Deferred Compensation Retirement Plan for Key Employees or Business Owners – A Case Study
In addition to gaining the ability to self-insure and to own a profitable second business, a captive insurance company can also serve as a remarkably efficient vehicle to house a deferred compensation plan for key employees and business owners. The logic behind this approach is quite simple. Rather than giving ownership or deferred compensation to key employees in the parent company, businesses can offer deferred compensation and ownership through a separate company – their own insurance company. This provides asset protection to the parent company and prevents dilution of the parent company’s ownership. This arrangement also provides a more tax efficient platform to fund a deferred compensation arrangement. However, prior to addressing this unique benefit, it’s worth noting the primary reasons that businesses form their own casualty 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 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 to a key employee or owner in the form of deferred compensation or a deferred compensation retirement plan.
A Common Business Challenge– (Affordably) Establishing a Deferred Compensation Plan
It’s a competitive business climate, and business owners have to work hard and develop creative and compelling incentives to attract and keep their talented employees. The cost to provide key employees or business owners with deferred compensation or a supplemental retirement plan can be quite daunting.
The Significance of the Challenge
To allocate $100,000 to a non-qualified deferred compensation plan for a key employee or owner, a business must earn $181,818 in profit (45% federal and state tax bracket).
A business that owns a captive insurance company can allow key employees or owners to have ownership in the captive. As such, the captive’s profits can serve as the wealth accumulation vehicle to fund a supplemental retirement plan for the key employees / owners. In addition, in structuring ownership in the captive, the parent company can have “strings attached” including a vesting schedule. This ensures the key employees or owners work a requisite number of years to be fully vested (own 100% of their allocated share of the captive). A well structured vesting schedule can give key employees and owners increasing ownership in the captive over time. Also, such an arrangement can serve both as “Golden Handcuffs” to retain talent and “Golden Parachutes” to reward talent once the agreements have been satisfied.
Why is Owning a Captive Insurance Company an Effective Solution?
Key employees and business owners can be given an equity stake in a separate company – in this case a captive insurance company. This equity ownership has tangible value, and it doesn’t dilute the equity of the parent company. Furthermore, owning a captive insurance company enables the parent company via anticipated profits of the captive insurance company to set aside funds for key employees and owners in a more tax efficient vehicle. The parent company can deduct the premium payments it makes to its captive, and the profits (accumulated retained earnings) within the captive are taxed at 0%. The result is a remarkably efficient vehicle to fund a supplemental retirement plan. In fact, it is more efficient than any profit sharing plan and any qualified plan (e.g. a 401k plan). As an added benefit, the captive can invest in investment grade life insurance on the life of key employees and/or owners to provide a pre-retirement death benefit – in case the key employee doesn’t live and work long enough to fund retirement for spouse and children, etc.
What Is A Captive Insurance Company?
A captive insurance company is unique. 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 risks. 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 or contract
- Loss of key personnel
- 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