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Captive Insurance Companies and the Closely-Held Business

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					                                               Feld, Hyde, Wertheimer, Bryant & Stone, P.C.
                                               2000 SouthBridge Parkway, Suite 500
                                               Birmingham, AL 35209

                                               Phone:         205.802.7575
                                               Fax:           205.802.7550
                                               Web site:      http://www.feldhyde.com




 Captive Insurance Companies
            and the
    Closely-Held Business

James J. Coomes, Esq.                       Birmingham Estate Planning Council
FELD HYDE WERTHEIMER BRYANT & STONE, P.C.            October 1, 2009
ATTORNEYS AT LAW
What is a Captive Insurance Company?

   A Captive insurance company is an insurance company
    formed primarily or exclusively to insure the risks of
    one or more affiliated businesses.

       There are many types of captives, however, the materials
        contained herein focus on captive insurance companies that insure
        property and casualty risks of affiliated closely held businesses
        (i.e., business risk insurance) through the issuance of insurance
        policies in return for premium payments; and

       The Captive insurance company is owned by one or more of the
        owners of the affiliated closely held business (and/or the heirs of
        the owners).

                                                                              2
                  Who Else is Doing It?


It is estimated that more than 80% Other examples:
of Fortune 500 companies            Wal-mart
benefit from captive insurance
                                     UPS
companies. In fact, Allstate
Insurance was founded as a           Exxon - Mobil
captive insurance company            Starbucks
for Sears.                           Delta Airlines
                                     Microsoft
                                     Coca-Cola

                                                       3
Lets Talk About Insurable Risks

 Some traditional risks

 General liability (includes property)
 Errors and omissions
 Directors and officers
 Employment practices
 Employee fidelity
 Construction defects
 Subcontractor default
 Workers compensation




                                          4
        Lets Talk About Insurable Risks
                 Some non-traditional risks
   Deductibles                     Product recalls
   Administrative actions          Loss of franchise agreement
   Data breach/cyber risk          Subcontractor default
   Loss of key customer            Terrorism
   Loss of key supplier            Earthquake
   Loss of key employee            Mold
   Litigation expenses             Kidnap, ransom
   Business interruption           Accounts Receivable
   Tax audit                       Intellectual property




                                                                   5
Mariah Carey’s legs, $1 Billion




                                  6
Rod Stewart’s voice, $6 Million




                                  7
Gene Simmons’ tongue, $1 Million




                                   8
Dolly Parton’s ………….… $600,000




                                 9
           Reasons to Form a Captive


 Underwrite risks that are presently being self insured (i.e.,
  those that are not presently being insured by a third party)
 Underwrite risks that are presently being insured by third party
  insurance companies
 Underwrite risks that are difficult to obtain or are expensive
 Tailor insurance policies to specific needs
 Risk management incentives
 Greater control over claims
 Share in underwriting profits
 Tax benefits
 Asset protection benefits
 Estate Planning opportunities

                                                                     10
                       Taxation of Captives
 Captives are formed as C corporations and are subject to Chapter C
and Chapter L of the Internal Revenue Code.

 Business risk insurance premiums paid by a business to a Captive are
a deductible business expense. IRC Section 162. T.R. Section 1.162-1(a)

   The premiums received by a Captive “may” be income tax-exempt.




                                                                          11
        Did You Say Tax Advantage?                       - continued



      The Internal Revenue Code provides a certain “tax
    advantage” to small property and casualty insurance companies
    depending on the amount of annual premiums it receives.

 Property and casualty insurance companies with annual
  premiums of $1.2 million or less can elect to be taxed only on net
  investment income under IRC Section 831(b).




                                                                       12
  Did You Say Tax Advantage?                            - continued


 Income tax consequences of an “831(b)” election:

    Investment income earned on assets owned by the
   Captive is taxable at ordinary C Corporation rates.

       Premiums received by the Captive are income tax free.

       Only investment related expenses may be deducted by
   the Captive.

       So is the 831(b) election really a “tax advantage”?



                                                                 13
                  Some Ground Rules

      The Captive must be respected as a valid insurance company for
    federal income tax purposes.

     What “ground rules” must be followed?




                                                                   14
                Some Ground Rules                        - continued


1. The Captive must be operated as a bona-fide insurance company.

         The Captive must be respected and treated as a separate
       entity (i.e., separate books, records and accounts, no
       commingling of assets with personal funds or funds of other
       entities, etc.).

