I was on a hike in the mountains when my children jumped on a log on the side of the trail. It crumbled under their weight, and we realized it had been hollowed out by insects and termites. The log looked solid enough to hold their weight but clearly wasn’t. The hollowed-out log reminds me of a lot of middle-market companies in 2020. Last year, they were thriving and looking strong. But, things change quickly and 2020 has been the year of COVID, social distancing, forced closures of “non-essential” businesses, riots, looting, so-called “canceling” of businesses, and the year is barely half over.
It’s no surprise that hollowed-out businesses are poorly positioned for long term survival, and 2020 has shown just how hollow many businesses were. We address many of the forces that hollow-out businesses in our recent article in CPA Practice Advisor – CLICK HERE. One force that hollows-out successful businesses is taxation. Excessive taxes can take a heavy toll on the economic viability of a business. This is particularly true for small and mid-size businesses that are often less prepared to manage risk, uncertainty, and economic swings caused by external forces. This was clearly the case in the 2008 downturn which shuttered many small and mid-sized businesses, wiping out the companies, the jobs they provided, and their impact on the local economies and communities where they previously operated. The same is true today. Many of these companies were ill-prepared and lacked the flexibility to respond in 2008 and in 2020 because their businesses had been hollowed out by years of taxation that thwart the build-up of reserves.
Hollowed out businesses are bad for local communities, bad for the labor market and bad for America.
How Can Business Owners Avoid Letting Excessive Taxation Hollow Out Their Business?
A business owner can choose to own their own insurance company, known as a captive insurance company (Captive). This captive insurance company forms the chassis of an Enterprise Risk Management (ERM) strategy. ERM is a more mature and more comprehensive approach to risk management. CLICK HERE to read more about ERM.
What Does ERM With A Captive Insurance Company Do?
First, it establishes a more robust risk management approach, placing the business on better survival footing. Second, it enables the business owner or business to own a profitable second business. This profitable business can build up loss reserves, helping prevent the total business entity from being hollowed out by excessive taxation. A Captive primarily insures the risks faced by the operating company or related companies. The primary reasons that businesses or their owners form Captives are:
- To replace commercial insurance and control insurance costs
- To insure Enterprise Risks (normally risks that are uninsured or under-insured
- To insure warranties
- To issue bonds
- To insure healthcare / employee benefits
- To protect assets from creditors of the operating business
Why are ERM and Owning a Captive Insurance Company Effective Solutions?
In addition to positioning a business to better manage risk, ERM can change risk management from a cost center to a profit center. CLICK HERE to read more about turning risk management from a cost center into a profit center.
One of the primary objectives of any insurance company is to build up significant reserves for the future. And, insurance companies enjoy many tax advantages as they accumulate reserves. Captive insurance companies are no different. When a business owner sets up a captive insurance company to formally insure risk, he or she also benefits by being able to accumulate wealth in a more tax efficient vehicle. The operating company (or parent company) pays tax deductible premiums to the captive insurance company. And, small captive insurance companies may make an 831 (b) tax election. As such, they are taxed at zero percent (0%) on their underwriting profit. Underwriting profit is simply defined as premiums collected fewer claims paid. Small insurance companies by definition receive $2.3 million or less in annual premiums according to the Internal Revenue Code (IRC). The result is a remarkably efficient vehicle to accumulate loss reserves (and by extension wealth) for the future. This prevents the business and its owners from being hollowed out by excessive taxation. Businesses that own their own captive are better prepared to survive the 2020 roller coaster.
What Is A Captive Insurance Company?
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self-insure risk, and captives are generally formed to insure primarily though not exclusively the risks of one or more businesses owned by the same or related parties.
How Does a Captive Insurance Company Work?
A captive primarily insures its parent company or related companies. It typically forms the backbone of a company’s Enterprise Risk Management (ERM) strategy. Hence, the parent company is able to purchase insurance from its captive, and it can insure risks that third party insurers will not insure or risks where third party insurance cost is unaffordable. The captive can also insure the gaps in third party commercial insurance policies. Premiums are paid from the parent (operating) company to the captive with pre-tax dollars. The captive can invest its assets mostly as its owners choose (some domiciles have restrictions).
The Road Ahead
The lessons of 2020 are clear. Many hollowed-out businesses are suffering terribly or already closed. We can’t really know what the rest of 2020 will hold, nor can we know what calamities may be ahead in 2021 or 2022 or in the near future. On the other hand, businesses can act now to ensure their businesses aren’t hollowed out, and that is the key to not getting squashed no matter what lies ahead.
Learn more about Captive Insurance – CLICK HERE.