When businesses grow and become more profitable, owners may look for strategies to build cash reserves for the unknown future. Forming a captive insurance company, also called an 831(b) Plan, is one strategy for businesses with excess cash to lower their tax bill in the current year while providing flexibility in future years.
A captive insurance company is a wholly owned subsidiary insurer formed to provide risk mitigation services for its parent company. For example, an S-corporation purchasing captive insurance would form a separate C-corporation. That C-Corp would be called the “reinsurance company.” The reinsurance company can be owned by the business, or its ownership can mirror that of the business. It can even be owned by a trust depending on the circumstances. Regardless of the particulars of ownership, the flow of cash remains the same. The S-corporation pays premiums to the reinsurance company, and the premiums are tax-deductible to the S-corporation.
Most businesses carry some insurance through a traditional insurance provider, but the reinsurance company offers protection against risks that are not sufficiently reduced by other policies. Insurable risks include audit, litigation, and cyber-attacks. The risks being addressed by the plan must be fortuitous in nature, not ordinary business risks.
The deductibility of premiums paid to the reinsurance company is the first part of the tax planning strategy. But after the expiration of the 12-month policy, the investor has a range of options for the remaining funds that were not paid in administrative fees or claims:
- The owners of the reinsurance company can leave the excess reserves in the reinsurance company to grow through conservative investments such as bonds. The investment income earned is taxed at the captive insurance company level at the federal corporate tax rate of 21% plus applicable state tax rate.
- The reinsurance company may distribute the funds as taxable qualified dividends. The distributions will be taxed at the long-term capital gains rate (currently 15 or 20%).
- The reinsurance company may lend up to 65% of the funds to the operating company. The funds may be used to invest in or expand the business. Importantly, interest on the loan must be paid at the IRS prescribed applicable federal rate (AFR) to the reinsurance company.
Captive insurance plans can be a powerful planning and tax deferment tool for businesses with excess cash reserves. In fact, the National Association of Insurance Commissioners (NAIC) estimates that about 90% of Fortune 500 companies today have captive subsidiaries. However, small and midsized businesses can often benefit as well.
Since the Treasury Regulations surrounding reinsurance companies is extremely complex, we always recommend working with a qualified administrator, such as SRA 831(b) ADMIN and an accounting firm that understands the rules around the small captive insurance company rules. SRA generally recommends that businesses have at least $100,000 to commit to the reinsurance company.
If you are interested in exploring a captive insurance plan for your business, please call our office at 480-392-6801 to discuss your situation with a Tax Manager.
