Little Known Business Tax Break – Captive Insurance Company
The best time to plan is early in the tax year – not at the last minute when uninformed maneuvers are made in a frenzy to reduce taxes. One of the least known business tax breaks is the Captive Insurance Company.
A Captive Insurance Company is established byfollowing therules and regulations to Internal Revenue Code Section 831(b). The Code Section permits annual ordinary deductions up to $1,200,000 for insurance premiums paid to a wholly owned insurance company (the “Captive”) that does not have to recognize the payment as income. At some point, when the owner dies, the Captive will be inherited by family members free of estate tax and will be taxed on the Captive’s value at capital gains rates.
Short summary: Current income tax deduction and recapture at a much later time at capital gain rates with no estate taxes on inheritance.
As with any complicated transaction, there are many issues that need to be considered including business applicability, commercial risks and qualification for a Captive. Also, this short heads-up summary cannot lay out all the details. If this is something that you think might apply to you, now is the time to seek out professional advice.
Following is a table comparing a Captive with not doing a Captive.
Captive Insurance Company Illustration
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- Company hassufficient income to be able to utilize an up to $1,200,000 deduction (this illustration assumes Company is a pass through entity, but it can be fully utilized by a C corporation)
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- Company has sufficient income to be able to utilize an up to $1,200,000 deduction but does not take it and owner is taxed on that amount as compensation (assume Company is a pass through entity)
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- Captive Insurance Company is established by owner of Company as a C Corporation thatwill be owned by an Irrevocable Grantor Trust (similar to a life insurance trust) with owner’s choice of beneficiaries
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- Current tax of 50% including state tax leaves $600,000 in Company
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- Companymakes an up to $1,200,000 tax deductible payment to the Captive
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- Captive receives the payment without having to recognize the payment as income
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- Any otherinvestment income received by the Captive will be taxed to the Captive
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- Captiveassumes an insurance risk which would cause payments by the Captive and whichwill not be deductible, but will be paid out of “reserves” created by the Company’s payment
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- Annualadministrative costs will be paid out of the Captive and will be deductible
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- When ownerdies, heirs will inherit the Captive through the Grantor Trust estate tax free
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- When ownerdies, heirs will inherit the Company and will pay a 40% estate tax (assume nostate tax)
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- WhenCaptive is liquidated, the proceeds will be taxed as a capital gain to heirs
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- WhenCompany is liquidates there is no additional capital gain tax
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- Assuming $1,200,000 tax deductible payment is paid into the Captive and no otherincome or loss and heirs inherit Captive with that amount, the estate tax is zero and capital gains tax is 30% including state tax, heirs will receive $840,000
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- Heirs end up with $360,000 after 40% estate tax
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- If this isdone for multiple years with the Captive earning compounded income, the amount to be received by the heirs can accelerate substantially
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- To extentthere is state estate tax the amount heirs receive will be less
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Thank you to Anthony M. Sardis, JD, LLM for his assistance in preparing this summary.
