In these times of eroding property rights, punitive tax rates, and financial insecurity, a U.S. taxpayer can use an irrevocable life insurance trust to protect trust property against creditors, legally avoid all future U.S. taxes, and also enjoy trust assets. Generally, a carefully-designed irrevocable life-insurance dynasty trust (or GST trust) provides tax-free growth of policy assets, and proceeds of the life insurance policy are paid to the trust free of income and estate taxes.

Previously, some uncertainty still existed whether the person who settled and funded a trust could also be a trust beneficiary without loss of estate-tax advantages. Private Letter Ruling (PLR) 200944002 ruled that the grantor (or settlor) of the trust may be a discretionary beneficiary (i.e., subject to the discretion of the trustee), but trust assets will not be taxed in his estate when he dies. A private letter ruling is applicable only to the taxpayer to which it is addressed. It has no precedential force for other tax cases. Nevertheless, a private ruling is a good indicator of the IRS’s general position. Furthermore, PLR 200944002 is consistent with the case law and revenue rulings that have treated related issues over past decades. For example, Revenue Ruling 77-378 clarified Revenue Ruling 62-13 to remove any implication that an entirely voluntary power
held by a trustee to distribute all of the trust assets to the grantor is sufficient to render a gift to the trust incomplete in whole or in part.

Thus, a U.S. taxpayer can fund an irrevocable trust that buys a life insurance policy insuring his life, the policy assets can grow tax-free, he can benefit from trust property during his lifetime, and when he dies, the insurance policy proceeds are paid to the trust free of income and estate taxes.

In the past, some U.S. taxpayers used secret offshore companies and numbered offshore bank accounts to avoid taxes. Now, similar benefits can be achieved in complete compliance with U.S. tax laws, and with the peace of mind that everything is completely legal.

An offshore trust holding an offshore private-placement life insurance policy provides virtually unassailable asset protection, in addition to tax-free growth and tax-free wealth transfer in the family legacy trust – a nice solution to the problem of high taxes and precarious property rights. A deferred variable annuity owned by a trust can provide some of the same benefits. Advice on these and other wealth-building and asset-protection techniques is available to clients of The Law Office of Thomas J. Swenson, at 303-440-7800, and at www.swenlaw.com.

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Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Copyright 2011 – Thomas Swenson

For US persons, an irrevocable life insurance trust (ILIT) is arguably the most efficient structure for integrating tax-free investment growth, wealth transfer and asset protection. An ILIT comprises two main parts: (1) an irrevocable trust; and (2) a life insurance policy owned by the trust. An international (or offshore) ILIT is a trust governed by the law of a foreign jurisdiction that owns foreign-based life insurance. An offshore ILIT is better than a domestic ILIT because it is more flexible and less expensive. Regarding US tax laws, a properly designed international ILIT is treated virtually the same as a domestic ILIT.

An ILIT becomes a dynasty trust (or GST trust) when the trust’s settlor (or grantor, the person who establishes and funds the trust) applies his lifetime exemption for the generation skipping transfer tax (GSTT) to trust contributions. Once a dynasty trust is properly funded by applying the settlor’s lifetime exemptions for gift, estate and GST taxes, all distributions to beneficiaries will be free of gift and estate taxes for the duration of the trust, even perpetually. The individual unified gift and estate tax exemption and the GSTT exemption are both $5 million ($10 million for a married couple) during 2011 and 2012, which are the highest amounts in decades.

Under the US tax code, no income or capital gains taxes are due on life insurance investment growth, and no income tax is due when policy proceeds are paid to an insurance beneficiary upon death of the insured. When a dynasty trust purchases and owns the life insurance policy and is named as the insurance beneficiary, no estate tax or generation skipping transfer taxes are due. In other words, assets can grow and be enjoyed by trust beneficiaries completely tax-free forever. Depending on how a trust is designed, a portion of trust assets can be invested in a new life insurance policy each generation to continue the cycle.

Private placement life insurance (PPLI) is privately negotiated between an insurance carrier and the insurance purchaser (e.g., a dynasty ILIT). Private placement life insurance is also known as variable universal life insurance. The policy funds are invested in a separately managed account, separate from the general funds of the insurance company, and may include stocks, hedge funds, and other high-growth and/or tax-inefficient investment vehicles. Offshore (foreign) private placement life insurance has several advantages over domestic life insurance. In-kind premium payments (e.g., stock shares) are allowed, whereas domestic policies require cash. There are few restrictions on policy investments, while state regulations restrict a domestic policy’s investments. The minimum premium commitment of foreign policies typically is US$1 million. Domestic carriers demand a minimum commitment of $5 million to $20 million. Also, offshore carriers allow policy investments to be managed by an independent investment advisor suggested by the policy owner. Finally, offshore policy costs are lower than domestic costs. An election under IRC § 953(d) by a foreign insurance carrier avoids imposition of US withholding tax on insurance policy income and gains.

