Tax Avoidance Is Perfectly Legal And May Be The Difference Between Thriving Or Going Out Of Business
Originally published on April 18, 2017
It’s Tax Day, and millions of Americans are mailing checks to the U.S. Treasury. I thought about this as I talked with a successful business owner this Spring who is considering forming a captive insurance company to help lower total insurance costs and provide better risk management flexibility. He has been in business over twenty years and has seen competitors come and go. I asked him about some of the keys to survival and success, and I was surprised that “tax strategies” was in his top three. He told me, “over the years, we have had a lot of competitors start up and take a slice of our business…they worked hard…really hustled…and I didn’t have anything against them…but every Spring, they would fold up and disappear.” After doing some research, he realized that taxes shuttered his competitors, and he was fortunate enough to have a financial advisor who helped him with advanced tax strategies. For example, his business purchased capital equipment that could be depreciated on accelerated schedules or entirely written off in some cases. As another example, the business purchased life insurance policies on its key employees. Life insurance policies have the advantage of providing tax free growth, and the business has been able to borrow money from the policies when needed. These were just two of many strategies his business employed that helped him outlast new entrants in his market.
And, this raises a question that all business owners and their advisors should consider…
“What tax avoidance strategies and vehicles would enable us to better serve our business and hold on to hard earned profits for the future?”
It’s important to note that tax avoidance is perfectly legal. Tax evasion is against the law.
The good news is that Congress wants businesses and business owners to avoid taxes. Yes -that’s right – Congress wants businesses and business owners to avoid paying taxes and provides American taxpayers with a myriad of ways to legally avoid taxes. In return Congress wants Americans (or businesses or business owners) to adopt certain behaviors. These behaviors often have desired public policy outcomes. For example, the mortgage interest rate deduction is designed to encourage home ownership. On the other hand, consumer credit card interest can’t be deducted, so tax law does not encourage credit card debt.
Consider the following examples:
The mortgage interest deduction not only encourages home ownership. It also drives more real estate transactions thereby boosting the real estate, appraisal, home inspection and mortgage industries.
Green energy credits encourage businesses and individuals to purchase “greener” technologies like tankless water heaters, solar cells, electric cars, etc. The desired public policy outcomes include reduced energy usage and reduced emissions.
Charitable deductions encourage giving to non-profits which have enabled enormous aid to the needy, benevolence, education, healthcare research, religious observance, ministries and numerous other beneficial organizations.
Depreciation expenses encourage companies to purchase new equipment. This helps companies increase capacity and also creates sales for the equipment manufacturer. Tax avoidance incentives often spur economic activity, create jobs and strengthen the very businesses that benefit from tax avoidance. Tax avoidance strategies often encourage companies to act in their own long-term best interest.
Speaking of long term best interest, there are few tax avoidance strategies that rival the benefits of owning a Captive Insurance Company (CIC) as part of an Enterprise Risk Management (ERM) strategy. After all, all insurance companies avoid taxes to one extent or another on reserves set aside for future claims.
Does Congress want successful small and mid-sized businesses to own a captive insurance company? Absolutely! In fact, Congress just raised the premium limit for small insurance companies, making an 831(b) tax election from $1.2 million to $2.2 million annually. The 831(b) election will be explained below.
What Is A Captive Insurance Company (CIC)?
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 Is Enterprise Risk Management (ERM)?
Large corporations have employed Enterprise Risk Management (ERM) for some time, and this mature approach to risk management can also be adopted by mid-size and smaller companies. A captive insurance company allows companies to engage in ERM because it enables the business (or business owner or CFO) to take an active versus a passive approach to risk management. ERM is a risk management approach that 1) increases the depth (or scope) of insurance coverage, and 2) increases the time horizon of risk management approach (from one year at a time to a multi-year forward looking approach). An ERM model categorizes risk as core risk, operational risk and strategic risk. Because of its flexibility, a captive insurance company will often insure risks that are difficult to cover via third party commercial coverage, often operational and strategic risks.
Another characteristic of ERM is its 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.
What Are The Benefits Of ERM With A CIC?
Some of the most common benefits of ERM with a CIC include:
- Improved Risk Management – the captive provides increased or improved insurance coverage to the parent company
- Funding Loss Reserves For The Future – the captive can accumulate reserves for potential losses in the future
- 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
- Wealth Transfer – the business owner’s heir (s) or key employees or other related parties can own the captive
How Can ERM With A CIC Function as a Tax Avoidance Strategy?
A captive insurance company receives favorable tax treatment on the premiums it collects. As an example, consider a limited liability company (LLC) with a single owner. The business has an annual profit of $1,000,000 and after tax retained profit of $500,000.
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 (ERM) and reduce the parent company’s taxable income from $1,000,000 to $500,000 in this example. Since annual premiums are below $2.2 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 premiums collected. Assuming administration and claims total $50,000 annually, the captive will have retained reserves of $450,000.
What Can ERM With A CIC Do For your Business?
Simply put, it can enable your small or mid-sized business to access the same tax avoidance strategy employed by large insurance companies. This tax avoidance strategy is provided for by Congress to encourage businesses to adopt more sophisticated risk management. For instance, a typical captive insurance company created for legitimate Enterprise Risk Management and asset protection reasons can save as much as one million dollars per year in combined federal and state income taxes. For many businesses, this could be the difference in surviving and thriving or going out of business.