introduction to micro captives & the 831(b) election · 831(b) election under section 831(b) of...

Introduction to Micro Captives & the 831(b) Election

Presenters:

• Tom Ullrich – Captive Resources• Ernie Achtien – Captive Resources• Matthew Howard – Moore, Ingram, Johnson & Steele• Doug Butler – Moore, Ingram, Johnson & Steele• Bill Johnson – Moore, Ingram, Johnson & Steele• Joe Herbers – Pinnacle Actuarial Resources• Rob Walling – Pinnacle Actuarial Resources

Today’s WebinarToday’s Webinar

Overview of 831(b) Election Captive Structure Flow of Operations Premium Funding Financial Requirements Next Steps

831(b) Election831(b) Election

Under Section 831(b) of the Internal RevenueCode, insurance companies that write $1.2 million or less

in annual premium only pay income tax on investment income. This means that

underwriting profits can accumulate in the insurance company on a

tax-deferred basis.

Qualifying FactorsQualifying Factors

First & foremost : this is an insurance company $1.2 million ceiling on annual premium income Design the insurance to fit individual needs Pre-Tax earnings of at least $1.5 million Viable for closely held or public companies

How does thecaptive work?

Micro CaptivesMicro Captives

7

Captive Insurance Companies

Presented by: MATTHEW J. HOWARD, JD, LL.M.MOORE INGRAM JOHNSON & STEELE, LLP

Emerson Overlook326 Roswell St Marietta GA 30060(770) 795-5022; (850) 231-5995; cell: (404) 771-0202 [email protected]

88

Captive vs. Small Companies

“Captive” means the insureds of insurance company are affiliated with the owners of the insured company(ies)

“Small” means the insurance company falls under one of the sections of the tax code controlling small insurance companies. We will focus here on IRC Sec. 831(b).

IRC Sec. 831(b) 831(b) Alternative tax for certain small companies (1) In general In lieu of the tax otherwise applicable under subsection (a), there is hereby

imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable investment income of such company for such taxable year by the rates provided in section 11 (b).

(2) Companies to which this subsection applies (A) In general This subsection shall apply to every insurance company other than life (including

interinsurers and reciprocal underwriters) if— (i) the net written premiums (or, if greater, direct written premiums) for the

taxable year do not exceed $1,200,000, and (ii) such company elects the application of this subsection for such taxable year. The election under clause (ii) shall apply to the taxable year for which made and

for all subsequent taxable years for which the requirements of clause (i) are met. Such an election, once made, may be revoked only with the consent of the Secretary.

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CIC Taxation

IRC 831(b) provides that: Insurance companies with less than $1.2

million of annual premium pay $0 income tax on insurance profits.

Investment income is taxed as income to C-corporation

831(b) must be timely elected and cannot be revoked without the permission of the Secretary

1111

Profitable business pays up to $1,200,000 in premiums each year

Premiums may be deductible under sec. 162

ProfitableBusiness

Tax Treatment of Premiums

CIC

1212

Captive Insurance Company – 831(b)

Provides insurance coverage for various

risks

$500k* to $1.2 million of annual insurance

premiums

* Practical not statutory

Business CIC

BusinessOwners

BusinessOwners

13

Economic Family Doctrine

Adopted by the IRS in 1977 (Rev. Rul. 77-316) Parent corporations and their subsidiaries form an

economic family. If the ultimate burden of loss is retained in the family, there

is no risk shifting or risk distribution (requirements to be considered insurance as set forth by the Supreme Court in Helvering v. LeGierse, 312 U.S. 531 (1941))

Therefore, premium payments are treated as capital contributions or dividends and are not deductible under Sec. 162

14

Economic Family Doctrine

IRS’ economic family doctrine was not accepted by the courts (See Humana Inc., 881 F. 2d 247)

IRS abandoned doctrine in Rev. Rul. 2001-31 Adopted instead a facts and circumstances approach

for determining if transactions constitute insurance (See Malone & Hyde, Inc., 62 F.3d 835, 76 AFTR2d 95-5962 (CA-6, 1995), rev’g TCM 1993-585)