Whether domestic or offshore, PPLI must satisfy the definition of life insurance according to IRC § 7702 to qualify for the tax benefits. Also, key investment control (IRC § 817(g)) and diversification (IRC § 851(b)) rules must be observed. When policy premiums are paid in over four or five years as provided in IRC § 7702A(b), the policy is a non-MEC policy from which policy loans can be made. If policy loans are not important during the term of the policy, then a single up-front premium payment into a MEC policy is preferable because of tax-free compounding.

An offshore ILIT provides much greater protection of trust assets against creditors of both settlor and beneficiaries. Courts in the US have no jurisdiction outside of the US, and enforcement of US court judgments against offshore trust assets is virtually impossible. Although all offshore jurisdictions have laws against fraudulent transfers, they are more limited than in the United States. In any case, an offshore ILIT is necessary to purchase offshore life insurance because foreign life insurance companies are not allowed to market and sell policies directly to US residents. An international trust, however, is a non-resident and is eligible to purchase life insurance from an offshore insurance carrier.

An international ILIT may be self-settled, that is, the settlor of the trust may be a beneficiary without exposing trust assets to the settlor’s creditors. In contrast, in the United States, the general rule is that self-settled trusts are not honored for asset protection purposes.
In Private Letter Ruling (PLR) 200944002, the IRS ruled that assets in a discretionary asset protection trust were not includable in the grantor’s (settlor’s) gross estate even though the grantor was a beneficiary of the trust. The trustee of a discretionary trust uses his discretion in making distributions to beneficiaries consistent with trust provisions. Previously, it was questionable whether a settlor could be beneficiary of an ILIT without jeopardizing favorable tax treatment upon his death. The new ruling gives some assurance to a US taxpayer who wants to be a beneficiary of a self-settled, irrevocable, discretionary asset-protection trust that is not subject to estate and GST tax. As a result, the trustee can (at the trustee’s discretion) withdraw principal from the PPLI or take a tax-free loan from the policy’s cash value and distribute it tax-free to the settlor, as well as to other beneficiaries. In other words, a settlor need not sacrifice all enjoyment of ILIT benefits in order to achieve preferred tax treatment.

An offshore ILIT is designed to qualify under IRS rules as a domestic trust during normal times and as a foreign trust in case of domestic legal threats to its assets. The offshore ILIT is formally governed by the laws of a foreign jurisdiction and has at least one resident foreign trustee there. As a “domestic” trust under IRS rules, the trust also has a domestic trustee who controls the trust during normal times. If a domestic legal threat arises, control of the trust shifts to the foreign trustee, outside the jurisdiction of US courts, and the trust becomes a “foreign” trust for tax purposes. A domestic trust “protector” having negative (or veto) powers may be appointed to provide limited control over trustee decisions. An international ILIT protects trust assets against unforeseen lawsuits, bankruptcy and divorce.

The objective of PPLI is to minimize life insurance costs and to maximize investment growth. The life insurance policy acts as a “wrapper” around investments so that they qualify for favorable tax treatment. Nevertheless, PPLI still provides a valuable life insurance benefit in case of an unexpected early death of the insured.

Initial costs of setting up an ILIT are high, but are recouped after a few years of tax-free investment growth. Initial legal and accounting fees are typically in a range of $25,000 to $50,000. Premium “loading” charges are in a range of about 3% to 5% of premiums paid into offshore PPLI (compared to 8 – 10% in domestic PPLI). Annually recurring charges depend on policy value and vary widely among PPLI carriers, so careful comparison shopping is advised. For example, annual asset charges should be in a range of about 40 to 150 basis points (0.4% to 1.5%) of the policy’s cash value. The annual cost of insurance is not substantial and declines over time. Annual costs for maintaining an offshore trust are several thousand dollars. Finally, investment manager fees are paid regularly out of policy funds.

Cash may be contributed to the ILIT, which then purchases PPLI. If asset protection of vulnerable fixed assets in the US is a concern, then equity stripping can be used to generate cash, which is then contributed to the offshore ILIT. Of course, stocks and bonds and other assets may also be contributed to the ILIT and used for investing in PPLI. Various value-freezing and valuation discounting techniques can be used to leverage the GSTT exemption.

