ELITE ADVISOR BEST PRACTICES
Winning Business Owners with Captive Insurance: The Basics - Part Two
What advisors need to know about this powerful risk management and tax mitigation tool (second in a series)
By Randy Fox
- For business owners with significant risks, predictable cash flow and some patience for complexity, the captive insurance company deserves consideration.
- A CIC can be used to achieve multiple estate planning concerns simultaneously.
- The main function of the CIC is to provide additional risk protection for the business owner, and the owner may not want or need to use the CIC for wealth transfer purposes.
In an earlier article we discussed the basics of captive insurance companies (CIC). We focused mainly on the legislative and tax history of the CIC as well as the future opportunities for advisors to help business owners create significant financial impact on their closely held businesses. To understand the power of the CIC better and to provide additional context, we’ll use an actual case study to demonstrate how the use of a CIC might impact a family’s financial situation in a positive way.
Carl and Cindy Ross are 58 and 56 years old, respectively. They have two daughters, Tina and Andrea, ages 28 and 26, respectively. Tina recently married Ron, while Andrea remains single. Carl is the sole shareholder of Ross Distributors, an S corporation that he has built into a very successful and substantial business. The business is currently valued at $34 million and produces almost $2.5 million of taxable income annually. Ross Distributors serves a multistate area and owns its own delivery trucks. Tina, Andrea and Ron are all working in the business full time, and Carl’s hope is that his daughters will take over the business in the future. Carl and Cindy are pillars of the local community, sponsors of a local Little League team, active in their house of worship and avid golfers at the local country club. By most descriptions, the Ross family is an American success story.
Current planning details
Like many business owners, Carl and Cindy have paid much more attention to building the business than to the details of their personal financial situation. Their wills date back to shortly after Tina was born. They have a $50,000 whole life policy on Carl that he bought right after he started the company and a $1 million survivorship policy in an irrevocable life insurance trust. They own their home and two vacation properties in joint tenancy (joint tenants with right of survivorship); they have about $500,000 in retirement accounts and another $3 million in nonqualified investments (also in JTWROS).
Ross Distributors has no formal succession plan, and while there is ample cash flow, there is not very much liquidity. Carl continually reinvests excess cash flow in the business, expanding operations, adding new product lines and increasing his reach. The family lives a very nice lifestyle, especially since their small community is in a relatively inexpensive part of the country.
When all the assets are totaled, Carl and Cindy have a net worth of just under $50 million. Even with the current combined estate exemption of $10.5 million, if they both were to die this year, federal estate taxes (40 percent) would be approximately $16 million and their home state would take another $2.5 million. Again, these numbers illustrate only what would happen if Carl and Cindy both were to die this year (2013). Projecting modest growth in their full IRS joint life expectancy, the results are even more stunning—the Ross’ net worth could grow to $200 million and federal estate taxes at current rates would be $76 million.
Without additional planning, it is quite likely that Ross Distributors would need to be sold or heavily leveraged to meet its estate tax obligation. Goals for local charities would go unfunded, and without a clear succession plan in place, it is very possible that Tina and Andrea would struggle with each other over the future of Ross Distributors.
How a captive insurance company can help
There would be many steps to consider when creating a comprehensive set of solutions for Carl and Cindy: Freezing the value of Ross Distributors through a recapitalization, a sale to a grantor deemed owned trust, additional survivorship life insurance, philanthropic planning and a clear succession plan integrated with family governance structures all come to mind. Will a CIC provide additional benefits beyond the other strategies?
Ross Distributors is in a high-risk business with trucks on the road and consumer products that are perishable. In addition, a complete review of existing coverage shows some risks in situations where no insurance currently is in force. With the company spending more than $2 million a year in insurance premiums, it makes sense to shift some of the risk to a CIC.
An actuarial determination justifies annual premiums of $500,000 to purchase the desired coverage and to retain the amount of risk internally. Carl and Cindy and their newly formed GDOTs establish a new LLC to operate as their CIC. The GDOTs own 99 percent of the LLC interests, and Carl and Cindy own 1 percent and are the managers of the LLC. Because of favorable rules, the LLC applies in Washington, D.C., for its captive license. After background checks, letters of reference and various financial submissions, the CIC is approved.
However, before the CIC can accept premiums, it must be capitalized with $250,000. A legitimate insurance company must have capital in reserve to operate and pay claims. This amount is determined by the rules of the jurisdiction where the CIC is formed. Since “capital” is not income tax-deductible, selection of appropriate jurisdiction is an extremely important decision.
Day-to-day operations of the CIC are carried out by a professional CIC manager. Responsibilities of the manager include accounting functions, compliance, purchasing reinsurance to mitigate risk, investment oversight and communication with the Rosses. The annual fee for these services is estimated to be $50,000 per year. With the CIC operational, the opportunity for successful planning is greatly magnified.
How the CIC works
Ninety-nine percent of the CIC is owned by Carl and Cindy’s GDOTs. It’s important to understand that this type of trust owns assets that are outside the taxable estate of the grantor, in this case Carl and Cindy. Normally, transfers to this type of trust are made by gifts or by selling assets to the trust in exchange for a note. However, in this case, the GDOTs formed the LLC with Carl and Cindy individually. Premiums paid to the CIC are tax-deductible for Ross Distributors under §162(a), ordinary and necessary business expenses. Because the CIC qualifies under §831(b) as a “small” captive with less than $1.2 million of annual premium received, the CIC pays no income tax on its earned revenue. Premiums paid to the CIC ultimately travel outside Carl and Cindy’s taxable estates without income tax or gift tax consequences. They don’t utilize any of Carl or Cindy’s exemption amounts either. Effectively, Tina and Andrea, as beneficiaries of the GDOTs, “own” the CIC. And while the CIC may pay claims out during its operational phase, reserves will accumulate and be reinvested inside the captive. If the CIC reserves earn only 7% and Carl and Cindy live to their life expectancies, the CIC would accumulate more than $50 million. With proper structures in place, the CIC enables a significant opportunity to increase wealth transfer.
Most of what has been illustrated in the above case study are estate and wealth transfer opportunities that are possible with the implementation of a CIC strategy. It is important to note that the main function of the CIC is to provide additional risk protection for the business owner. Furthermore, additional asset protection is developed for the assets of the CIC. Those assets no longer belong to the business owner and are protected from the owner’s creditors. It’s also important to point out that the business owner may not want or need to use the CIC for wealth transfer purposes. In that case, owning the CIC outright would be a feasible option.
For the business owner with significant risks, predictable cash flow and some tolerance for complexity, the CIC deserves consideration. Often the CIC can be positioned or utilized to solve multiple concerns and achieve multiple goals. There are many decisions that need to be thoroughly considered before entering into a captive strategy, but in the right circumstances the benefits are remarkable.