An Eight Point Treatise In Defense Of Small Captive Insurance Companies
Small businesses that own their own captive insurance company are quite often far different from large corporations. These differences are well understood by small business owners, their staffs and the service providers that support them. Not surprisingly, they also have a different approach to risk management, operations, personnel and financial strategies. There are a myriad of solid business reasons for small and mid-size business owners to own their own captive insurance company. In fact, the strategic significance of owning their own captive insurance company may be far more important than the strategic significance of captives to large corporations, because for small businesses the captive is often critical to the very survival of the entire business. However, small business captives are often misunderstood and maligned by captive managers, attorneys and actuaries who have built their careers and made their fortunes serving large corporate captives. Their approach often does not match the needs of small businesses, and they are being left out of the lion’s share of the growth in the industry. Not surprisingly, since the majority of Fortune 1000s own their own captive (or more than one), much of the growth in the industry is fueled by small and mid-size businesses.
CIC Services, LLC’s In-House Counsel, Sean King, JD, CPA, MAcc recently published an eight point treatise on Linked-In in response to dubious attacks by some “Old Guard” captive industry professionals against small captive insurance companies that make an 831(b) tax election. Not surprisingly, most small captives are owned by small and mid-size businesses or business owners.
This brief eight point treatise clearly outlines the legitimacy of small captive insurance companies, their unique needs and Congress’ express intent for small businesses to own captives and benefit from the 831(b) tax election. It is a refreshing read.
Sean G. King, JD, CPA, MAcc
Principal, In-House Counsel, CIC Services, LLC
Thanks [for your reply]. I am authoring a piece for Captive Review as we speak that will address your concerns specifically. For now, I will just note the following:
1). Your and the IRS’s issue with tax-motivated transactions is misplaced, as will eventually become evident. As most any tax lawyer will tell you, when Congress specifically writes a tax INCENTIVE into the code–like 831(b) or even 401(k) for that matter–it’s very purpose is to induce taxpayers to engage in transactions that they otherwise would not in order to achieve important public purposes. If you understand anything about small businesses, you will understand the important public purpose served by 831(b). The courts do not permit the Service to penalize taxpayers for being motivated by tax savings when the explicit purpose of Congress was to provide just such motivation. And similarly, it’s disingenuous for the Old Guard to do so.
2). I’m sure there are some sham captives being formed, just like there are sham 401(k)’s being formed or sham charities being formed. In the captive space, I doubt they represent nearly the percentage that you suspect, and I doubt that you and I would agree on which are which. Should we self-regulate to eliminate the shams? Of course. Should we label most everything and everyone associated with 831(b)s a sham, as Donald (to give just one example) is so apt to do, and then appeal to regulators to put them all out of business? Of course not.
3). The traditional example cited by the Old Guard for “bogus” insurance isn’t a volcano but rather terrorism. A great many have asked rhetorical questions like “who needs terrorism insurance in Iowa?”
Spend a little time on the Department of Homeland Security’s disaster preparedness website for business (ready.gov) and tell me that there is no need for terrorism insurance in Iowa. Talk to folks in Oklahoma City, and then tell me there is no need for terrorism insurance in the Heartland. Talk to any FBI agent, and then tell me that terrorism insurance is irrelevant to most small businesses anywhere.
4). As for pricing these policies, answer this question for me: How much would a small business owner have to pay for business interruption insurance in the commercial market that would reimburse him for lost revenue that results from terrorist attack (including chemical, biological and nuclear attack), a failure of the power grid (due to terrorist attack or the inevitable solar storm), a pandemic disease outbreak (let’s say, Ebola) in the US, or the government confining all non-essential workers to their homes for 30, 60 or 90 days to stem some national emergency? The answer: NOTHING. No mainline commercial insurer will write all such coverages AT ANY PRICE, and not because they are “not real” (they’d love to charge us for insurance that we will never need, after all) but rather because they are TOO REAL AND TOO GREAT, as ready.gov or any FBI agent will tell you . Consequently, any premium charged by a captive for such risks is, as a matter of pure logic, not “inflated” or bogus.
