Game Changing Financial Tool For Owners of Businesses or Professional Practices
Ancillary Benefit Of Owning A CIC – Efficiently Funding A Buy Out Agreement Between Business Owners
One of the benefits of owning a captive insurance company is that it provides a remarkably efficient vehicle to fund a buy-out agreement among business owners. Before discussing this unique benefit, let’s review the primary reasons that businesses form their own insurance company – specifically a captive insurance company.
1. To manage business risk by formally self-insuring certain risks with pre-tax dollars
2. To protect assets from creditors of the operating business and its owners or other risks
3. To realize profits and accumulate wealth inside of a separate business entity
All of the above are well known as the primary reasons that legitimate captive insurance companies are formed. What is less well known is that a captive insurance company can also be an incredibly efficient means of transferring assets or wealth from one party to another—e.g., from one generation to another or from one business owner to another. In this article we’ll discuss the second of these options—transferring a business from one owner to another.
A Common Challenge– Buy-Out Agreements Between Business Owners Can Be Cumbersome And Take An Inordinate Amount Of Time
A challenge common to many businesses, including often professional practices like CPA firms, physician practices, law firms, etc. is transferring ownership of the business from its current owners to the up-and-coming crop of new owners. Such transfers present a host of practical and tax complications, many of which can be resolved via use of a captive insurance company.
When a business forms a captive insurance company and uses it to formally insure risks that it previously informally self-insured, two relevant things happen. First, its profits decrease since premiums paid to the captive insurance company represent business expenses. This in turn means that the insured business is worth less (since its value is usually some multiple of net income or EBITDA). Second, the business gets a tax deduction for the premiums paid.
For example, assume that a given business is valued at a five times multiple of EBITDA and begins paying $1 million in premiums to a captive insurance company owned by the current (selling) owners of the business. This transaction reduces the value of that business by $5 million, which makes it far easier for the up-and-coming owners (the buyers) to afford the buy-in. Does this mean that the selling partners are short-changed? Hardly, since they reap the profits of the captive that, if it is selective about the types of insurance sold, will be substantial. These benefits alone are often enough to make what was previously an undoable deal doable.
But there are additional benefits as well. Remember that small captive insurance companies pay a zero percent tax on their underwriting profits under the Internal Revenue Code. Thus, the $1,000,000 in premiums received by the captive (owned by the sellers of the operating business) in the example above is received tax-free even though the premiums were tax deductible to the business that paid it (i.e., to the buyers). Thus, the reduced tax friction of the captive arrangement also contributes to making previously undoable deals doable.
But, what about claims? Won’t the captive have to pay claims on policies sold to the operating business? Of course. But, with a properly structured and managed captive, one that writes a wide variety of select types of coverage that includes proper deductibles and policy limits, claims can be managed and will almost never amount to more than the tax savings that result from the transaction in any given year. Often they will be substantially less. Thus, the existence of claims is no impediment to the deal.
What Is A Captive Insurance Company?
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self-insure risk, and captives are generally formed to insure primarily though not exclusively the risks of one or more businesses owned by the same or related parties.
A captive is a unique but REAL casualty insurance company. It can be used to replace insurance that your client is currently purchasing from third parties. But most businesses find that the real benefit of a captive is to insure risk that CAN’T be insured by third parties at any reasonable price. Most every business has insurable risks that it can’t afford to insure elsewhere. In fact, businesses often face major risks that are often not insured at all.
It’s worth noting that most businesses informally self-insure such risks with after tax dollars, meaning that its “rainy day fund” is usually comprised of retained earnings that have already been taxed. With a captive in place, businesses can formally insure these risks with pre-tax dollars.
Premiums paid from the parent company to the captive insurance company to buy legitimate business-related insurance coverage are deductible just as if such premiums were paid to a third party insurer. Further, small casualty insurance companies (as defined in Section 831(b) of the Internal Revenue Code) pay tax in a ZERO percent tax bracket on their underwriting profits. Such profits accumulate as reserves within the captive, and these reserves can be invested into a wide variety of assets or investments (some domiciles have restrictions). Also, for a properly structured captive, the reserves that accumulate in the captive are protected from creditors of the operating business and its owners.
How Does a Captive Insurance Company Work?
A captive primarily insures its parent company or related companies. Hence, the parent company is able to purchase insurance from its captive, and it can insure risks that third party insurers will not insure or risks where third party insurance cost is unaffordable.
Premiums are paid from the parent company to the captive with pre-tax dollars. The captive can invest its assets mostly as its owners choose (some domiciles have restrictions).
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