An offshore “frozen cash value” policy is a variation of PPLI governed by IRC § 7702(g). The minimum premium commitment is about $250,000. During the life of the insured, the cash surrender value is fixed at the sum of the premiums paid. Withdrawals up to the amount of the paid-in premiums are tax-free, but cash value in excess of the premium amounts is inaccessible until after death of the insured.
Another alternative investment for an ILIT is a deferred variable annuity (DVA). There is no cost of insurance, so investment growth is faster. Tax on appreciation is deferred, but DVA distributions are taxed as income.

Generally, for public policy reasons and because the insurance industry possesses strong political influence, life insurance has long enjoyed favorable tax treatment. Over the past two decades, numerous IRS rulings have clarified the tax treatment of PPLI and irrevocable discretionary trusts. At the same time, strong, new asset protection laws and reliable service providers in numerous foreign jurisdictions have enabled safe, efficient and flexible management of international trusts and insurance products. As a result, an international irrevocable, discretionary trust owning PPLI can provide tax-free growth of a global, variable investment portfolio managed by a trusted financial adviser in full compliance with US tax laws. At the discretion of the trustee, trust assets (including tax-free insurance policy loans and withdrawals) are available to the settlor during his lifetime. Upon death of the insured, policy proceeds are paid tax-free to the trust. Thus, a well-managed life insurance dynasty trust perpetually secures the financial well being of settlor, spouse, children and their descendants.

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Warning & Disclaimer: This is not legal advice.

Copyright 2011 – Thomas Swenson

1. A CIC benefits its owner(s) generally through a combination of factors.

1.1 As with any conventional insurance premium, premiums paid from a business to the CIC are tax deductible expenses under IRC § 162(a).

1.2 A CIC that elects treatment under IRC § 831(b) is exempt from income taxation of premiums received up to $1.2 million annually. There is a public policy rationale for this favorable tax treatment. By including this provision in the tax code in 1986, the US Congress intended to increase competition among insurers and increase the range of choice for insurance consumers.

1.3 An 831(b) CIC is taxed only on its investment income. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.

1.4 Policy premiums paid to the CIC stay in the economic family. Roughly 35–50% of premiums paid for conventional “retail” insurance go to overhead, administration and profit. A CIC reduces those costs. Further, since a CIC invests its reserves and surplus in its own investment accounts, investment gains benefit the CIC’s owner(s) (not an outside insurer).

1.5 A CIC customizes insurance policies directly to the needs and preferences of a business to improve insurance coverage and/or decrease premium costs.

1.6 A CIC customizes policies to insure risks that are otherwise uninsurable or too expensive to insure using conventional insurance. Thus, a CIC is a tax-efficient substitute for “self-insurance” (i.e., no insurance). Instead of using post-tax dollars to make a “rainy-day” fund, up to $1.2 million no-tax dollars can be shifted as insurance premiums to the 831(b) CIC annually.

1.7 A CIC is particularly well-suited for insuring “business loss” risks; for example, loss of business revenue resulting from loss of key employee or customer, change in government regulations, loss of operating license, etc. (see Section 6 below).

1.8 A CIC has access to reinsurers. For a high-premium policy (e.g., $1 million), a CIC can negotiate directly with a reinsurer for favorable “wholesale” insurance rates.

1.9 A CIC established in an offshore jurisdiction incurs no state income tax liabilities.

1.10 Although a non-831(b) CIC must recognize premiums as income, deductions under IRC § 832(b)(5) for IBNR (incurred but not reported) loss reserves provide arbitrage opportunities to the CIC. The “dividends received deduction” under IRC § 243 also applies.

1.11 A CIC offers flexible financing of annual premiums (and capitalization requirements), accommodating a business’s cash flow problems. For example, a significant portion of annual premiums may be paid at the end of the premium year.

1.12 CIC reserves and surplus are not exposed to general creditors of the operating business. Insurance reserves are available for paying insurance claims only. At the end of a policy term, corresponding insurance reserves become surplus. CIC surplus is not subject to claims and can be invested to maximize return.

1.13 When owned by one or more asset protection trusts, a CIC is a valuable part of an integrated asset protection, wealth accumulation and generational wealth transfer structure.

2. A well-designed CIC managed by a “turnkey” service provider can be operated and properly reinsured for about 15% of annual premium payments. For example, if premiums of $1 million were paid to the turnkey CIC, total management costs including the cost of reinsurance could be less than $150K, potentially resulting in a profit of $850K at the end of the year if there were minimal non-reinsured claims.