         Insurance policies issued by the Captive must be
       commercially reasonable with respect to their terms
       (including premiums).

         The Captive must comply with capitalization, surplus,
       investment and other regulatory requirements of the
       jurisdiction in which the Captive is domiciled.
                                                                       15
                     Some Ground Rules                       - continued

2.    Risk distribution must be present.

     A.   The Captive must insure a sufficient number of insureds:
              Revenue Rulings 2002-90 and 2005-40:
                12 insureds is enough.
              Case Law:
                8 insureds is enough.

     B.   Third party risk pools are available for those Captive insurance
          companies that do not meet the safe harbor ruling.


                                                                             16
        Jurisdiction: Onshore vs. Offshore
    Fees (both startup and ongoing)
    Capitalization requirements
    Margin of solvency requirements
    Investment restrictions
    Degree of regulation
    Premium taxes
    Income taxes
    Federal excise tax
    (offshore only but does not apply if IRC Section 953(d) election is made)

 But aren’t there income tax advantages to forming offshore?
         NO , NO and NO!!!
         Captive will elect to be treated as a U.S. Corporation for
          federal tax purposes. IRC Section 953(d)



                                                                                17
Typical Ownership Structures
   Publicly Held Company

           Parent
         Corporation



       Captive Insurance
          Company



                               18
                    Closely Held Companies

        Individual Owners                                       Individual Owners
           Jack and Joe                                            Jack and Joe

                                $400,000 in premiums

Closely Held Business       Insurance policies/claims paid   Captive Insurance Company




     Business receives $400,000 ordinary business deduction.

          Captive insurance company receives $400,000 income tax free.

                                                                                     19
                Closely Held Companies
                                                                 Children of
      Jack and Joe                                               Jack and Joe
                                                           (or trust FBO children)


                          $400,000 in premiums

Closely Held Business   Insurance policies/claims paid   Captive Insurance Company


     Business receives $400,000 ordinary business deduction.

   Captive insurance company receives $400,000 income tax
    free.

   Premium payment should not represent a gift to heirs for gift
    tax purposes.
                                                                                     20
                 Closely Held Companies
                                                          GST Trust FBO heirs of
      Jack and Joe
                                                              Jack and Joe


                           $400,000 in premiums

Closely Held Business   Insurance policies/claims paid   Captive Insurance Company


      Business receives $400,000 ordinary business deduction.

   Captive insurance company receives $400,000 income tax
    free.

   Premium payment should not represent a gift to heirs for gift
    tax or generation skipping tax purposes.
                                                                                   21
                     Closely Held Companies

      Jack and Joe                                        Key Employees of Closely Held Business



                           $400,000 in premiums

Closely Held Business    Insurance policies/claims paid        Captive Insurance Company



      Business receives $400,000 ordinary business deduction.

   Captive insurance company receives $400,000 income tax
    free.



                                                                                             22
               How are assets of the Captive
              Insurance Company Invested?
 Recall that the Section 831(b) captive insurance company is
  taxed on its investment income at C corporation rates.

 Subject to applicable regulatory restrictions, the captive
  insurance company may invest in the following:
    Money market funds, CDs, etc.
    Stocks/Bonds
    Real Estate
    Closely held Businesses
    Life Insurance



                                                                23
          How do the owners of the insurance company
    benefit from the profits earned by the insurance company?



     Dividends
      Taxed at 15% federal rate. IRC Section 1(h)


     Liquidation
      Taxed at 15% federal rate plus C corporation tax rates on the net
       appreciation of the assets owned by the insurance company. IRC
       Sections 331 and 336




                                                                      24
Under requirements imposed by the IRS, any advice concerning one or more U.S. federal tax issues contained in this
communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the
Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or tax-related matter
addressed herein.

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DOCUMENT INFO
Description: A Captive insurance company is an insurance company formed primarily or exclusively to insure the risks of one or more affiliated businesses. There are many types of captives, however, the materials contained herein focus on captive insurance companies that insure property and casualty risks of affiliated closely held businesses (i.e., business risk insurance) through the issuance of insurance policies in return for premium payments; and The Captive insurance company is owned by one or more of the owners of the affiliated closely held business (and/or the heirs of the owners).