Are Taxes Weakening Your Business?

A better question might be, “Did you just weaken your business by sending a large check to the IRS?”

And, if you answered, “yes” to that question, would you instead like to strengthen your business by sending far smaller checks to the IRS?

If you can affirmatively say, “yes” to the following statement, “I want to make my business stronger and more survivable by sending smaller checks to the IRS,” then this article is for you.

At the outset I want to be very clear that I am not advocating tax evasion.  CLICK HERE to read Tax Avoidance Is Perfectly Legal, But Tax Evasion Is Against The Law.

I am advocating one of the most responsible strategies that small and mid-sized business owners can implement to ensure the long-term survival of their enterprise.  This strategy has legitimate business purpose, provides significant tax savings, and is encouraged by Congress.  CLICK HERE to read Congress Wants You To Own A Captive Insurance Company.

What is this responsible strategy that is also a financial game-changer?  Well, I partially tipped my hand in the link provided above.  This wealth-preserving, business survival strategy is Enterprise Risk Management Utilizing A Small Captive Insurance Company.

BACKGROUND: Congress And Small Captive Insurance Companies

Over time, taxes can take a heavy toll on a business and its owners.  Year after year, profits are stripped away to pay taxes often resulting in a business that is less prepared for the challenges and risks it may face in the future.  Congress doesn’t want small and mid-size businesses and business owners to be hollowed out by excessive taxation either.

In the mid-1980s, Congress passed legislation creating the 831 (b) “small” insurance company tax election.  A small insurance company is defined as an insurance company that collects $1.2 million or less in premiums.  In most captive insurance company arrangements, premiums are paid by the parent company to the captive insurance company.  In return, the captive provides insurance policies to the parent company.  The 831(b) tax election allows small insurance companies to be taxed at a zero percent (0%) tax rate on underwriting profit.  Underwriting profit is simply defined as premiums collected less claims paid.  Hence, a small business could pay up to $1.2 million in premiums to its captive insurance company and the captive would pay no taxes.  The captive can be owned by the business, the business owner, business owners, heirs or other related parties.  Depending on claims, a captive can save up to $600,000 per year in taxes.

It’s worth noting that “small” captive insurance company legislation was a bi-partisan effort passed by a Democratic controlled Congress and signed into law by Republican President, Ronald Reagan.  This issue united both sides of the political aisle in America because small captive insurance companies are good for small businesses, good for long term business sustainability and good for America.

How Is Enterprise Risk Management With A Captive Insurance Company A Game Changer?

The illustration below shows why captive ownership is so often good for businesses and good for business owners.   A captive can serve as the backbone or chassis of an Enterprise Risk Management (ERM) approach.  ERM addresses risk holistically, expands insurance coverage to the business, takes a long-term approach to risk management, and simultaneously puts more wealth at the disposal of the business owner.

The illustration below compares the status quo on the left with ERM implementation and captive ownership on the right.  This illustration covers a 10 year period and assumes a 4% rate of investment return for both scenarios.  Both businesses have third party insurance coverage in place to insure core risks.  The business on the right which implemented ERM with a captive insurance company has more insurance coverage and more money.  In fact, over a ten year period, the business on the right has almost 80% more wealth than the business on the left.

Clearly, the business that implemented ERM with a Captive Insurance Company is better prepared for the future.   Remember, small insurance company legislation united both sides of the political aisle in America because small captive insurance companies are good for small businesses, good for long term business sustainability, good for employment, and good for America.  Don’t just pay more taxes if your business would benefit from owning its own insurance company!

What Is Enterprise Risk Management (ERM)

ERM is the discipline by which an organization in any industry assesses, controls, exploits, finances and monitors risks from all sources for the purpose of increasing the organization’s short and long-term value to its stakeholders.  Beginning in the mid-80s, many businesses continued down an entrepreneurial path and shifted their mindset from risk management simply as a form of cost containment to risk management as a profit center. Indeed, a more mature approach to risk management can be quite creative and entrepreneurial.  Making a paradigm shift from viewing risk management purely as a cost center to viewing risk management as a profit center and strategic pillar of the business can be very rewarding from a financial standpoint.