Generally, a CIC makes good economic sense when the CIC receives about $250K or more in premium payments annually. The insurance licensing agency in the jurisdiction of formation requires initial capitalization of a CIC, typically about 20 percent of the first year’s premiums.

Generally, formation of a CIC is less expensive in one of the traditional foreign jurisdictions than in one of the states in the US. In any case, an 831(b) CIC usually elects to be taxed as a domestic company under IRC § 953(d), its operating account is located in the US, and its investment account (holding the bulk of its assets) can also be located in the US and controlled by its owner(s).

Unrelated owners of businesses (i.e., owners from different “economic families”) can form a multi-owner CIC, a so-called “group captive”. For example, four unrelated owners of businesses having similar types of risk could form a group captive that insures some or all of their operating business entities.

3. CIC assets can be accessed in several ways.

3.1 Dividends. Unfortunately, beneficial tax rates for qualified dividends are scheduled to expire in 2013.

3.2 Direct investments. The CIC can invest directly in new business ventures.

3.3 Shareholder loans. Loans should be transacted only with strict formalities at arms length to avoid problems with the IRS and licensing agency.

3.4 Liquidation of the CIC will be treated as a long term capital gain.

4. To qualify as insurance, an insurance policy must shift a genuine risk from the insured to the insurer. A rule of thumb used by actuaries is that there should generally be a 10% chance of a 10% loss of the policy limit. In any case, a good CIC manager employs underwriting and actuarial skills to provide sound insurance coverage, satisfy statutory and IRS requirements, and maximize profits for a given set of circumstances.

To avoid scrutiny by the IRS concerning the appropriateness of deducting insurance premiums under § 162, total annual premiums paid by a business entity to an 831(b) CIC should not exceed 10% of the business’s gross revenue. For example, if a business has annual gross revenues of $3 million, insurance premium payments should not exceed $300,000.

For discussion purposes, risks can generally be characterized as follows.

4.1 Low-frequency/low severity risks. A CIC can issue a policy that is efficiently priced and avoid paying overhead costs of retail insurers.

4.2 High-frequency/low severity risks. Conventional insurance for such risk can be expensive because of high administration costs. The operating business can purchase a low-cost high-deductible (stop-loss) conventional policy and pay the numerous small claims up to the deductible amount. The CIC can then issue an indemnification policy to the business that covers the high deductible.

4.3 Low frequency/high severity risks. A CIC is well suited to insure this type of risk. Operating businesses often pay high insurance premiums for high severity events that rarely if ever occur. Other businesses are completely exposed to such high severity events because they do not insure against them, simply because they occur so rarely. Such risks are efficiently covered when the operating business purchases a conventional low-cost stop-loss (catastrophic) policy and the CIC writes an indemnification policy to cover rare, high-severity events.

4.4 Premiums approach policy limits of insured risk. There is little benefit from conventional insurance if premiums paid are close to policy limits. A CIC can underwrite risks more efficiently by reducing overhead costs and investing the premiums in its own accounts.

4.5 Risks that the business manages better than the industry average. A CIC enables the operating business to customize its insurance to meet its own risk profile, rather than indirectly subsidizing other companies having high claims histories.

5 Business Liability Policies. Liability policies cover claims made against the operating business by third-party claimants.

Direct policies directly pay claimants and pay legal fees and expenses. They could create an asset for plaintiffs to pursue and, therefore, are not preferred for a CIC.

Indemnification policies indemnify, or reimburse, the business for third-party claims that the business pays. The business decides whether it will pay third-party claims. In other words, an indemnification policy could cover the risk for the business without offering an asset for plaintiffs to pursue.

Litigation expense policies pay only legal defense fees and expenses. These are good policies for a CIC because they do not create any rights in favor of third-party claimants.

Business liability risks commonly exist in the following exemplary areas:

Vehicle use
Construction and design defects
Performance liability
Structural defects
Title insurance
Environmental impacts
Product liability
Professional malpractice
Advertising liability
Copyright and trademark infringement
Antitrust
Unfair trade practices (e.g., Lanham Act violations)
Director and officer liability
Errors and omissions
Sarbanes-Oxley violations
Employee relations (e.g., discrimination, sexual harassment)
Failure to investigate/control employees and agents
Libel and slander
Workers Compensation (subject to limitations)
Employee Health Insurance (subject to limitations)

6 Business Casualty Policies. A good type of policy for a CIC to issue is a business casualty (i.e., business loss) policy because only the business can assert a claim and no third-party claimant is involved. Most businesses consciously or unconsciously self-insure many potential business casualty risks.
Business casualty risks commonly exist in the following exemplary areas:

