by Keith Mohn
Keego Harbor, Mich.-. In the twenty-five years that Keith L. Mohn, CLU, CHFC has been creating asset management plans and compensation strategies for physicians and other business owners, he has seen financial planning techniques come and go. “From the massive changes in the tax code enacted under ERISA in the mid-seventies through today’s Pension Protection Act, one thing has become certain,” says Mohn. “Death and taxes aren’t the only things we can count on. Here to stay is also a constantly changing business, regulatory and economic environment, one through which planners must constantly navigate in order to provide advantageous money management to clients.”
Having focused on high net worth individuals, business owners and medical professionals since 1983, Mohn, says advisors like him must continue to give significant attention to traditional segments of planning, like changes in estate and pension law. However, in Mohn’s view, there is an area of asset management that few advisors and almost no clients even consider as a vehicle for enhancing their wealth transfer goals. ”That is the small insurance company or captive,” says Mohn. Mohn is convinced that for a certain class of clients, financial strategies that include a captive insurance company can provide more powerful and significant wealth accumulation benefits than traditional approaches.
“Using a captive insurance company approach in planning is absolutely not for everyone,” emphasizes Mohn. “But for the client who fits my ‘captive profile,’” he adds, “this strategy can quite possibly be the ‘Holy Grail’ of planning.”
Who is the typical candidate for this money management tool? Mohn says it is a successful business owner or a professional with stable, predictable income and profitability in excess of $500,000 per year (after lifestyle expenses). Benefits of a captive for this kind of client are many and far-reaching. First, a client’s corporation may be able to deduct up to $1.2 million per year and convert current income into capital gains income. The corporation can create a pre-tax (tax deductible) war chest to protect the business against any disaster. Finally, the captive enables corporation owners to self-insure, with pre-tax dollars, certain risks that are not currently insured, secure in the knowledge that their large and growing deductible war chest is not accessible to creditors or owners or the business
Captive insurance companies are not a new technique in asset management. In fact some estimates have over 80% of the Fortune 500 companies utilizing captives for various reasons, mostly to manage risk more efficiently. While captive insurance companies come in many forms, they also are regulated as such. The Internal Revenue Code (IRC), allows for certain benefits for small non-life companies that qualify under two particular IRC sections: 501(c)15 and 831(b). In fact the benefits under these regulations were revisited by congress with legislation as recently as November of 2004.
Simply stated, a captive insurance company (CIC) is one that purely underwrites the risks of the other companies owned by the same owner(s) as the insurance company. For example, a group of doctors may form a CIC to underwrite tasks associated with their practice, physical facility or other related businesses they may own. Frequently, the types of risks should be risks for which ordinary commercial insurance cannot be obtained cheaply or easily.
Here are a few examples of risks that may be covered by a CIC:
• Administrative Actions Insurance
• Computer Equipment and Data Recovery Insurance
• Loss of Key Employee Insurance
• Employee Practices Liability Insurance
• Executive/Professional Liability Insurance
• Business Income Loss (Contracts)
• Litigation Expense Insurance
• eCommerce Risk Insurance
• Directors and Officers
• Kidnapping and Ransom Insurance
• Sexual Harassment Insurance
• Income Tax Indemnity Insurance
• Deductibles/Gap Coverage
A significant non-tax benefit of a CIC is that while policy terms may be tailored to meet certain events, the policies can also be labeled as “litigation expense only” policies, providing only legal fees and litigation costs. This effectively creates the war chest to fight lawsuits with pre-tax funds, while protecting the assets against claim. Premium payments effectively remove or deplete the assets of the business being underwritten or insured. Every dollar of premium paid to the CIC has been moved out of the business and away from creditors of that business.
A good captive arrangement can protect profits of the business against loss. Because premium payments are made “for value” it becomes very difficult for any creditor to prove a fraudulent transfer.
This leads to the advantages of asset protection and the statutory protection afforded captives. Insurance companies enjoy a very high level of statutory protection for the reserves of the company due to the requirement to protect the policy owners and to insure that the company will always be able to meet its claims responsibilities. Captive insurance companies are no different. Creditors of the owners are not in the position to force judgments against owners in personal judgments.
Here is another benefit. When the captive is no longer needed, owners can simply terminate the corporation, distribute the assets, declare gains as capital gains and pay the tax. For this reason, the entity enjoys better tax benefits than those afforded to qualified retirement plans and other compensation strategies.
Captives formed under 831(b) are structured as “C” corporations for tax purposes. The election to be taxed as an 831(b) on the tax form is quite like making the election to be taxed as an “S” corporation. It’s simple and straightforward. As long as all the insurance company rules have been followed in the formation of the entity, the reporting for tax purposes is very straightforward. Caution must be taken in the process of establishment of the company to insure full compliance with the requirements of insurance company regulations and rules that protect the benefits afforded to insurance companies. Formation as well as ongoing administration are somewhat complex and require working with professionals who have experience in this particular section of the code.
In summary, the CIC as a planning tool for the high net worth business owner or professional can be the most powerful piece of the planning pie if structured properly. Compared to traditional methods of accumulating wealth, such as qualified retirement plans to name just one, the captive insurance company offers tax benefits, asset protection, wealth accumulation, as well as opportunities to efficiently transfer wealth to next generations far in excess of any other planning methods. Professional guidance and assistance are an absolute necessity, here, as insurance industry regulations and rules apply. Clients who fit the fact pattern metrics would do well to consider including this approach to investigate and determine appropriateness for a particular situation.
Keith L. Mohn, CLU, CHFC is a financial consultant and lecturer, and President of Benefit Solutions Group. LLC, in Keego Harbor, Michigan, a full service financial consulting and planning firm specializing in the advising of high net worth individuals, business owners and medical professionals since 1983. Mr. Mohn is a charter member of the Wealth Preservation Institute. For more information on Captives and other business planning information, Mr. Mohn can be reached at 248-681-9320, or via his website http://www.benefitsolutionsgroup.biz/.
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