESTMENT PLAN IS MANAGED FOR C CORPORATION INCOME TAX EFFICIENCY. 5

What s the Fuss About? February 2015: IRS Dirty Dozen List of Tax Scams - Another abuse involving a legitimate tax structure - In the abusive structure, unscrupulous promoters persuade [businesses] to participate in this scheme - Promoters create and sell poorly drafted insurance binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant premiums, while maintaining economical commercial coverage - The promoters manage the entities captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade. 6

What Are the Benefits? Benefits to the Business Tax Benefits Estate Planning Benefits 7

Benefits to the Business Risk Management - Obtain coverages not commercially available - Increase coverage amounts Cash Flow - Lower cost of coverage difficult to obtain - Premiums stripped of brokerage, marketing expenses - Access to less expensive reinsurance market Policy Design Control over claim processing timing 8

Tax Benefits (of Micro Captive) Premiums paid by insured business are tax deductible Premiums received by captive are tax free Captive taxed (as C corp.) only on investment income Dividends paid to captive owner taxed at qualified dividend rates 9

Estate Planning Benefits Pre PATH Act Opportunity shifting Low capitalization with quick growth IF no or low loss experience Be judicious with lifetime gift tax exclusion 10

Estate Planning Benefits Pre PATH Act (cont d) Business Owner $250,000* Children s Trust 100% of stock $250,000 capitalization Operating Business Premiums Policies Captive * At least required capital of captive 11

Estate Planning Benefits Pre PATH Act (cont d) Business Owner $127,500 Children s Trust Business Owner LLC 100% of stock $250,000 capitalization Operating Business Premiums Policies Captive 12

Captive Insurance Companies Under the PATH Act The PATH Act added Section 831(b)(2)(B)(ii), which eliminates the estate planning advantages of captives as of January 1, 2017. Under PATH, a captive can make an 831(b) election only if it annually satisfies one of the following tests: - Risk Diversification: No more than 20% of the insurer s written premiums can come from a single policyholder. Related policyholders will be treated as a single policyholder for purposes of this section. - Ownership Diversification: no spouse or descendant of a business owner, either directly or indirectly (e.g., through a trust or entity), own a percentage interest in the captive that exceeds by more than 2% their ownership interest in the underlying insured business or business assets. Consequence of no 831(b) election: premiums are taxable to the captive. 13

Captive Insurance Companies under the PATH Act Invalid 831(b) Captive Structure: 14

What s Required to Obtain Tax Benefits? Form a corporation / protected cell / series (LLC) that is: - an insurance company - providing insurance - 831(b) election 15

Insurance Company Licensing in jurisdiction formed - requires minimum capitalization Predominant business is issuing insurance contracts - 831(c): more than half or else 16

Providing Insurance Arrangements must be insurance under federal tax law Criteria: - Insurance risk - Insurance in commonly accepted sense - Risk shifting and risk distribution 17

Providing Insurance (cont d) Insurance risk - Insured faces loss resulting from hazard and Insurer provides benefit or performs act when loss materializes - Not investment risk or business risk 18

Providing Insurance (cont d) Insurance in commonly accepted sense: - Insurer organized and operated as insurance company - Company is regulated by jurisdiction s insurance regulator - Premiums negotiated at arms length - Arrangement is valid and binding - Arrangement between insured with insurable interest in insurable hazard or risk and insurer who accepts risk in exchange for premium 19

Providing Insurance (cont d) Risk Shifting - Risk is transferred from insured to insurer - Not self insurance Risk Distribution - Risk is dispersed by insurer among a larger pool of policy holders - Insurer reduces risk that single claim exceeds total premiums of all 20

Providing Insurance (cont d) Risk shifting / Risk distribution - Prior to 2001: Economic family doctrine - Courts eschew economic family for balance sheet test - Rev. Rul. 2001 31: IRS withdraws economic family doctrine - Revenue Rulings in 2002 2002 89: > 50% of premiums from unrelated policy holders 2002 90: 12 operating entities acquire policies from captive none < 5%, none > 15% of total risk 2002 91: Diverse ownership of captive: none > 15% of ownership, Avoid interrelated risks no owner s risk > 15% total captive risk 21

831(b) Election Annual premiums cannot exceed $2.2 million Timely election via statement attached to captive s income tax return Effective until premiums > $2.2 million or revoked with IRS consent Premium aggregation for related captives - controlled group rules: > 50% common ownership parent subsidiary brother sister combined group Watch out for multiple captives 22

Where Can I Do This? Domestic - Vermont is oldest - Delaware, North Carolina, Utah typically micro captives - Now Texas Foreign - Bermuda, Guernsey - 953(d) election: domestic treatment; avoids excise tax on premiums - Special Subpart F regime for non 953(d) captives Factors - capitalization - allowable risks - operational requirements - local professionals - loans permitted? 23

How Does It Work? Policy Design - Layered Risk: Policy Limits 80% above retained layer borne by pool (% pooled varies) 1 st 20% of policy limit retained by captive Deductible (insured) - First Dollar Quota Share: Policy Limits 49% of first dollar quota share retained by captive (% varies) 51% of first dollar quota share borne by pool (% varies) Deductible (insured) - Hybrid: Policy Limits top 20% of policy limit retained by captive 15 % quota share retained by captive 85% of quota share borne by pool Deductible (insured) 24

How Does It Work? (cont d) Achieving risk shifting / risk distribution through pooling - Example 1: Premium paid directly to captive Operating Business Premiums Policies Captive Retrocession Agreement Reinsurance Premiums Reinsurance Agreement Risk Pool Retrocession Premiums 25

How Does It Work? (cont d) Achieving risk shifting / risk distribution through pooling - Example 2: Premium paid directly to risk pool Premiums Operating Business Policies Risk Pool Reinsurance Premiums Reinsurance Agreement Captive 26

Who s a Good Candidate? Risks that are different or expensive to insure At least $300,000 in premiums, in light of expenses: - Startup: $60,000 to $100,000 - Annual: $50,000 to $60,000 captive management, audit, accounting, legal Sufficient cash flows from business operations 27

How Do I Stay Out of Hot Water? Lack of Business Purpose - Tax motivation, marketing - Wealth Transfer / Assignment of Income - Avoid parental indemnification Capitalization and Excess Accumulated Earnings - Meet jurisdictional and actuarial requirements - Avoid loans from captive Management and Operational Formalities - Employ a quality captive manager 28

How Do I Stay Out of Hot Water? (cont d) Excessive Premiums and Inappropriate Risks - Employ a quality captive manager - Obtain feasibility study - Engage pricing actuary for annual review - Avoid multiple captives Claim History - File claims! - Pool should have some loss history ( 5%) Investments - Investment income must be less than insurance income - Avoid life insurance 29

And What Happens If It Blows Up? Loss of deductions for premiums - Amendment of returns for all entities and their owners - Increased taxes and interest - Accuracy related (20%) or even nondisclosed noneconomic substance (40%) penalties Pool related risks - Loss of participants can eliminate risk distribution - Pool invalidation effects all Possible taxation of premium payments State taxes and impact on licensing 30

Micro Captives: The Insurance Company You Keep 100 CONGRESS AVENUE, SUITE 1440 AUSTIN, TEXAS 78701 phone 512.767.7100 fax 512.767.7101 WWW.GSRP.COM