5). And lastly, unlike a Fortune 1000 company or a large hospital or other traditional users of the larger varieties of captives, most small businesses won’t survive even a SINGLE occurrence of ANY of the risk noted in the last paragraph, or a great many not noted. Per ready.gov, 40 percent of small businesses impacted by a disaster NEVER reopen. NEVER. Thus, even one occurrence of these risks is a true existential threat. Given that, and given how every small business owners personal financial security is tied to that of his business, and that small businesses employ half of all private sector workers, it is no wonder that small business owners would look to insure these risks through captives, and it’s no wonder that Congress has seen fit to incentivize them to do so.
6). Most small business owners understand everything I said above about risk in their gut – – not just intellectually, but emotionally. Their interest in these existential threats is understandable and genuine. With rare exceptions often cited by the Old Guard, they are not searching for “fake” risks to achieve a “bogus” tax deduction but rather are planning for real existential threats in a manner recommended by their own government.
7). Given their innate understanding of these risks, an 831(b) “promoter” need not spend too much time discussing them, modeling them, doing elaborate feasibility studies, etc.. Rather, when it comes to these existential threats to the business, the 831(b) advisor “had them at hello.” Most of the elaborate risk work is there’re done behind the scenes by the captive manager and actuary without the small business owners major involvement.
However, what the small business owners does NOT understand (that a Fortune 1000 CEO would) is:
–The tax benefits of 831(b) and that they are available and legitimate
— What happens to “their” money while it is in the captive
— Asset/liability matching
— The circumstances under which they can take money out of the captive and the tax implications of doing so
— The impact of forming this new captive on their existing estate planning (no responsible highly successful business owner who is well advised makes any long term business decisions without considering the estate planning implications since estate taxes are likewise an existential threat).
Unlike the risk work (writing and underwriting the policies) which is done behind the scenes by professionals, the above-listed items are all very complex issues that require elaborate explanation, modeling and convincing of both the client and his/her CPA, wealth manager and perhaps estate planning attorney. The client is invariably HEAVILY involved in these conversations, and understandably so.
Consequently, it is not unusual, nor should it be considered improper, for captive manager’s or advisor’s “marketing materials” to focus on addressing the points that, from experience, he or she knows will require more elaboration and explanation.
Thus, when dealing with a small business owner, unlike when dealing with a Fortune 1000 CFO, as much or more attention will often be paid to explaining and modeling the tax, asset management and estate planning implications than to the formation and operation of the captive itself (which is comparatively easy to explain and model). The Old Guard would have the IRS believe that this “proves” that the whole thing is just a “tax sham”, and I’m sure sometimes it is. But the fact that the business owner did extensive due diligence on understanding the income and estate tax implications of the captive, and the associated asset management issues, and that the captive manager spent considerable time explaining these things in its “marketing materials”, should not be considered “proof” of an “improper” tax motivation. In the absence of significant additional evidence, it’s only proof of the fact that the business owner was rightly diligent in vetting the tax effects of the transaction, and that he/she is using a captive manager or other advisors who are highly competent and thorough.
8. And one final point. I promise.
The IRS and the Old Guard seeming want to have their cake and eat it too. Where a taxpayer is less-than-diligent in vetting the tax implications of the transaction, the IRS and Old Guard are apt to allege that he or she had “no reasonable basis” for taking the deduction, and therefore accuracy/negligence penalties and preparer penalties are due. If you have spent any time defending 831(b)s against the IRS, you know what I’m talking about (not that these penalties ever stick, at least not that I’ve seen).
And yet, when the business owner and his advisors DO in fact vet these issues EXTENSIVELY, the Service and the Old Guard offer up the “focus on tax savings” as “proof” that the whole transactions was a tax-motivated sham, likewise then assessing accuracy/negligence penalties and preparer penalties. Again, if you have any experience defending 831(b)s against the IRS, you know what I’m talking about (not that these penalties ever stick, at least not that I’ve seen).
Both the Service and the Old Guard are therefore disingenuously putting small businesses and their advisors in a “damned if we do and damned if we don’t” situation. I get that from the Service. I lost all confidence in their fairness years ago. The only way to beat them nowadays is not an appeal to fairness, but to simply beat them, which we and a great many others have done. But I don’t get the disingenuousness of the Old Guard in these situations. Either they simply do not understand small business (which is likely the case) or they are shamelessly trying to use the IRS to put an honest competitor out of business.