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Income tax reduction coupled with additional insurance coverage makes CICs an attractive
tool for owners of closely help business such as medical, legal or accounting practices.
As frequent speakers to physicians on risk management and tax-favored
wealth planning, we are often asked about captive insurance companies (CICs). While
Fortune 500 companies have long used CICs to manage risks and gain tax advantages,
it is only in the last decade that medical groups have begun to take advantage of
them as well. Certainly, CICs can be ideal tools for physicians, if established and
maintained properly, and if suited to practice's economic needs.
A CIC is an insurance company that is wholly owned by your client's
and funded through insurance premiums paid for by the client's company. CICs are
generally licensed to write insurance in the U.S. and registered with the IRS as
legal entities. In the past CIC were based in an offshore jurisdiction in order to
take advantage of favorable insurance laws and tax treatment. With the recent changes
in few US state laws (like South Carolina), CIC can now be done in a 100% "on
shore."
Why form a CIC?
The CIC as a risk management tool. A CIC has a number of risk management
benefits:
Supplemental Coverage. Clients can use the CIC to supplement their existing
liability policies, so that he or she will not be wiped out by a lawsuit award in
excess of traditional coverage limits. As clients see more and more outstanding jury
awards in areas such as medical malpractice, wrongful termination, sexual harassment,
and product liability cases, this additional protection can be significant. Or, clients
can use the CIC to reduce existing third-party coverage by utilizing the CIC to provide
replacement coverage for a portion of the total risk.
Coverage for Exclusions & Limitations. Many policies
contain significant gaps in coverage due to the policy's limitations and exclusions.
A carefully structured CIC policy can give the client the flexibility to add coverage
for liabilities not covered by traditional policies. Given that over the last decade,
jury awards in excess of $1 million have become almost commonplace, clients may be
well advised to establish a CIC for this purpose alone.
Pricing and Coverage Stability. Since a CIC insures only
the client's company, or a small group of third parties, the risk of adverse selection
is reduced. Adverse selection occurs when an insurance company is forced to raise
its premiums due to payment of claims to a relatively small group of insureds. The
healthier insureds are able to shop around and get coverage elsewhere, at better
rates, while the unhealthy claimants remain. A CIC reduces the client's exposure
to the adverse selection spiral because the client controls both the insured and
the insurer.
No Loss of Control. The CIC structure allows for complete
and discloseable control by the client. There is no need for the client to relinquish
control or trust to any other person or entity with their assets.
The Tax Benefits of CICs
Many clients are currently self insuring against a portion of their potential losses.
By simply saving funds (often in a completely unprotected status) to cover any lawsuit
expenses that may arise, or by purchasing high-deductible policies and intentionally
self-insuring for the deductible amount, clients attempt to fill the gaps inherent
in traditional coverage. While this planning may prove to be wise, many clients would
be better off using a CIC to insure against such risks. This is because the premiums
paid to the CIC are fully tax-deductible, while amounts set aside to self insure
are not. The CIC allows the business owner to get a full deduction each year to protect
against the same risk they previously self-insured against.
CICs that are in their growth phase are given special benefits.
Under IRC section 501c(15), an insurance company that earns less than $350,000 annually
in premiums may in some circumstances qualify for tax-exempt status. This exemption
covers not only premium income, but also passive investment income. Under certain
circumstances, the CIC will pay no taxes on its investment income, including dividends,
premium income, short-term capital gains, long-term capital gains, interest income,
or royalties. A CIC that earns less than $1.2 million annually in premiums may in
some circumstances avoid taxation on those premiums. However, the company will be
taxed on all investment income.
While the CIC is in the growth phase and qualifies for exempt
status, it may be possible to diversify highly appreciated assets utilizing the CIC.
Highly appreciated assets, such as stock and real estate, can be used to initially
capitalize the reserves and surplus of the CIC. These assets can then be liquidated
and diversified by the CIC without realizing capital gains (because of the CICs exempt
status).
CICs can be used as an Estate Tax planning tool, as well. Many
opportunities exist for owners and participants of CICs, which can often serve as
one of the family businesses for purposes of wealth accumulation, preservation and
transfer. For example, the CIC could be formed with the client's adult children as
the owners. The client's existing business could purchase insurance coverage from
the children's CIC, giving the client's business a deduction for the premiums paid,
while also moving these assets out of the parent's estate and to the children's CIC.
- Case Study: Dr. Steve
Dr. Steve is a successful cardiologist in Phoenix who was concerned about protecting
his assets from a judgment beyond his $1 million/$3 million policy and wanted to
build tax-favored wealth beyond his profit-sharing plan. He established a CIC individually.