ERM is the paradigm shift that transforms risk management from a cost center to a profit center.  Large corporations have employed ERM for some time, and this mature approach to risk management can also be adopted by small and mid-size companies.  The chassis of an ERM approach is a captive insurance company (or companies).  Captive insurance companies give business owners or CFOs the ability to take an active versus a passive approach to risk management.  ERM increases depth of coverage and is a forward-looking approach to risk management.  Furthermore, as a company’s ERM strategy matures, risk management can transition from being a cost center to serving as an entrepreneurial profit center.

Ownership of one or more captive insurance companies makes ERM possible, because a business is able to both:

• Increase depth of insurance coverage
• Increase the time horizon of its risk management approach

Increase Depth Of Insurance Coverage

When employing a mature ERM model, business owners can categorize risk as core risk, operational risk and strategic risk.  Most businesses and individuals simply insure core risk and usually do so via third party commercial coverage.  Utilizing an ERM approach, a captive insurance company, in its formative years, gives businesses depth of cover by addressing the second and third layers of risk management (operational risk and strategic risk).  As the captive matures and amasses reserves, it can also play a role in addressing core risk.  It’s worth noting that many non-core risks evolve into core risks.  Examples include: cyber, supply-chain risk, extended warranties, administrative action, terrorism, receivables, key contracts, key employees and employment risk.  Operational and strategic risks and the existential threat that can pose to small and mid-size business owners are outlined in detail at FEMA’s Ready.Gov web site (CLICK HERE to read more).

Increase The Time Horizon Of Risk Management

Another characteristic of a mature risk management approach is taking a forward looking stance.  A short term approach to risk management typically buys insurance from year-to-year with the goal of keeping costs as low as possible.  Each year, all premiums paid for third party commercial coverage are a “sunk cost.”  At the end of the year, if there are no claims, the money is gone.  Because a captive insurance company is owned by the business owner(s) or the parent company, premiums paid to the captive insurance company are retained after claims are paid.  Wealth accumulates in the captive as insurance reserves and provides flexibility to the business in its risk management in future years.  A captive facilitates an ERM strategy because it enables a multi-year approach to risk management.

Summary:  Financial Impact Of ERM With A CIC

Adopting an ERM approach with a captive insurance company as the chassis can be a financial game changer for business owners.  Because the business owner and/or company can reap additional profits from its captive insurance company, the organization will inevitably make risk management and risk mitigation a higher priority.  Furthermore, as the CIC grows its reserves, it is in a position to help reduce total reliance on third party commercial cover for core risks.  This can often be achieved by reinsuring deductibles and insuring additional potential losses not covered by commercial insurance (including losses above third party insurance policy limits).  Finally, CIC ownership enables the business owner or owners to capitalize on the favorable tax treatment that insurance companies receive on their reserves set aside for future claims.  As noted already, a well-structured ERM strategy with a CIC can save a business owner up to $600,000 per year in taxes.

Because a captive insurance company is owned by the business owner(s) or the parent company, premiums paid to the captive insurance company are retained after claims are paid.  Wealth accumulates in the captive as insurance reserves and provides flexibility to the business in its risk management in future years.  A captive facilitates an ERM strategy because it enables a multi-year approach to risk management.

ERM with a captive insurance company is particularly powerful, because this approach enables a business or business owner to capitalize on insurance law.  Fortune 500 companies and other large company CFOs have been capitalizing on insurance law and tax treatment since the 1950s.  The exact same strategies are available to small and mid-size companies.  As part of its ERM, a business can purchase insurance from its captive insurance company (ies).  Premiums paid to the captive are a tax deductible expense to the parent company.  The captive insurance company receives the premiums in a tax-favored manner as a large portion are set aside as reserves for future claims.  Reserves are not taxed, hence the insurance company is able to invest and grow a large pool of money.  Insurance companies amass wealth by investing large amounts of pre-tax reserves.  As already covered, if the insurance company qualifies as a “small” insurance company (defined as receiving annual premiums of $1.2 million or less), it can make an 831 (b) tax election and be taxed at a 0% (zero percent) rate on its underwriting profits.  Hence, a well-structured ERM strategy with a CIC can save a business owner up to $600,000 per year in taxes.  Most importantly, rather than being weakened by taxation, the business is strengthened and better prepared for long term survival.