The views expressed in this article do not necessarily reflect the opinions of CIC Services, LLC or its principals. This article contains financially mature themes including the use of three letter words. CIC Services, LLC does not actually recommend that businesses eliminate their qualified retirement plans. Reader discretion is advised.
If you are a highly successful small business owner and the thought of being audited and possibly fined or penalized by the IRS or DOL or another federal alphabet agency makes you queasy, here’s something you might consider:
Shut down your retirement plan and replace it with a Captive Insurance Company (CIC) with employee ownership in the CIC.
Two weeks ago, Captivating Thinking (CT) pointed out that the Internal Revenue Service (IRS) and Department of Labor (DOL) have been auditing and continue to aggressively audit qualified retirement plans (401(k)s, 403(b)s, etc). CT referenced a PLANSPONSOR article which reported that one third of retirement plans have been audited by the IRS in the last two years (a rate of 15% annually). Furthermore, the DOL collected $2 Billion in fines from employers in 2015.
Shortly after our CT article on retirement plan audits was published, the Washington Report Marketplace (WRMarketplace) reported on the subject, noting, “The IRS and U.S. Department of Labor (“DOL”) have shifted their focus over time from document and reporting compliance to administration and fiduciary investigations. Accordingly, both agencies have developed detailed examination programs to review qualified retirement plan compliance.”
In short, these federal agencies are not so much looking for compliance as looking for revenue. And they are often able to extort fines and settlements even from taxpayers who have not clearly broken the law.
So, what is an audit averse business owner or CFO to do? Or, what if you own a business or run a company, and you don’t like the idea of being fleeced by the DOL with fines against your 401(k)?
- Freeze the retirement plan.
- Set up a Captive Insurance Company to better manage risk.
- Give employees ownership in the Captive Insurance Company.
Many small business owners use their retirement plans not so much as…well…a retirement plan but rather as an emergency reserve. For many business owners, “retirement plans” are a tax-efficient sinking fund from which they can draw when the unexpected happens—when they lose a big customer, they come under investigation, they are hacked, they are sued, etc.
In actuality, captive insurance companies are far better risk management tools than retirement plans. For one, they provide meaningful insurance. For another, they have less restrictions on accessing the money, and the money can be accessed without early withdrawal penalties. And finally, while they have come under IRS scrutiny, they are less likely, to be audited than retirement plans these days.
Benefits to Employees
Like a retirement plan, ownership in a CIC can provide some meaningful benefits to employees. If the CIC qualifies as “small,” it can make an 831(b) tax election and be taxed at a rate of 0% on underwriting profits. In 2017, “small” insurance companies will be defined as receiving $2.2 million or less in premiums and meeting some other criteria.
An employee’s share of annual underwriting profits are not capped like a 401 (k). An employee would not face a 10% withdrawal penalty for exiting the captive early, and the employee would not be forced to take mandatory distributions (and pay ordinary income taxes) at retirement age. In fact, the employee could simply sell their share of the CIC back and pay taxes at long term capital gains rates. Likewise, the employee could be paid dividends from the CIC and be taxed at dividend rates. The owner of the business can have more “say so” regarding if and when an employee is cashed out.
Benefits to the Company
By setting up a CIC, the business is far better positioned to manage risks it faces, particularly if it sets up the CIC as part of an Enterprise Risk Management (ERM) program.
It’s also important to note that employees who are owners in a captive insurance company now have a far greater stake in the company’s risk management. For example, if the CIC insured cyber losses, it is far more likely that employees would be diligent to follow cyber best practices. And, if the CIC insured worker’s comp deductibles, it is far more likely that all employees would be focused on safety and eliminating work place injuries. As another example, if the CIC insured employment practices, all employees would have a very powerful interest in ensuring a safe work place free of harassment and discrimination. During a talk this Spring, Michael Corbett, Director of the Tennessee Captive Insurance Division, painted a picture of his “dream captive” – a worker’s comp captive owned by the employees – Brilliant! This is what captives do best – tie profit and wealth accumulation to vigilant risk management.
This Isn’t As Crazy As It Sounds
In conclusion, retirement plans and captive insurance companies serve two very different purposes, so in reality businesses need both. But business owners should avoid trying to make their retirement plan work as an emergency reserve or risk management tool. It’s just not efficient for that purpose. Instead, they can form a captive insurance company to insure their risk, give key employees a vested interest in managing those risks and, if the company proves profitable (as they usually do), provide supplemental retirement and “golden handcuffs” to the business owner and key employees.