Unforeseen administrative action of a governmental body
Changes in state or federal law
Judicial or administrative delays
Extortion (even if not provable legally)
Market volatility
Inability of key individual to work
Loss of professional or business license
Loss of key client or investor
Business credit (e.g., credit loss, delayed or withheld loans)
Labor cost or strike
Property damage
Unfair calling of guarantees
Litigation costs
Tax audit defense
Business interruption (e.g., due to computer, supply chain, weather)
Lawsuit interruption (i.e., interruption by lawsuit into business operations)
Consequential damages
Contract frustration
Advertising and marketing failure
Business reputation
Commercial crimes (e.g., theft of trade secret)
Currency risks

7. Bonds. CICs are also suitable in some circumstances to underwrite surety, performance and other types of bonds.

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Copyright 2012 Thomas Swenson

Two key tax benefits enable a structure containing a CIC to build wealth efficiently: (1) insurance premiums paid by a business to the CIC are tax deductible; and (2) under IRC § 831(b), the CIC receives up to $1.2 million of premium payments annually income-tax-free. In other words, a business owner can shift taxable income out of an operating business into the low-tax captive insurer. An 831(b) CIC pays taxes only on income from its investments. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.

Starting about 60 years ago, the first captive insurance companies were formed by large corporations to provide insurance that was either too expensive or unavailable in the conventional insurance market.

Over the years, a combination of US tax laws, court cases and IRS rulings has clearly defined the steps and procedures required for the establishment and operation of a CIC by one or more business owners or professionals.

To qualify as an insurance company for tax purposes, a captive insurance company must satisfy “risk shifting” and “risk distribution” requirements. This is easily done through routine CIC planning. The insurance provided by a CIC must really be insurance, that is, a genuine risk of loss must be shifted from the premium-paying operating business to the CIC that insures the risk.

In addition to tax benefits, principal advantages of a CIC include increased control and flexibility, which improve insurance protection and lower cost. With conventional insurance, an outside carrier typically dictates all aspects of a policy. Often, certain risks cannot be insured conventionally, or can only be insured at a prohibitive price. Conventional insurance rates are often volatile and unpredictable, and conventional insurers are prone to deny valid claims by exaggerating petty technicalities. Also, although business insurance premiums are generally deductible, once they are paid to a conventional outside insurer, they are gone forever.

A captive insurance company efficiently insures risk in various ways, such as through customized insurance policies, favorable “wholesale” rates from reinsurers, and pooled risk. Captive companies are well suited for insuring risk that would otherwise be uninsurable. Most businesses have conventional “retail” insurance policies for obvious risks, but remain exposed and subject to damages and loss from numerous other risks (i.e., they “self insure” those risks). A captive company can write customized policies for a business’s peculiar insurance needs and negotiate directly with reinsurers. A CIC is particularly well-suited to issue business casualty policies, that is, policies that cover business losses claimed by a business and not involving third-party claimants. For example, a business might insure itself against losses incurred through business interruptions arising from weather, labor problems or computer failure.

As noted above, an 831(b) CIC is exempt from taxes on up to $1.2 million of premium income annually. Total insurance premiums paid by an operating business should not exceed 10 percent of annual revenues. As a practical matter, a CIC makes economic sense when its annual receipt of premiums is about $250,000 or more. A group of businesses or professionals having similar or homogeneous risks can form a multiple-parent captive (or group captive) insurance company and/or join a risk retention group (RRG) to pool resources and risks.

A captive insurance company is a separate entity with its own identity, management, finances and capitalization requirements. It is organized as an insurance company, having procedures and personnel to administer insurance policies and claims. An initial feasibility study of a business, its finances and its risks determines if a CIC is appropriate for a particular economic family. An actuarial study identifies appropriate insurance policies, corresponding premium amounts and capitalization requirements. After selection of a suitable jurisdiction, application for an insurance license may proceed.

Fortunately, competent service providers have developed “turnkey” solutions for conducting the initial evaluation, licensing, and ongoing management of captive insurance companies. The annual cost for such turnkey services is typically about $50,000 to $150,000, which is high but readily offset by , reduced insurance costs, reduced taxes and enhanced investment growth.

