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| By Lance Wallach, CLU, ChFC, CIMC |
Parts of this article are from the book by John Wiley and Sons, Protecting Clients from Fraud, Incompetence and Scams, authored by Lance Wallach.
September 24, 2010
Herol Graham has turned defensive boxing into a poetic art. Trouble is, nobody ever got knocked out by a poem.
—Eddie Shaw
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.
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.
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 percent 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. More than 80 percent of Fortune 500 companies take advantage of some sort of captive insurance company arrangement. Now small companies can, too.
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 United States and in certain parts of the world have adopted a series of laws and regulations that allow small non–life insurance companies, taxed under IRC Section 831(b), or as 831(b) companies.
Captives can be a great cost-saving tool, but 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.