How to Tell a Good Captive Insurance Company from a Sham—Part 4
By Sean King, JD, CPA, MAcc
Principal & In-House Counsel, CIC Services, LLC
Question: Is a captive insurance company a sham if it was introduced to a business owner by a financial advisor?
This week, I am continuing my series about distinguishing legitimate captive insurance arrangements from shams.
Remember, there is growing concern among regulators, the IRS, and captive insurance professionals that too many small captive insurance companies (CICs) lack economic substance—that is, that they are shams constructed for the purpose of avoiding taxes rather than for real insurance and risk management reasons. While we share this concern, many of the guidelines offered up by the IRS and some captive professionals to differentiate good and bad captives (and good and bad captive advisors), are mostly useless. Most are nothing more than characterizations and are both too broad (in that they tend to suggest that some perfectly legitimate captive arrangements are shams) and too narrow (in that they fail to identify many abusive arrangements).
One mischaracterization offered up by the IRS and some in the captive industry is: “If a small or mid-size business owner is introduced to the concept of captive insurance by a financial professional or CPA, the motivation behind the captive arrangement should be suspect.” The implication is that the captive must be a tax-motivated transaction since outside advisors, some of whom (like CPAs) are tax professionals, “marketed” the idea to the business owner rather than the business owner, for his or her own true risk management reasons, deciding to do a CIC on his or her own without any outside guidance or influence.
This implication is simply wrong. It is fraught with large company bias, and it results from ignorance regarding how small and mid-size businesses obtain proactive financial and risk management advice. The simple reality is that, unlike Fortune 1000 companies, many small and mid-market businesses don’t really have a CFO or Finance Department. Yes, they may have a department called “finance” or someone with a “CFO” title, but in small and mid-market businesses, such people generally concern themselves with day to day busines operations (accounts receivable, accounts payable, bookkeeping, etc.) rather than sophisticated and proactive financial or risk management planning.
So, where do small and mid-market businesses get the proactive planning help that they need? Historically from an independent wealth manager, an independent and proactive CPA, and/or an independent risk manager or insurance agent – the very people that the IRS and certain old guard captive managers would have us believe are inherenlty suspect marketers of “tax shelters.” In many cases, these independent advisors simply serve as de facto CFOs to the small and mid-market businesses that they serve.
Do we have any reson to believe that these independent advisors are any more or less motivated by taxes in recommending a captive insuarnce company than their Fortune 1000 peers, who have reeped the benefits of captive ownership for decades? Of course not. First, Fortune 1000 CFOs are, if anything, more highly tax motivated than the independent advisors to small business. For instance:
Burger King pursued a merger with a much smaller Canadian restaurant chain, Tim Horton’s. Keep in mind that Canada’s population is roughly 10% of the U.S. Was this a case of a large company acquiring a smaller one? No! The smaller company, Tim Horton’s, was acquiring the larger one, Burger King. CNN Money described it as a “Whopper of a tax dodge,” noting the “deal” would reduce taxes paid in the U.S. by $400 million! Clearly, Burger King’s Finance Army earned their money. To read about Burger King’s corporate inversion scheme, CLICK HERE.
Apple’s incredibly low corporate tax rates suggests that, pound-for-pound, Apple’s lawyers and Finance Army are for more valuable than Apple’s programmers. An article in USA Today on Tuesday, May 21, 2013 noted “Apple has avoided tens of billions of dollars in U.S. taxes on its profits, according to a Senate report summary issued Monday…” The article also stated, “The California-based firm has used a web of offshore entities – including three Ireland subsidiaries… to cut some of its tax rates to 0.05%, the Senate Permanent Subcommittee on Investigations reported.” As a large corporation, Apple has scale advantages and access to a legal and financial dream team. To read about Apple’s massive tax avoidance, CLICK HERE.
And second, these independent advisors, who serve numerous small and mid-market business clients, are uniquely positioned to see the various risks that small businesses face. Talk to any of them for any length of time and you will quickly hear stories of businesses that failed as a result of litigation expenses, canceled or breached contracts, supply chain interruption, natural disasters, and a great many other risks that are true existential threats to small businesses. Helping their small business clients prepare for and protect against such risks benefits both them and their client.
In short, learning of the benefits of a captive from one’s CPA, wealth manager or independent advisor is not, by itself, evidence of some improper tax motivation. Rather, an improper tax motivation is evidenced by, among other things:
–Advisors recommending business owners establish captive arrangements for tax purposes with little or no attention paid to risk management
–Advisors encouraging business owners to treat a captive insurance company like a personal bank account rather than as an insurance company with potential claims obligations
–Advisors recommending that captives invest their assets in a way that does not support the liquidity and claims-paying obligations of the captive itself