A captive insurance company may be organized under the laws of one of several offshore jurisdictions or in a domestic jurisdiction (i.e., in one of 39 US states). Some captives, such as a risk retention group (RRG), must be licensed domestically. Generally, offshore jurisdictions are more accommodating than domestic insurance regulators. As a practical matter, most offshore CICs owned by a US taxpayer elect to be treated under IRC § 953(d) as a domestic company for federal taxation. An offshore CIC, however, avoids state income taxes. The costs of licensing and managing an offshore CIC are comparable to or less than doing so domestically. More importantly, an offshore company offers better asset protection opportunities than a domestic company. For example, an offshore irrevocable trust owning an offshore captive insurance company provides asset protection against creditors of the business, grantor and other beneficiaries while allowing the grantor to enjoy benefits of the trust.

For US business owners paying substantial insurance premiums every year, a captive insurance company efficiently reduces taxes and builds wealth and can be easily integrated into asset protection and estate planning structures. Up to $1.2 million of taxable income can be shifted as deductible insurance premiums from an operating business to a low-tax CIC.

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Download This PDF Article Here and Learn More About How To Reduce Taxes and Increase Wealth

Copyright 2011 – Thomas Swenson

http://swenlaw.com

Thomas Swenson practices law in the areas of asset protection, business planning and intellectual property.

Among his specialties are the design and implementation of offshore dynasty trusts holding private placement life insurance (PPLI). In full compliance with U.S. tax laws, an irrevocable, discretionary, offshore PPLI dynasty trust provides a life insurance benefit, tax-free investment growth, asset protection against all creditors, financial security, and perpetual tax-free enjoyment of trust assets by beneficiaries.

He also provides counseling and services to US business owners regarding captive insurance companies, which reduce taxes, build wealth and improve business insurance protection.

1. A captive insurance company (CIC) provides insurance to one or more operating businesses in the CIC-owner’s “economic family”.

2. Two key tax benefits enable a structure containing a CIC to build wealth efficiently:

2.1 Insurance premium payments from operating business to CIC are tax deductible; and

2.2 Under IRC 831(b), a CIC can receive up to $1.2 million of premium payments annually income-tax-free.

In other words, so long as insurance issued by the CIC is reasonable and genuine, up to $1.2 million of business revenues in the form of deductible insurance premiums can be shifted out of operating businesses into the low-tax CIC. An 831(b) CIC pays taxes only on investment income and gains (no state taxes if formed offshore).

3. Other principal benefits of a CIC include:

– increased control and increased flexibility regarding insurance policies, premium payments, risk management, claims processing, etc.
– insurance of risks for which retail insurance either does not exist or is too expensive

– tax-efficient substitute for self-insurance, i.e., a “rainy day fund” of no-tax dollars
– asset protection, wealth accumulation, wealth transfer

4. Formation Criteria:

4.1 Annual gross business revenues of $2.5 million or more

4.2 Annual total business profits + insurance costs of $250K or more

5. Formation, Management, Costs.

5.1 “Turnkey” service includes: initial evaluation, CIC formation, licensing, ongoing management, actuarial analysis, policy underwriting, reinsurance, claims management, auditing, accounting and tax compliance.

5.2 CIC owner(s) can retain control of CIC accounts and assets.

5.3 Typical cost of comprehensive turnkey solution, including cost of reinsurance and claim payments: 12–18% of annual premiums, depending on total premium amount (16–26% in first year). Thus, assuming a typical CIC claims profile, annual CIC profits can be 80% or more of annual premiums (plus investment income and gains).

5.4 Initial CIC capitalization requirement: 20% of 1st year’s premium amount.

DETAILED INFORMATION AVAILABLE UPON REQUEST

Thomas Swenson 631.350.1513 303.440.7800 tswenson@swenlaw.com

1. A CIC benefits its owner(s) generally through a combination of factors.

1.1 Policy premiums paid to the CIC stay in the economic family. Even if insurance policies are absolutely identical to a business’s previous
insurance policies, profits that would otherwise go to an outside insurance company remain instead in the CIC. Roughly 35–50% of premiums paid for conventional “retail” insurance go to overhead, administration and profit. A CIC keeps a large portion of those costs inside the economic family.

1.2 A CIC has access to reinsurers and, therefore, to “wholesale” insurance rates and can negotiate directly with a reinsurer for favorable rates.

1.3 A CIC customizes insurance policies directly to the needs and preferences of a business to improve insurance coverage and/or decrease premium costs.

1.4 A CIC customizes policies to insure risks that are otherwise uninsurable ortoo expensive to insure using conventional insurance.

1.5 A CIC is particularly well-suited for insuring “business loss” risks; for example, loss of business revenue resulting from loss of key employee or customer, change in governmental regulation, loss of operating license, etc. (see Section 5, below).

