By Fred Whitaker
The American Taxpayer Relief Act of 2012 has a very misleading name. While it provides certainty and generous credits for estate taxes, it raised rates across the board for income, capital gain and dividend taxes. Based on ATRA, our goal for 2013 is to manage your tax brackets for the current year and the long term. The best long term leveraging tool to reduce current taxation is the Captive Insurance Company – specifically, Internal Revenue Code Section 831(b) small insurance company captives.
Think about risks you have in your business today for which you don’t purchase insurance. Is it credit risk in your accounts receivable? Or is it environmental contamination for upset/overturn and overfill greater than the mandatory endorsement to your commercial auto policy? Or perhaps it’s environmental contamination and clean up at your sites because the State UST fund is underwater or not paying claims and you need to cover the up front costs?
Whatever the risk, if a problem happens when you are self-insured, you are paying for it out of your pocket. An actuary can calculate from industry averages and your own history on what type of premium would be needed to really insure against such losses up to a certain level. Typically, you are self-insuring these risks today because the likelihood/frequency of claims is low and/or the premiums for coverage are really high, because claims could be catastrophic in size. But what would happen if you were the insurance company?
If you own your own captive insurance company, the premiums you pay are going to you. It is a real insurance company. You will have to invest some capital to pay some costs for administration, and to purchase some re-insurance to plan for catastrophic claims. However, now you get a sizeable tax deduction for premiums paid, instead of paying tax on the money you leave in the business or distribute personally to cover these risks.
It gets even better because the Section 831(b) small insurance company is allowed to receive up to $1.2mm per year in premiums without paying any federal income tax on them. It only pays tax on the investment income (next month’s article will discuss investment scenarios). So, you now have a tax deduction to help you cover your self-insured risks and no income tax in your insurance company on the premium you sent it.
So, what can you do or not do with all these tax efficient funds sitting in the captive insurance company? While you are not allowed to invest in or loan back to your operating business, there are a variety of investment strategies for the captive that should be customized to the business owner’s needs and goals.
Investment opportunities include:
• Income producing real estate or loans.
• Income producing loans to customers and ancillary companies of the operating business.
• Stock market, mutual funds, and other traditional investments.
• Life Insurance
Of these strategies—life insurance— is one that can work particularly well. Unlike other investments, the cash build up or cash value crediting rate inside a life insurance policy is tax free. The proceeds can be borrowed from without being taxed, and, of course, the death benefit is tax free. Life insurance can be a double tax-free benefit for the owners of the captive.
Since the premiums paid to the Captive are not taxed, but the investment income is taxed, tax free growth inside a life insurance policy can be very attractive. Also, it can be a tremendous estate tax planning tool.
First, you should have the second generation own the Captive. The only use of the gift tax exemption might be the initial capitalization needed for licensing. The Captive will then receive income tax free premium income, moving $1.2mm of wealth each year to the second generation without a taxable gift. Second, if you buy a life insurance policy(ies) on one or more members of the second generation, the amount of premium allocated to the provision of a death benefit is much lower than if the first and older generation was insured. This saves most of the $1.2mm to build up in the cash value investment portion of the policy tax free. Usually, within two years the cash value at the crediting rate exceeds the premiums being put in. The cash value continues to grow as invested and can be borrowed out as needed for the second generation’s schooling, housing, other needs and investments. It can even be used to pay the estate tax when the first generation passes away. There is instant tax free liquidity for the family’s use. If you compare this to the standard use of an Irrevocable Life Insurance Trust to have estate tax free liquidity, it saves $480,000 a year in gift tax, based on $1.2mm in premiums. Nothing beats the double tax efficiency of the captive.
Now, how do we tax efficiently exit? When an insurance company has no claims and builds up too many reserves, it is required by law to do one of two things – provide return premiums to the insured or pay dividends to the shareholders. If we return premiums to your operating company, we inadvertently create taxable income where we previously took a deduction. That is not very efficient. It can work when you need cash back in the operating company and don’t mind the taxable income. The deferral of taxation has some value. However, the best exit strategy is to instead pay a dividend to the shareholders of the Captive. In the top income tax brackets under ATRA 2012, the Federal tax rate is 20%. You just took profits taxable at 39.5% Federal and paid no tax on them for several years, then took them out at almost 20% less in taxation. If the next generation is the owners of the captive, we have added succession to the exit by moving it without the 40% gift and estate tax. We also protected it from your creditors.
The final exit/succession benefit is in the transition. If you intend to pass the operating company down to the next generation, the years of premiums depressing earnings have depressed the value, helping reduce estate and gift tax and/or lowering the sales price. If you intend to sell to a 3rd party, you can demonstrate the free cash flow from discontinued premiums, increasing the sale price. So you took out profits without tax, but can still harvest the value. Nothing in the current law beats captives for the amount of tax value.
Captive Insurance is a great form of risk management because it helps companies shelter taxable income, set aside funds in case of catastrophic losses and if all things work well, move wealth to the next generation in a tax efficient manner.
Fred Whitaker is the managing partner of Cummins & White, LLP. He specializes in commercial transactions and corporate governance and has a keen understanding of the petroleum industry. During his career, he was vice president and general counsel of SC Fuels in Orange, Calif., and later became chief operating officer of their Northwest Division. Whitaker is a member of Society of Independent Gasoline Marketers of America (SIGMA) and California Independent Oil Marketers (CIOMA). Contact: [email protected]