IRS continued to apply facts and circumstances test (See TAM 200149003, FSA 200202002, Notice 2002-70)

15

Risk Distribution

Risk Distribution – does the insurance company distribute its risk to other insureds? Rev. Ruls. 2002-89 (50%); 2002-90 (12 subs or no more than 15%

of total premium); 2002-91 (Group Captive-7 unrelated insureds) Harper Group and Includable Subsidiaries v. Commissioner, 96

T.C. 45 (1991): Because the CIC had at least 30% unrelated third party risk, the arrangement constituted insurance

Rev. Rul. 2005-40: risk distribution requirement is met if CIC has 12 or more insureds (10% risk distribution insufficient; DRE disregarded for RD) Affiliated companies count, but not single-member LLCs Compare to Humana, Inc. v. Commissioner, 881 F.2d 247 (6th

Cir. 1989) in which sums paid to parent company’s Captive Insurance subsidiary, on behalf of several dozen parent company subsidiaries was sufficient risk distribution to constitute insurance

15

Achieving Risk Distribution under Revenue Ruling 2002-89

OperatingBusiness A

TerrorismInsurance

Provider (“Pool”)

OperatingBusiness A’s

Captive

Operating Business B

Operating Business B’s

Captive

OperatingBusiness C’s

Captive

Operating Business C

Operating Business D

OperatingBusiness D’s

Captive

• Each Operating Business will pay 50%+ of its captive premium to the Pool in return for terrorism coverage.• The Pool then reinsures its risk with each Operating Business Captive in the same percentage that the Operatingbusiness’s premium represents. •Example: Assume Operating Business A pays $200k to the Pool and that $200k premium represents 2% of all premiums received by the Pool. The Pool will then pay Operating Business A’s Captive $200k to reinsure 2% of the Pool’s total risk (i.e. 2% of all of the other participating Operating Business’s risk).

Achieving Risk Distribution under Revenue Ruling 2002-90

RelatedEntity 2*

Related Entity 4*

Related Entity 3*

Related Entity 1* Related

Entity 5*

Related Entity 6*

Related Entity 7*

Captive InsuranceCompany (“Captive”)

•Related entities pay premiums directly to the Captive for various lines of P&C insurance. •Each Related Entities premium cannot be less than 5% nor more than 15% of the total premiums received by the Captive.

*Related entity must not beconsidered a disregarded entity

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Recent IRS Guidance December 31, 2004 - IRS releases rulings

showing non-sham, bona fide captive insurance companies (TAMs 200453012 & 200453013)

Rev. Rul. 2005-40, 2005-2 CB 4. A company that insures a single corporation cannot be an “insurance company”, even if the insurer is unrelated to the insured, premiums are arm’s length and the insurer is adequately capitalized, since there is no risk distribution.

Recent IRS Guidance (cont) Ltr. Rul. 200644047. An insurance subsidiary insured the risks of

its parent. Although various physicians performing work for the parent were also insured, the Service concluded that the risks insured were essentially that of the parent. (Rev. Rul. 2005-40)

TAM 200816029. For purposes of applying Rev. Rul. 2005-40, the common GP of several ltd. partnerships is treated as one insured.

PLR 200907006. Service concluded that there was adequate risk distribution to warrant the company being treated as an insurance company. (Rev. Rul. 2002-91)

Recent IRS Guidance (cont) PLR’s 200950016 & 200950017. Service finds reinsurance pools

adequately satisfy risk distribution requirements as provided in Rev. Rul. 2002-90.

PLR 201030014. Service finds that a Small Captive (831(b)) is recognized as a valid insurance company. “Risk distribution incorporates the statistical phenomenon known as the law of large numbers. Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim.”

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Why Own a Small Insurance Company?

Estate Planning Best practice: CIC owned by dynastic trust for heirs Jurisdiction shopping for unlimited Rule Against Perpetuities:

AK,DE,FL(360 yrs) Can structure to allow client shared access to investments

Buy-out Retirement Planning CIC can tie into a business buy-out/retirement plan/employee

benefits More tax efficient than traditional methods

Tax Planning Premiums can be tax deductible Benefit to family can be estate/gift tax free Profit can be accessed at lower tax rates

2222

Risk Management ConceptEach business or practice has risks that it currently does

not insure against, including: Deductibles & co-payments in existing policies:

Medical malpractice Excess Liability Environmental Liability E&O, D&O, and others

Liability risks for which there is no coverage Employee claims, partnership liability, government liability, etc.