1.6 As with any conventional insurance premium, premiums paid from a business to the CIC are tax deductible expenses under IRC § 162(a).

1.7 A CIC that elects treatment under IRC § 831(b) is exempt from income taxation of premiums received up to $1.2 million annually. There is a public policy rationale for this favorable tax treatment. By including this provision in the tax code, the US Congress intended to increase competition among insurers and increase the range of choice for insurance consumers.

1.8 An 831(b) CIC is taxed only on its investment income. The “dividends received deduction” under IRC § 243 provides additional tax efficiency for dividends received from its corporate stock investments.

1.9 CIC reserves and surplus are not exposed to general creditors of the operating business. Reserves are available for paying insurance claims
only. CIC surplus is not subject to claims and can be invested to maximize return.

1.10 When owned by one or more asset protection trusts, a CIC is a valuable part of an integrated asset protection, wealth accumulation and generational wealth transfer structure.

2. A well-designed CIC managed by a “turnkey” service provider can be operated and properly reinsured for less than 15% of annual premium payments. For example, if premiums of $1 million were paid to the turnkey CIC, total management costs including the cost of reinsurance could be less than $150K, potentially resulting in a profit of $850K at the end of the year if there were minimal non-reinsured claims.

Generally, a CIC makes good economic sense when the CIC receives about $250K or more in premium payments annually. The insurance licensing agency in the jurisdiction of formation requires initial capitalization of a CIC, typically about 20 percent of the first year’s premiums.

Generally, formation of a CIC is less expensive in one of the traditional foreign jurisdictions than in one of the states in the US. In any case, an 831(b) CIC usually elects to be taxed as a domestic company under IRC § 953(d), its operating account is located in the US, and its investment account (holding the bulk of its assets) can also be located in the US and controlled by its owner(s).

Unrelated owners of businesses (i.e., owners from different “economic families”) can form a multi-owner CIC, a so-called “group captive”. For example, four unrelated owners of businesses having similar types of risk could form a group captive that insures some or all of their operating business entities.

3. To qualify as insurance, an insurance policy must shift a genuine risk from the insured to the insurer. A rule of thumb used by actuaries is that there should generally be a 10% chance of a 10% loss of the policy limit. In any case, a good CIC manager employs underwriting and actuarial skills to provide sound insurance coverage, satisfy statutory and IRS requirements, and maximize profits for a given set of circumstances.

To avoid scrutiny by the IRS concerning the appropriateness of deducting insurance premiums under § 162, total annual premiums paid by a business entity to an 831(b) CIC should not exceed 10% of the business’s gross revenue.

For example, if a business has annual gross revenues of $3 million, insurance premium payments should not exceed $300,000.

For discussion purposes, risks can generally be characterized as follows.

3.1 Low-frequency/low cost (severity) risks. It might make sense for a CIC to pay claims directly out of reserves, rather than incur the expense of reinsuring the risks. The CIC can still write a policy covering the risk, however.

3.2 High-frequency/low cost risks. Conventional insurance for such risk can be expensive. It might make sense for a CIC to write a high-deductible policy to cover claims over a certain accumulated amount.

3.3 Low frequency/high cost risks. A CIC is well suited to insure this type of risk. An operating business might be paying high insurance premiums for high severity events that rarely if ever occur. Also, operating businesses are commonly completely exposed to such high severity events but do not insure them simply because they occur so rarely. A sensible approach for a CIC is to write a policy for stop-loss insurance, that is, reinsure risk only above a high stoploss amount.

4. Business Liability Policies. Liability policies cover claims made against the operating business by third-party claimants.
Direct policies directly pay claimants and pay legal fees and expenses. They could create an asset for plaintiffs to pursue and, therefore, are not preferred for a CIC.

Indemnification policies indemnify, or reimburse, the business for third-party claims that the business pays. The business decides whether it will pay third party claims. In other words, an indemnification policy could cover the risk for the business without offering an asset for plaintiffs to pursue.

Litigation expense policies pay only legal defense fees and expenses. These are good policies for a CIC because they do not create any rights in favor of third party claimants.

Business liability risks commonly exist in the following exemplary areas:

• Vehicle use
• Construction and design defects
• Performance liability
• Structural defects
• Title insurance
• Environmental impacts
• Product liability
• Professional malpractice
• Advertising liability
• Antitrust
• Unfair trade practices (e.g., Lanham Act violations)
• Director and officer liability
• Errors and omissions
• Sarbanes-Oxley violations
• Employee relations (e.g., discrimination, sexual harassment)
• Failure to investigate/control employees and agents
• Libel and slander

5. Business Casualty Policies. A good type of policy for a CIC to issue is a business casualty (i.e., business loss) policy because only the business can assert a claim and no third-party claimant is involved. Most businesses consciously or unconsciously self-insure many potential business casualty risks.

