April is upon us once again, and all over the Fruited Plain, business owners, CFOs and CPAs are talking about that five letter word – TAXES. Small and mid-market businesses and their owners have largely been under assault with higher health care costs, increasing regulation and historically heavy taxation. Also, they lack the scale required to access the powerful tax avoidance strategies employed by large corporations.
This week, I read that pharmaceutical giant, Pfizer, is in the midst of a merger with another pharmaceutical giant, Allergan. Although both companies have the majority of their intellectual capital in the United States, Allergan is officially headquartered in tax friendly, Ireland. Pfizer is planning to move its headquarters to Ireland as well as part of the merger. Not surprisingly, the Treasury Department is opposing the merger, and a battle royal is likely to ensue. This strategy is commonly known as corporate inversion, and it removes countless billions in tax revenue from the United States. Apple provides one of the most egregious cases of tax avoidance with its corporate headquarters in Ireland as well, while the vast majority of its intellectual know-how is in the U.S.
To read about Pfizer possibly moving its headquarters to Ireland, CLICK HERE.
To read about Apple’s monstrous tax avoidance play, CLICK HERE.
Do I share these large company examples to somehow suggest they are evil? No. Frankly, these large companies are behaving quite rationally. Their first duty is to their shareholders, which often places them squarely at odds with politicians. I share these examples with the goal of encouraging small and mid-market businesses to fend for themselves in the same way their large corporate brethren do.
Small and mid-market businesses also lack the scale to survive disasters and harsh market downturns. The sad reality is that taxes can severely weaken businesses by stripping out profits, leaving them vulnerable in the future. This is more thoroughly explained in our CAPTIVATING THINKING article, “Don’t Let Taxes Hollow Out Your Business,” CLICK HERE.
And, this brings us to a very important question:
To what lengths should business owners and professionals go to reduce their taxes and keep more of their hard earned money?
The answer is:
Provided they are conducting legitimate business transactions, the answer is “to the full extent the law allows.” The phrase “tax avoidance” may cause some to feel uncomfortable. It is critical to make the following distinction. Tax avoidance is perfectly legal, but tax evasion is against the law.
For perspective, this article will compare a well-known tax avoidance vehicle – real estate – with a lesser known tax avoidance vehicle – a captive insurance company.
First Things First
It must always be noted that business owners should not make business decisions based on tax implications alone. Business decisions are often based on a myriad of variables, and the financial entities or business vehicles discussed in this article are no exception. There are many compelling reasons for business owners to own the real estate assets that serve the needs of the business. There are also equally compelling reasons for a business and/or its owners to own an insurance company, known as a captive insurance company, that also serves the needs of the business.
What Is A Captive Insurance Company?
In short, a captive insurance company is a fully licensed insurance company owned by the business, its owners or related parties. It is also a unique insurance company and includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self-insure risk. Captives are generally formed to insure (primarily though not exclusively) the risks of one or more businesses owned by the same or related parties.
What Are Some Benefits a Business Receives by Owning Its Own Real Estate?
There are numerous benefits that a business and / or its owner (s) receive by owning real estate that serves the parent company. Some of the most common are:
- Asset Protection – if properly structured, real estate may be unreachable by the parent company’s creditors
- Flexibility – the parent company has flexibility to expand or modify its property or facilities
- Cost Control – the parent company has increased control over costs and rent increases
- Wealth Accumulation – the parent company and / or its owners accumulate real estate wealth
What Are Some Benefits a Business Receives by Owning Its Own Insurance Company?
Interestingly, many of the benefits of owning a captive insurance company are quite similar to the benefits of real estate ownership. Both real estate and a captive insurance company serve the parent company and meet some of its operational and financial needs. Some of the most common benefits of captive ownership include:
- Improved Risk Management – the captive provides increased or improved insurance coverage to the parent company
- Asset Protection – if properly structured, the captive and it assets (reserves) may be unreachable by the parent company’s creditors
- Flexibility – the captive gives the parent company flexibility if the commercial insurance market changes or additional risks are identified
- Cost Control – as a licensed insurance company, the captive has access to reinsurance markets
- Wealth Accumulation – the parent company and / or its owners can accumulate wealth as reserves of the captive
How Can Real Estate Function as a Tax Avoidance Vehicle?
Real estate receives favorable tax treatment in that it can be depreciated and thereby reduce taxable income. Consider this simple example. A limited liability company (LLC) with a single owner has an annual profit of $500,000. In most cases the owner would pay ordinary income tax on this $500,000 profit at a rate of approximately 50% (state and federal combined). This would result in after tax retained profit of $250,000.
However, the business owner could own the businesses’ facility in a separate holding company. For this example, assume the property was purchased for $2 million. Also assume the LLC pays $500,000 rent annually to the holding company, reducing the LLC’s profit and tax liability to $0. The holding company has annual rental income of $500,000. For simplicity’s sake, assume no other expenses (interest, repairs, insurance, etc.). The $2 million property can be depreciated over 27.5 years, so the business can take a write-off of $73,000 annually. This reduces taxable income to $427,000 yielding after tax retained profit of approximately $286,000.
How Can a Captive Insurance Company Function as a Tax Avoidance Vehicle?
Much like real estate, a captive insurance company also receives favorable tax treatment on the premiums it collects. As an example, consider the same limited liability company (LLC) with a single owner listed above. The business has an annual profit of $500,000 and after tax retained profit of $250,000.
However, the business owner could own a captive insurance company and pay $500,000 in insurance premiums annually from the parent company to the captive. The business would benefit from improved risk management and reduce the parent company’s taxable income to $0 in this example. Since annual premiums are below $1.2 million, the captive could make a small insurance company tax election known as an 831 (b) election. The captive pays taxes at a 0% rate on its underwriting profit. Underwriting profit is simply premiums received less claims paid. Assuming captive administration and claims total $50,000 annually, the captive will have retained reserves of $450,000. Compare $450,000 of retained reserves to $250,000 above. This represents an 80% increase (or $200,000 more). Note that in 2017, the premiums limit to make an 831(b) election will increase from $1.2 million to $2.2 million.
What Can a Captive Insurance Company Do For your Business?
Simply put, it can enable your small or mid-sized business to access the same tax avoidance strategies employed by large companies. For instance, a typical captive insurance company created for legitimate risk management and asset protection reasons can save as much as six hundred thousand dollars per year or more in combined federal and state income taxes. In 2017, possible tax savings will be as high as $1.1 million annually.
Don’t let TAXES be a four letter word. Reach out to us to discuss if a captive insurance company or additional captive is the right solution for your business.