Economic risks for which there is no coverage Loss of income, revenue cutbacks, loss of key person, loss of a

key contract, etc.

2323

CIC with Advanced Planning

Insurance coverage

$500k to $1.2 million premiums

Business CIC

Owned byDynastic Trust for

Heirs Business Owners

Can be structured for efficient estate planning, retirement access and partner buy outs, etc.

Investment LLC for CIC Assets

Shareholder

2424

Buy-Out and Retirement ConceptBusiness owners and employees are always looking for tax

efficient ways to transfer wealth during buy-ins of younger partners and buy-outs of older ones.

A business can create an internal buy-out plan using the CIC reserves.

With particular structures, funds can be accessed by senior (retiring) partners during their lifetime in a tax-favored manner.

The total retirement benefit from such arrangements can be significant.

Operating business or practice will pay tax deductible premiums to the CIC owned by the senior partners so funds will accrue to older owners’ for their retirement.

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Tax Planning Benefits1. Deductibility of premiums §162/§212

Assuming premiums are market comparable or can be valued by an actuary

2. Taxation of CIC’s profits 831(b) provides tax exemption from premium tax and from

underwriting profit. 831 (b) must be elected timely and cannot be revoked

without permission of Secretary Federal Tax on investment income only

3. Retirement Certain investments and structures could allow client to

access CIC invested funds tax efficiently. 4. Estate/Gift Taxes

Could transfer millions to heirs tax efficiently.

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Premiums and policies must be market-comparable Actuarial support needed Insurance formalities complied with Risk distribution must be present Initial Capitalization required

4:1 (premiums to capital) with certain minimums Gift tax return Form 709

The Ground Rules

27

Domicile Considerations

Form CIC in US Domicile, which would include several states such as KY, DE, HI, UT or MT.

Favorable Captive legislation regarding fees and investment options

Minimize Premium Taxes and Ongoing Fees.

2828

Captive Insurance Company Policies

Everything a business currently self-insures: Deductibles Excess losses above coverage limits Environmental Liability

Loss of income as a result of: Losing key employee/salesperson Loss of license/professional risks (professionals) Loss of a key contract (Gov’t. contractors) Weather, terrorism, etc.

Liability defense expenses: Employee lawsuits – sexual harassment, wrongful termination,

discrimination, etc. Environmental issues Professional claims

Suggest Focus on First Party Liability

Examples of Captive Insurance Policies Written

Professional liability Gap Coverage HIPAA/Billing Audit Liability Contractual Liability Cyber Liability Environmental Liability Excess Environmental Liability Labor Shortage/Strike Loss

Reimbursement Employment Practices Employee Dishonesty Patent Infringement/Intellectual Property

General Liability Gap Property Management Professional Professional Misconduct Product Recall FDA Administrative Actions Liability Product Liability Gap Directors and Officers Liability Punitive Damages Loss of Key Employee Wind Deductibles on Property

3030

Greater Leverage for Larger Clients

Clients’ children (or trusts) can own CICs Each child (or trust) can own one CIC (children

under age 21 are attributed to their parent) Client can still be the manager of the CIC and

control the investments of CIC Effectively, this option saves current income taxes

(35%-47%) to client and future estate taxes (35%) on net proceeds

Children will only pay capital gains or dividend tax rates (currently 15% federal) in future

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Highly Profitable Business

InsuranceCompany #1

Trust for Child #1or for Childrenof Owner #1

InsuranceCompany #2


InsuranceCompany #3


Parent’s Business could pay up to $1.2 million per year into EACH child’s CIC or into a CIC for each owner’s children. §1563 attribution rules apply . Children under age 21 are attributed to the parent.

