Protecting Clients from Fraud Incompetence and Scams
Over the past decade business owners have been overwhelmed by a plethora of choices designed to reduce the cost of providing employee benefits while increasing their own retirement savings. The solutions range from traditional pension and profit sharing plans to more advanced strategies.
Every accountant knows that increased cash flow and cost savings are critical for businesses in 2009. What is uncertain is the best path to recommend to garner these benefits.
Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, the high life insurance commissions (often 90% of the contribution, or more) fostered an environment that led to aggressive and noncompliant plans.
The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. For unknowing clients, the tax consequences are enormous. For their accountant advisors, the liability may be equally extreme.
Recently, there has been an explosion in the marketing of a financial product called Captive Insurance. Small companies have been copying a method to control insurance costs and reduce taxes that used to be the domain of large businesses: setting up their own insurance companies to provide coverage when they think that outside insurers are charging too much. A captive insurance company would be an insurance subsidiary that is owned by its parent business (es). There are now nearly 5,000 captive insurers worldwide. Over 80 percent of Fortune 500 Companies take advantage of some sort of captive insurance company arrangement. Now small companies can also.
These so called “Captives” are typically small insurance companies designed to insure the risks of an individual business under IRS code section 831(b). When properly designed, a business can make tax deductible premium payments to a related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed as capital gains. Single-parent captives allow an organization to cover any risk they wish to fund, and generally eliminate the commission-price component from the premiums. Jurisdictions in the U.S. and in certain parts of the world have adopted a series of laws and regulations that allow small non-life companies, taxed under IRC Section 831(b), or as 831(b) companies.
Here’s how captive insurers work. The parent business (your client’s company) creates a captive so that it has a self-funded option for buying insurance, whereby the parent provides the reserves to back the policies. The captive then either retains that risk or pays reinsurers to take it. The price for coverage is set by the parent business; reinsurance costs, if any, are a factor. In the event of a loss, the business pays claims from its captive, or the reinsurer pays the captive. Captives are overseen by corporate boards and, to keep costs low, are often based in places where there is favorable tax treatment and less onerous regulation – such as Bermuda and the Cayman Islands, or U.S states like Vermont and South Carolina.
Captives have become very popular risk- financing tools that provide maximum flexibility to any risk management program. The additional possibility of adding several types of employee benefits is of further strategic value to the owners of captives. While the employee benefit aspects have not emerged as quickly as had been predicted, there is little doubt that widespread use of captives for employee benefits is just a matter of time. While coverages like long term disability and term life insurance typically require Department of Labor approval, other benefit-related coverages such as medical stop-loss can utilize a captive without the department’s approval. Additionally, some midsized corporate owners also view a captive as an integral part of their asset protection and wealth accumulation plans. The opportunities offered by a captive play a critical role in the strategic planning of many corporations.
A true captive insurance arrangement is where a parent company or some companies in the same economic family (related parties), pay a subsidiary or another member of the family, established as a licensed type of insurance company, premiums that cover the parent company. In theory, underwriting profits from the subsidiary are retained by the parent.
There are a number of significant advantages that may be obtained through sharing a large captive with other companies. The most important is that you can significantly decrease the cost of insurance through this arrangement.
By sharing a large captive, participants are insured under group policies, which provide for insurance coverage that recognizes superior claims experience (in the form of experience-rated refunds of premiums) and other profit-sharing options made available to the insured. The second advantage is that sharing a captive does not require any capital commitment and has very low policy fees. The policy application process is similar to that of any commercial insurance company, is relatively straightforward, and aside from an independent actuarial and underwriting review, bears no additional charges. By sharing a captive, you only pay a pro rata fee to cover all general and administrative expenses.
The cost for administration is very low per insured (historically under 60 basis points annually). By sharing a large captive, loans to its insureds (your company) can be legally made. So you can make a tax deductible contribution, and then take back money tax free. Sharing a large captive requires little or no maintenance by the insured and can be implemented in a fraction of the time required for stand alone captives. If done correctly, sharing a large captive can yield a small company significant tax and cost savings. If done incorrectly, the results can be disastrous. Buyer Beware!
Stand alone captives are also likely to draw IRS attention. Another advantage of sharing a captive is that IRS problems are less likely if that path is followed, and they can be entirely eliminated as even a possibility by following the technique of renting a captive, which would involve no ownership interest in the captive on the part of the insured. (your company).
While captives can be a great cost saving tool, they can also be expensive to build and manage. Also, captives are allowed to garner tax benefits because they operate as real insurance companies. Advisors and business owners who misuse captives or market them as estate planning tools, asset protection or tax deferral vehicles, or other benefits not related to the true business purpose of an insurance company, face grave regulatory and tax consequences.
A recent concern is the integration of small captives with life insurance policies. Small captives under section 831(b) have no statutory authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable at corporate rates, and then will be taxable again when distributed. The consequence of this double taxation is to devastate the efficacy of the life insurance, and it extends serious liability to any accountant who recommends the plan or even signs the tax return of the business that pays premiums to the captive.
The IRS is aware that several large insurance companies are promoting their life insurance policies as investments within small captives. The outcome looks eerily like that of the 419 and 412(i) plans mentioned above.
Remember, if something looks too good to be true, it usually is. There are safe and conservative ways to use captive insurance structures to lower costs and obtain benefits for businesses. Some types of captive insurance products do have statutory protection for deducting life insurance premiums (although not 831(b) captives). Learning what works and is safe is the first step an accountant should take in helping his or her clients use these powerful, but highly technical insurance tools.
Captive Insurance Companies are one of the more sophisticated cost-savings vehicles available to the small business owner. While the benefits of such a vehicle are compelling, rigorous due diligence is necessary PRIOR to implementation in order to pass the careful I.R.S. scrutiny which will almost assuredly follow. If something sounds too good to be true, it undoubtedly is. Make sure your Captive consultant has both the ability and the experience to advise you fully and accurately.
The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.