Captive insurance cuts business costs

June 1, 2009
Section 831(b)of the Internal Revenue Code, dealing with captive insurance companies, is primarily an income-tax saving machine for your business and can be structured to offer tax-advantaged benefits that create wealth for you or even your heirs when properly used.

The Internal Revenue Code is not a friendly creature. It is designed to take your money. Yet, there is a section of the Code, Section 831(b), dealing with captive insurance companies, which is primarily an income-tax saving machine for your business and can be structured to offer tax-advantaged benefits that create wealth for you or even your heirs when properly used.

About 80% of the Fortune 500 take advantage of Captive benefits. But much smaller businesses can join the tax-saving/wealth-building fun. If you own all or a part of a business, listen up, you'll love what you are about to read.

Please note the Obama administration has made it clear that income tax rates are increasing on high earners. As you are about to learn, a Captive is an especially welcomed friend in a rising tax-rate environment.

It's difficult to find a CPA or lawyer who has even heard of Captives. The few that know Captives exist don't have a clue as to how to take advantage of the benefits offered by Captives for family owned businesses or small public companies.

What is a Captive?

First and foremost, it is a bona fide insurance company — an insurer established to provide coverage for the company or people who founded it. For example, Joe owns Success Co., which has some uninsured risks, which will be explained in greater detail later, that his current property and casualty insurance company will not insure. Joe creates New Co., a Captive corporation, which is an insurance company, covering Success Co.'s uninsured risks. The stock of New Co. is owned by Joe's children.

Now for the fun part: suppose the insurance premium for the uninsured risks are determined by a consulting actuary to be $500,000 per year. Success Co. pays the $500,000 premium to New Co. The entire premium is immediately deductible by Success Co. like any other PCI. Under the Captive rules, all of the $500,000 is income-tax free to New Co.

Say Success Co. is in a 40% tax bracket, state and federal combined. Success Co. is only out of pocket $300,000 ($500,000 less $200,000 in tax savings). New Co. has the entire $500,000 to invest. But remember, New Co. is a Captive and must hold the $500,000, plus earnings, as a fund to pay potential claims for the risks it insures.

Uninsured risks

Every business has risks — some insured and some uninsured. The most common risks, like workmen's compensation, vehicle, property and general liability, are transferred to a third-party (your traditional property and casualty insurance carriers) and are insured risks.

Now let's list some typical uninsured risks, the kind that you can't buy coverage for in the traditional insurance market (as you review the list, check off those that apply to your business): litigation defense/asset protection, loss of a key customer, loss of a key supplier, change in a law/regulation/ruling, product warranty, product liability, professional liability, strikes/labor problems, traditional policy exclusions/deductibles and employment practices.

The list could go on and on. You probably have one or more uninsured risks peculiar to your business. Go ahead — add those risks to the list. Let's face it, your business is self-insured for all of theses risks either by choice or because the risks just can't be insured commercially. A Captive reduces the amount needed to fund such possible future losses. How does it reduce the amount? The premiums paid to your Captive are immediately deductible.

Here are two more examples in which the use of a Captive can save your business significant insurance costs:

Example No. 1: You own a new or very up-to-date building in an area with “zone coverage.” Your building is in total compliance with stringent building codes. Many older buildings in the zone are not complaint. Your building can obtain lower rates from your Captive if you can show that your building is a better risk than the zone's rating.

Example No. 2: Success Co. pays premiums to the Captive to insure for litigation defense, strikes and product warranty. Remember with a commercial insurance company, if the insured has no losses, the CIC keeps the entire premium — no refunds.

Even though a Captive cannot reduce (actuarially determined) premiums, a financial windfall results (unused reserve) if the insured's actual losses are less than actuarially predicted. For example, suppose Joe's Captive (New Co.) has an unused reserve. A portion of the unused reserve can be refunded to Success Co., reduce future premiums or be paid to the Captive's shareholders (Joe's children) as a dividend.

There are a number of other fringe benefits to a Captive structure, such as someday liquidating your Captive and taking out the unused reserve at capital gains rates; having the Captive invest a portion of its reserve funds to pay premiums for life insurance on the Captive's founder or his family members (in effect, deducting the life insurance premiums); and using the Captive as an estate planning strategy, passing the Captive (and any life insurance proceeds) to your heirs.

Make no mistake, your Captive must be formed and operated for a business purpose. The Captive must demonstrate that it is, in fact, acting as a proper insurance company. Follow the rules, and the IRS is not a problem. Trying to fool the IRS by forming your Captive to take advantage of only the tax-advantaged fringe benefits, without a real business purpose, is almost certain to cause the loss of the sought-after benefits.

No attempt is made in this article to explore all the rules, traps and opportunities in forming your own Captive. It is essential that you work only with qualified, experienced advisors that specialize in Captives. The right advisors can easily tailor your Captive to fit you, your business and circumstances perfectly.

Is a Captive right for you?

If costs were not an issue, a captive would be right for almost every business. Unfortunately, costs are a factor. For a Fortune 500 company, it's a slam dunk. The insurance cost savings and tax-benefits are well worth the required costs to create and administer a Captive.

You should strongly consider forming a Captive if your before-tax profit is $1 million or more per year, traditional insured property and casualty expenses are $1 million or more per year, or one or more of the uninsured risks listed above is a significant factor in your business and worth a premium of about $200,000 or more a year.

Logic tells you that the larger your business, the more likely a Captive should be a top priority for next year's business plan (i.e. make $1 million or more before tax, and Captive is a must). Costs are easily covered by Captive benefits.

What about smaller family businesses? A Captive is possible with a new strategy the experts have perfected if your before-tax profits are in the $250,000 per year range. Benefits are the same as for a larger company, but costs are substantially reduced.

What if your company is even smaller? Then we need some help. Please show this article to the decision makers of your trade association. Have your trade association adopt a Captive program, so you and the other members can participate. The cost is minimal.

Finally, if you are lucky enough to be a Florida resident and your business is located in a different state, there is a little known and legal tax strategy that enhances your tax savings.

How can you learn if a Captive will work for your business? Please fax the following information (on your company letterhead) to 847-674-5299: your name, title, type of business, total number of employees and any other information you think will be helpful. Also include business, home and cell phone numbers. Trade associations should fax the following information on their letterhead: number of members and name of decision maker. Please mark “Captive” at the top of your fax.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at

About the Author

Irving L. Blackman

Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847/674-5295, via e-mail or on the Web at:

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