Multiple CIC Structure

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Real Life Example – ResultsDo Nothing with $1.2M

No risk management, profit, asset protection, buy-out/retirement benefits of CIC

Earn money, income taxes Taxable/tax deferred

investments Die, pay estate taxes

CAPTIVE 831(B)Risk management, profit,

asset protection, buy-out/retirement benefits of CIC Create dynastic trust to

own CIC CIC invests in tax

deferred investments Tax efficient

withdrawals from LLC

Income Tax with No CaptiveFiling Status Joint Joint JointPersonal Exemptions 2 2 2

------------------------------------------------------

Ordinary Income 1,200,000 1,200,000 1,200,000------------------------------------------------------

Adjusted Gross Income 1,200,000 1,200,000 1,200,000------------------------------------------------------

Standard Deduction 11,600 11,600 9,650------------------------------------------------------

Taxable Income 1,181,000 1,181,000 1,190,350------------------------------------------------------

AMTI Net of Exemption 1,200,000 1,200,000 1,200,000------------------------------------------------------

Schedule or Table Tax 383,222 383,222 435,439Tentative Minimum Tax 332,500 332,500 332,500

------------------------------------------------------Net Federal Tax 383,222 383,222 435,439

------------------------------------------------------State Tax 71,560 71,560 71,560

------------------------------------------------------Total Net Tax Liability 454,782 454,782 506,999

Income Tax Benefits with Captive Year 1 Year 2 Year 3 Cash Non-Captive Scenario

Premiums 1,200,000 1,200,000 1,200,000 3,600,000 3,600,000 No Premium paid

Savings Tax (tab 2) 460,000 460,000 510,000 1,430,000 (1,430,000) Tax Costs

Mgmt Fees (90,100) (83,500) (83,500) (257,100) Tax benefit 36,040 33,400 33,400 102,840

Net Savings 405,940 409,900 459,900 1,275,740

Projected Earnings @ 3% 36,000 36,000 - 72,000 151,900 Earning @ 7% on after tax dollars

Projected Cash Balance Prior to liquidation 3,517,740

Capital Gain Tax on Liquidation (703,548)

Net Cash Available 2,814,192 2,321,900

Estate Tax Obligation - (812,665)

Net Cash After All Taxes 2,814,192 1,509,235

Increase in net worth after all expenses 1,304,957

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MIJS Implementation Team

MIJS Captive Management, LLC, KY LLC Matthew J. Howard, JD, LL.M., Senior Tax Partner, Moore

Ingram Johnson & Steele, LLP Bill Johnson, JD, liability attorney; Moore Ingram Johnson

& Steele, LLP Alec Galloway, JD, liability attorney; Moore Ingram

Johnson & Steele, LLP Douglas W. Butler, Jr, JD, corporate/trusts and estate

attorney, Moore Ingram Johnson & Steele, LLP

Matthew J. Howard, JD, LL.M,MIJS, LLP Partner

Matthew has been practicing law since 1989 and working with Micro Captives since 2004. He heads up the firm's tax section. Matthew's team insures all IRS rules are complied with in setting up and managing their micro captives.

William R. JohnsonMIJS, LLP Partner

Bill has been a practicing attorney since 1983 and involved with insurance coverage and captive insurance companies since that time. He has been directly involved in micro captives since 2006.

Alexander T. (“Alec”) Galloway IIIMIJS, LLP Partner

Alec has been a practicing attorney since 1993 and involved with insurance coverage and captive insurance companies since that time. He has been directly involved in micro captives since 2006.

Doug W. Butler

Doug worked in the life insurance industry before becoming an attorney in 2009. Since that time he has worked in MIJS’s corporate and tax departments and has been involved in formation and management of all of MIJS’s micro captive insurance companies.

Adon J. Solomon

Adon has been practicing law since 2008 and joined Moore Ingram Johnson & Steele in 2010 focusing his practice in the areas of trusts and estates, tax and asset protection planning, along with assisting clients in the formation and management of micro captive insurance companies.

Bram L. Scharf

Bram was admitted to practice law in Florida on January 5, 1995. As part of the Captive Insurance Team at MIJS, Bram prepares insurance policies and declaration pages to suit the individual needs of the client.

