Ancillary Benefit Of Owning A Captive Insurance Company – Efficient Removal Of Retained Earnings From A C Corp.
In our weekly articles we have discussed the tremendous business benefits of owning a small insurance company – specifically a Section 831 (b) captive insurance company. Four very common benefits are:
- To formally self-insure business risks with tax deductible dollars
- To protect assets
- To accumulate wealth and earn additional profits
- To more effectively transfer assets to one’s heirs
And, owning and operating a captive insurance company enables a business owner or owners to achieve all 4 benefits outlined above at the same time in one vehicle. Captive ownership also affords many ancillary benefits, including the efficient removal of earnings from a C Corporation.
The Challenge – Retained Earnings “Trapped” in a C Corp
Another issue common to many small and mid-size businesses is the accumulation of retained earnings inside of a C Corporation. Retaining significant amounts of earnings inside of a C Corporation often only makes it a bigger target for creditors or plaintiffs. And yet distributing retained earnings via dividends often only aggravates the creditor/plaintiff issue and triggers a second layer of tax on the businesses accumulated profits (i.e., “double taxation”). Captive insurance companies can assist in resolving this issue.
Our client was the owner of a construction company that built large commercial buildings including hospitals and shopping malls. The business was a C Corporation in a high risk business and had numerous uninsured risks. With over $5 million in retained earnings that had already been taxed at the corporate rate of 35% (at that time), it was a target. The owner planned to phase out of the business over a several year period. And, the owner faced an additional dividend tax on the distribution of retained earnings.
The client formed a captive insurance company to formally self-insure business risks that it previously only informally self-insured. This gave the business owner better overall risk management at a reduced cost. Furthermore, the business owner was able to pay tax deductible insurance premiums to the captive insurance company – up to $1.2 million annually, for the needed insurance coverage. Over five years, the owner was able to transfer a significant amount of retained earnings from the C Corporation to the owner’s captive insurance company in a tax-preferred manner, thereby removing it from the C Corp and protecting it from the C Corps future creditors. Importantly, electing small insurance companies such as the one described above pay tax at a zero percent rate on their underwriting profits (i.e., premium income less claims and operating expenses).
What Is A Captive Insurance Company?
A captive is a unique, closely-held insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a sophisticated way to self-insure and is generally formed to insure the risks of its owners and related or affiliated third parties.
How Does a Captive Insurance Company Work?
A captive provides many benefits to its parent company or business owner including risk mitigation, asset protection, security from creditors and increased profits. A captive primarily insures its parent company or related companies. Hence, the parent company is able to purchase insurance from its captive. A business can insure risks that third party insurers will not insure or risks where the cost to insure with a third party is prohibitive.
Some examples include (but are not limited to):
- Loss of a key account
- Loss of key personnel
- Loss of income to new competition
- Loss of a license or certification
- Loss of a sales or distribution territory
- Loss of dealership rights
These are risks that many businesses regularly face and informally self-insure. Which means that if an event occurs, the business either has to have built up a sinking fund with after tax dollars or it “bites the bullet,” often taking a loss, laying off workers and possibly facing partial or total closure. With an 831 (b) captive in place, businesses can also formally insure risks not normally insured by third party insurers. And, importantly, claims paid by the captive are paid from pre-tax dollars and are not recaptured as income by the operating company.
Premiums are paid from the parent company to the captive with pre-tax dollars, and accumulate tax-free as reserves of the captive (up to $1.2 million annually). Captive reserves can be translated into virtually any other type of asset (some domiciles have restrictions). Hence premiums paid to the captive are in effect a “transfer of wealth” and are protected from the parent company’s creditors and lawsuits.