In addition to gaining the ability to self-insure and to own a profitable second business, a captive insurance company can also facilitate the purchase/sale of a business. Prior to addressing this unique benefit, it’s worth noting the primary reasons that businesses form their own insurance company – specifically a captive insurance company.
- To manage business risk by formally self-insuring certain risks with pre-tax dollars
- To protect assets from creditors of the operating business and its owners or other risks
- To realize profits and accumulate wealth inside of a separate business entity
These are well known reasons that legitimate captive insurance companies are formed by businesses. Assuming a captive insurance company is formed for the above reasons (or similar ones), it can also be an incredibly efficient way to transfer assets or wealth from one party to another – for this discussion – from a business purchaser to a business seller.
A Common Challenge– Funding a Buy/Sell Agreement Can Be Difficult
Selling a business can be difficult. If a qualified buyer is found, difficult negotiations ensue related to the true value of the business. And, even if a business demonstrates a certain value “on paper,” it may be difficult for the purchaser to justify the cost to buy the business. One reason for this is that the purchaser is either buying the business with dollars that have already been taxed, or the deal is financed and the purchaser will be making payments with after tax dollars. Plus, the seller may owe additional taxes on any money he/she receives from the buyer. What’s needed is a way to reduce tax friction to bring the parties together. Quite often, an existing captive insurance company can serve this purpose.
When a business owner forms a captive insurance company and uses it to formally insure business risks, the business owner now owns two companies—the operating entity (the insured) and the insurance company (the insurer). In addition to giving the owner more flexibility to insure risk for the parent company, the owner is also in the unique position of having one business serve as a supplier or vendor to the other.
And, a captive insurance company enables a business owner to make significant purchases of insurance coverage for the parent company from the captive insurance company. In this case, not only is the parent company more thoroughly insured against risk, but the parent company has also reduced its taxable income by paying insurance premiums to its captive insurance company. Also, the captive insurance company does not pay taxes on the insurance premiums that it collects up to $1.2 million annually, provided it is an 831 (b) captive.
How Does this Facilitate a Buy-Sell Agreement?
The short answer is that the business owner can sell the operating business and keep the captive insurance company. Assuming the operating business continues to pay premiums to the insurance company, which can be structured as part of the deal, that such premium payments reduce the businesses profits and therefore it’s value. This means that the buyer pays less for the business but is nonetheless required to purchase tax deductible insurance from the captive insurance company for some period of time. The total amount transferred from buyer to seller is likely MORE than what was originally contemplated because the buyer is transferring much of that money with pre-tax dollars. And the Seller received much of that money, or at least his/her insurance company did, tax-free. In short, on an “all in” basis and after considering taxes, the buyer pays less but the seller receives more. It’s a win/win.
Clearly there is some risk to the seller. After all, the buyer can, and likely will, file claims against the insurance company someday. But, properly structured, those claims should be far less than the tax friction in all but the most unlikely scenarios.
Also, no one should ever form a captive simply to facilitate the sale of a business. But, having said that, businesses that have existing captives shouldn’t overlook the role that it can play in facilitating the sale of that business in the future.
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. 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.
Some examples include (but are not limited to):
- Loss of a key account
- Loss of key personnel
- Loss of data
- Loss of sales due to “down-time”
- Loss of a license or certification
- Loss of a sales or distribution territory
- Loss of dealership rights
Premiums are paid from the parent company to the captive with pre-tax dollars. The captive can invest its assets mostly as its owners choose (some domiciles have restrictions).
Call us to discuss whether or not a captive insurance company or additional captive insurance company is the right move for your business.
Phone – 865- 386-4920
E-Mail – Tom@CICServicesLLC.com
Web – www.CICServicesLLC.com