Insured

Captive ResourcesCaptive Resources

Independent consultant to the captive Coordinate/oversee all activities and service providers Underwriting coordination and assist in pricing development Financial services- oversee financial process and tax

reporting Board meeting facilitation Develop and implement program enhancements Legislative oversight

Captive FlowCaptive Flow

Broker Oversees insurance program Provides Current Policies to MIJS Bills premiums Prospect development

Insured

Pinnacle Actuarial Resources Leading U.S. Property & Casualty Actuarial Consulting Firm Actuary to all Captive Resources/Kensington group captives Key Personnel

Joe Herbers Rob WallingManaging Principal Principal

Microcaptive/831(b) Services Funding Studies to 831(b) and Pooling Mechanism Loss Reserve Analyses Statement of Actuarial Opinion and Other Regulatory Compliance

what is myinvestment?

CapitalizationCapitalization

CapitalizationCapitalization

Capitalization

Cash or Letter of Credit (“LOC”)Minimum 4:1 Ratio$1,000,000 Premium

$250,000 Capital*

*State Requirements Vary

About the CaptiveAbout the Captive

Annual Board meeting conducted via teleconference Focusing on DE as common domicile Owner of captive need not be insured corporation Investments individually managed, but must meet

regulatory guidelines Utilizing Ernst & Young for 831(b) tax preparation Utilizing Pinnacle Actuarial Resources for premium

support

what’snext?

Underwriting ProcessUnderwriting Process

Copies of All Current Policies Complete MIJS Application Company Brochures Current Financial Statements

(With Current Clients’ Consent we can have these forwarded by John Flanagan)

Data needed:Data needed:

Underwriting ProcessUnderwriting Process

Capitalization check received

Captivedecision completed

Policies issued

831(b) Funded

Premium SupportPresented

Actuarial Review Policies ReviewedData collected

ExpensesExpenses

Initial feasibility study at no charge Implementation costs: $85,000 to $90,000 Annual costs: $80,000 to $85,000 No additional fees for tax or estate planning work with

MIJS.

yourquestions?

Micro Captive

53

Captive Insurance Companies:Frequently Asked Questions

Presented By:

Matthew J. Howard, JD, LLMMoore, Ingram, Johnson & Steele, LLP

5454

Frequently Asked Questions Q: What is the minimum number of affiliated entities

I need to have to achieve adequate risk distribution? What happens if I do not have enough affiliated entities? Can I still utilize a Micro-Captive?

A: An insured with at least 7 entities can achieve adequate risk distribution without invoving the risks of other unrelated businesses. Most of our clients do not have this structure and enter into our risk pool with other companies. Only our clients participate in our pool which allows us to maintain control.

5555

Frequently Asked Questions

Q: Can my Micro-Captive insure the risks of unaffiliated entities or entities affiliated with a Group Captive program I participate in? Could this help me achieve adequate risk distribution, if allowed?

A: Yes. Most of our Captives enter into a reinsurance agreement whereby they agree to insure the risks of unrelated businesses under a policy of insurance which we have written.

5656

Frequently Asked Questions Q: Does my company need to pay the full $1.2M in premiums

a year to the Micro-Captive? What is the minimum amount my company can pay for the Micro-Captive planning to make sense? What if my company can pay over $1.2M in premiums?

A: The election under IRC Sec 831(b), which permits premium income to be tax free, requires that the annual net premiums be $1.2M or less. The commitment is year to year under a 12 month policy of insurance. Therefore the amount paid by the operating company, as well as the insurance coverage can change from year to year. There is no minimum and a business can take up to three years grace period of paying zero premium and keep the captive in place. We believe over time that an average of $500K per year or more makes the most economical sense.

5757


Q: Are there any requirements as to what type of entity the Insured must be (C-Corp, Partnership, LLC)? Does the Micro-Captive have to be a C-Corp?

A: No. The insured can be any type of entity. C Corp, S-Corp, LLC tax as a partnership, LLC taxed as a corp and even a sole proprietorship. The Captive must be a C-Corp.

5858

Frequently Asked Questions Q: Who can be the owner of the Micro-Captive? Is

the Insured the owner? Can the Shareholders of the Insured be the owners? Can key employees or other individuals or entities be an owner?

