Captive Insurance and Other Tax Reduction Strategies – The Good, Bad, and Ugly

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Captive Insurance and Other Tax Reduction Strategies – The Good, Bad, and Ugly

By Lance Wallach
May 14, 2008

Every accountant knows that increased cash flow and cost savings are critical for businesses in 2008. 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 ranged 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% 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. 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.

While captives can be a great cost saving tool, they also are 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 vehicles, tax deferral 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.

The IRS is aware that several large insurance companies are promoting their life insurance policies as investments with small captives. The outcome looks eerily like that of the 419 and 412(i) plans mentioned above. Remember, if something looks too good to be true, it usually is. There are safe and conservative ways to use captive insurance structures to lower costs and obtain benefits for businesses. And, some types of captive insurance products do have statutory protection for deducting life insurance premiums (although not 831(b) captives). Learning what works and is safe is the first step an accountant should take in helping his or her clients use these powerful, but highly technical insurance tools.

Lance Wallach speaks and writes extensively about VEBAs, retirement plans, and tax reduction strategies. He speaks at more than 70 conventions annually, writes for 50 publications, and was the National Society of Accountants Speaker of the Year. Contact him at 516.938.5007 or visit

The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.

National Society of Accountants


Lance Wallach said...

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Then You Should Know:
Have You Dealt With Any of These People

Shadhin Kangal said...

A captive is an insurance company that has been specifically formed to insure the risks of an affiliated business. Captive insurance companies are becoming wildly popular with owners of privately-owned mid-market businesses because they provide powerful benefits unseen with other planning strategies. With a captive insurance company, business owners receive platinum-level, tailored coverages that can fill gaps in their existing commercial policies. Additionally, captive insurance companies provide great ancillary benefits such as:

- Tax-exempt or tax deferred premiums paid to the captive insurance company
- Tax-advantaged dividend income
- Improved cash flow through secured loans to the operating company

Internationally, there are 7000 captive insurance companies in operation, with most sponsored by United States entities.

Captive legislation is being passed across the U.S., providing greater opportunities for closely-held businesses to take charge of their risk management. Business owners of profitable closely-held companies in manufacturing, transportation, construction, healthcare services, and other industries are seeing first-hand what captive insurance companies can do.


Insuring the uninsurable
The captive can write/retain certain risks that may not be available commercially, or at an acceptable price.

Direct access to reinsurance market
Saves costs of involving third parties in arranging cover.

Tailor made policies
Flexibility to tailor insurance cover to meet bespoke requirements.

Increase Reserves
Over time if (claims are less than premiums paid) the captive builds up reserves reducing reliance on the reinsurance market.

Avoids the capacity/appetite and pricing fluctuations that are seen in the insurance market.

Cash Flow
Premium payments are timed to fit the cash flow of the parent organisation.