Tax avoidance is perfectly legal and encouraged by the IRS,
but tax evasion is against the law.
– Internal Revenue Service Website
Business owners across America mailed checks to the IRS last week. Parting with hard earned profits certainly isn’t easy. Which begs the question, to what lengths should business owners and professionals go to reduce their taxes and keep more of their hard earned money?
“Tax avoidance” may sound a bit sinister, particularly in a culture where politicians and the media rail against “loopholes that help the rich.” And, billionaire Warren Buffett tells the press his secretary pays a higher effective tax rate than he does. In case you are wondering, Buffett hasn’t written any checks to the Federal Treasury to “right” this great “wrong” he has complained about. Are you surprised? Buffett has an army of financial vehicles at his disposal and a staff of lawyers and financial professionals working to make the most of every dollar earned.
Which brings us back to the question, “To what lengths should business owners and professionals go to reduce their taxes and keep more of their hard earned money?” Provided they are conducting legitimate business transactions, the answer is “to the full extent the law allows.” Even the IRS acknowledges that tax avoidance is perfectly legal and encouraged.
In reality, tax avoidance is part of life in America. H&R Block airs radio ads claiming taxpayers missed out on billions of dollars in deductions on their tax returns last year. The mortgage interest deduction on homes is designed to encourage home ownership. Businesses write off expenses, interest and depreciation to avoid taxation. My plumber recently told me I can earn a tax credit (a form of tax avoidance) by replacing my failing gas water heater with a tankless water heater. If I choose a regular gas water heater, I receive no tax avoidance benefit. For business owners, one of the benefits of owning a captive insurance company is tax avoidance. After all, all insurance companies avoid taxes to one extent or another on reserves set aside for future claims.
Consider a well-known tax avoidance vehicle – real estate. There are many similarities between owning real estate and owning 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. This is the case for both real estate and captive insurance companies (and many other business decisions). Business decisions are often based on a myriad of variables, and the financial entities or business vehicles discussed in this article are no exception. For a business and its owners, there are many reasons to own real estate that serves 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
- Wealth Transfer – the business owner’s heir (s) or key employees or other related parties can own the real estate
What Are Some Benefits A Business Receives By Owning Its Own Insurance Company?
Interestingly, 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 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
- Wealth Transfer – the business owner’s heir (s) or key employees or other related parties can own 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 premiums collected. Assuming administration and claims total $50,000 annually, the captive will have retained reserves of $450,000.
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 business empires like Berkshire Hathaway and their owners. For instance, “A typical captive insurance company created for legitimate risk management and asset protection reasons can save as much as half a million dollars a year or more in combined federal and state income taxes.” It is no surprise that Warren Buffett built much of his wealth through the insurance company he owns.