A: Anyone can own the Captive. Most of our clients have their captive owned partially or entirely in a dynasty trust for their heirs to take advantage of the tremendous benefits in avoiding estate and gift tax laws. A captive owned by an LLC with the key employees as members of the LLC allows the employer to create golden handcuffs for key employees on a discriminatory basis.

5959

Frequently Asked Questions Q: Can an ESOP be used in connection with a

Micro-Captive? Can the Micro-Captive be owned by the ESOP?

A: Yes. It makes the most sense for a company that is partially owned by an ESOP. Most ESOP owned companies are S Corps and an S Corp owned 100% by an ESOP is not subject to tax so the 831(b) benefits are lost. The best way to structure ownership of the captive is in a brother-sister arrangement rather than parent-subsidiary.

6060

Frequently Asked Questions Q: Are there any limitations as to the type of

insurance risks or liabilities the Micro-Captive can insure? Are there any types of businesses of an Insured that would disqualify it from setting up a Micro-Captive?

A: A captive can insure any uninsured risk of any operating business. As long as there exists a “fortuity of loss” than such loss can be insured. Fortuity, a contingency or uncertainty with respect to the risk insured, is a requirement of all insurance contracts.

6161


Q: Can a Micro-Captive write policies to insure fines levied by the state or Federal government (such as OSHA or EPA fines)? Can the policies insure punitive damages?

A: Yes. These are all insurable and types of policies we have written.

6262

Frequently Asked Questions Q: Can health insurance premiums be included in the

Micro-Captive planning? Would it be appropriate for the Micro-Captive to provide Umbrella coverage or excess Umbrella coverages?

A: No, primarily for two reasons: 1. State laws require certain regulations that would prohibit a micro captive from insuring this risk; and 2. the micro captive is too small to take on this much risk. A micro Captive is also too small to take on umbrella coverage, at least in the early years.

6363


Q: What is the role of an agent or broker when setting up a Micro-Captive?

A: They play a helpful role in helping us identify uninsured risks of the business and ongoing helping us coordinate the captive with the commercial coveragees.

6464

Frequently Asked Questions Q: What can be done with the premiums received by

the Micro-Captive? Can these funds be invested? Are their limitations as to the investments? How are investments taxes to the Micro-Captive?

A: The premiums received by the Captive are invested by the Captive owners. We do not provide investment advice but can certainly make needed introductions to investment experts. The States we work in, like Delaware, are very liberal in what the captive can invest. The Captive does have to pay income tax on investment income so tax free and tax deferred investment are very popular.

6565


Q: What happens if I sell my company and I have a Micro-Captive set up? What happens to the Micro-Captive? Can a publicly traded company set up a Micro-Captive?

A: The Captive usually just ceases to be a licensed insurer and is then a regular corporation with investments. The Captive can be liquidated or can acquire another business. Yes, a public company can form a captive.

6666


Q: Who are the other members of the reinsurance pool? Do we have the opportunity to exclude members if we feel they are too great a risk?

A: Our other Captive clients who need risk distribution. Yes, every participant gets basic information about the other participants and you can refuse to insure certain companies.

6767

Frequently Asked Questions Q: What is the difference between a Micro-Captive

domiciled in a US jurisdiction (such as Delaware) versus a company domiciled offshore (such as in the Cayman Island)

A: The main difference is the State domiciles are more strict and have more regulations to follow. There is the opportunity for abuse with a micro captive (unlike the large group Captives) and therefore we like the idea of more regulation for a micro captive.

6868


Q: Who handles the insurance claims made against the Micro-Captive? Who manages the Micro-Captive and ensure it functions correctly and remains in compliance with all state and federal laws?

A: Our management company, MIJS Captive Management handles all claims and administration. Captive Resources assists us with Board Meetings and financial accounting. We coordinate the actuarial and financial audits along with all State filings.

6969


Q: Are there additional capital contributions required beyond the $250,000.00 initial capital?

A: No.

7070


Q: What is an estimate of the typical ongoing fees to maintain the Micro-Captive?

A: $76,000/yr for everything including the annual tax return and State premium tax.

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