Let's take a look at the benefit Dr. Steve enjoyed from his CIC:
Dr. Steve and his CIC: Effects on His
Practice's Bottom Line
| |
Before
Creating The CIC
|
Year
1
|
| Malpractice protection |
Traditional $1/$3 million
coverage
|
Traditional coverage
plus additional $2 million in total
|
| Practice income (net) |
$300,000
|
$300,000
|
| CIC premium paid |
$0
|
$100,000a
|
| Personal income: stock transactions |
$75,000
|
N/A
|
| CIC income: stock transactions |
N/A
|
$75,000
|
| Taxable income |
$375,000
|
$200,000
|
| Federal & state income taxesb |
$168,750
|
$90,000
|
| Adjusted after-tax wealthc |
$206,250
|
$285,000
|
| Benefit to Steve's bottom line |
|
$78,750
|
a. Deductible premiums can be as high as $1.2 million per year
b. Assumes combined federal and state income taxes of 45%
c. Exclusive of transactions costs
Dr. Steve and his CIC: Building His
Tax-Free Nest Egg
| |
Before
Creating The CIC
|
Year
1
|
Year 2
|
End Year 10
(projected)
|
| Annual premium paid to CIC |
N/A
|
$100,000
|
$100,000
|
$100,000
|
| CIC income: return on prior reserves |
N/A
|
$10,000*
|
$21.000
|
$159.374
|
| CIC reserves |
N/A
|
$110,000
|
$221,000
|
$1,753,117
|
*Assumes 10% return on investments. The CIC will
pay no tax on its earnings.
Avoid the Land Mines.
To create and manage a CIC properly, using professionals who have expertise in the
area is critical- especially the attorneys, accountants, and insurance managers involved.
Ideally, your client's CIC structure will involve seasoned veterans of the CIC industry.
The exemptions mentioned earlier, while attractive, only apply to bona fide insurance
companies that are established and operated as bona fide insurance companies. While
this may mean that the CIC is more expensive than some of the cheaper alternatives
being touted on the internet or at fly-by-night seminars, this is one area where
doing it right is the only way to go. This means the CIC must do a number of things,
including:
Be properly licensed and adequately capitalized. A bona fide CIC
will have an insurance licensed issued to it by a jurisdiction having a respected
regulatory regime. Thinly capitalized CICs invite a challenge from the IRS; a CIC
must be adequately capitalized for the purpose it is being formed, and for the risks
that it is underwriting.
Have managers, actuaries, underwriters, and be audited by a major
firm on an annual basis. A CIC that does not meet these requirements is at risk of
being declared a sham for tax purposes. The CIC should have experienced professionals
guiding the companies business.
Have an insurance purpose and underwrite insurance risks. A CIC
which fails to underwrite insurance risks commensurate with its capitalization and
business plan runs the risk of being declared a sham for tax purposes. A company
that is formed and exists for only several years to accomplish a particular transaction,
such as to liquidate highly appreciated assets, also runs this risk.
Who Qualifies?
As might be expected, the professionals most experienced in these matters charge
significant fees for both the creation and maintenance of CICs. Set-up costs are
typically around $40,000 and annual maintenance costs another $20,000. For multi-parent
captives (set up by a group of physicians, for instance) or association captives
(established by an association to insure the risks of its members) these costs can
be spread among the founders/owners/members. While these fees can seem significant,
given the CICs potential risk management and tax benefits, the CIC may be an economically
viable option for certain clients. Obviously, CICs are not for everyone. However,
for the client with an interest in tax reduction, asset protection, and wealth accumulation,
a CIC can be a powerful tool.
Roccy M. DeFrancesco, Jr. is President of Financial
Management Group, LLC (FMG) and a founding member of TriArc Advisors (www.triarcadvisors.com),
a nationwide network of asset protection and estate planning, tax, financial, and
insurance professionals. He is also a practicing attorney specializing in estate
planning, business and real estate law, and asset protection planning for high net
worth individuals.
Roccy M. DeFrancesco, Jr.
Financial Management Group, LLC
139 North Whittaker
New Buffalo, MI 49117
Telephone 269-469-0537
Facsimile 269-469-5029
Email roccy@triton.net
Scott H. Cavitt is a Partner with Cypress Capital Management,
LLC, a fee-only Registered Investment Advisor in Lafayette, LA. His practice focuses
on asset management and asset protection strategies for high net worth individuals,
business owners, and physicians. He is a member of TriArc Advisors and President
of Cypress Capital Agency, LLC, an employee benefits and qualified pension plan consulting
firm.
Scott H. Cavitt
Cypress Capital Management, LLC
1405 West Pinhook Rd, Suite 205
Lafayette, LA 70503
Telephone 337-291-6005
Facsimile 337-237-0359
Email scott@pensiondoctors.com
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