Business casualty risks commonly exist in the following exemplary areas:

• Unforeseen administrative action of a governmental body
• Changes in state or federal law
• Judicial or administrative delays
• Extortion (even if not provable legally)
• Market volatility
• Inability of key individual to work
• Loss of professional or business license
• Loss of key client or investor
• Business credit (e.g., credit loss, delayed or withheld loans)
• Labor cost or strike
• Property damage
• Unfair calling of guarantees
• Litigation costs
• Tax audit defense
• Business interruption (e.g., due to computer, supply chain, weather)
• Lawsuit interruption (i.e., interruption by lawsuit into business operations)
• Consequential damages
• Contract frustration
• Advertising and marketing failure
• Business reputation
• Commercial crimes (e.g., theft of trade secret)
• Currency risks

6. Bonds. CICs are also suitable in some circumstances to underwrite surety, performance and other types of bonds.

Warning & Disclaimer: This is not legal or tax advice.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Copyright 2012 Thomas Swenson

Save extra $40K to $400K every year in a CIC, compared to no CIC.

Eliminate wasteful payments to conventional retail insurance companies. With regular retail insurance, 35-50% of your premium pays for the insurer’s profit, overhead and administration.

Get better insurance coverage.

Reduce federal and state income taxes.

CIC replacement for “self-insurance”: A CIC can build an emergency (“rainy day”) fund using no-tax dollars. Example: Without a CIC, to put $100K in an emergency reserve, a business needs about $165K before federal and state taxes. With a CIC, the equivalent substitute costs about $115K.

CIC builds a “nest egg” for its owners. CIC profits accumulate over years, insulated from liabilities of the operating business(es).

At least 23 states and D.C. have passed captive insurance statutes (e.g., Colorado, Delaware, Vermont, New York). Forming a CIC offshore, however, is easier and cheaper, and also avoids state taxes on CIC investment income.

CICs enjoy federal tax benefits under IRC 831(b).

Qualifying Criterion for forming a CIC: Annual gross revenues of at least about $2.5 million in one or more businesses in the same “economic family”.

CIC pays for itself, including “Turnkey” management service: initial evaluation, CIC formation, licensing, ongoing management, actuarial analysis, policy underwriting, reinsurance, claims management, auditing, accounting and tax compliance.

Owner(s) can retain control of CIC accounts and assets.

Two key tax benefits enable a structure containing a captive insurance company to build wealth efficiently: (1) insurance premium payments from a business to the captive insurance company are tax deductible; and (2) under IRC section 831(b), a captive insurance company can receive up to $1.2 million of premium payments annually income-tax-free. In other words, so long as insurance purchased from the captive is reasonable and genuine, a business owner can shift up to $1.2 million of business revenues in the form of deductible insurance premiums out of an operating business into the low-tax captive insurance company. An 831(b) captive insurance company pays taxes only on income from its investments.

In addition to tax benefits, principal advantages of a captive insurance company include increased control and increased flexibility, which improve insurance protection and lower costs. As a practical matter, a captive insurance company makes economic sense when the economic family has annual business revenues of $2.5 million or more. A captive’s direct access to reinsurance increases efficiency. A captive insurance company typically participates in a reinsurance pool to diversify risk. A group of businesses or professionals having similar or homogeneous risks can form a multiple-parent captive (or group captive) insurance company and/or join a risk retention group (RRG) to pool resources and risks.

“Turnkey” solutions are available for conducting an initial evaluation, actuarial studies, licensing, and ongoing management of a captive insurance company. The annual cost for such turnkey services is typically about $50,000 to $150,000, which is high but readily offset by the tax reduction and investment growth enabled by a captive insurance company.

For more details, click on the article titles below, or contact this office for a free consultation (see CONTACT page).

Downloadable PDFs About Captive Insurance

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Taxes and Build Wealth

When trust assets (e.g., cash, stocks, bonds, business entities) are invested in a private placement life insurance (PPLI) policy (min. premium commitment usu. $1 million), no income or capital gains taxes are paid on investment growth.  Accordingly, trust assets in the life insurance wrapper can grow and be distributed to beneficiaries completely free of taxes perpetually.  In contrast to foreign PPLI, domestic PPLI requires a minimum premium commitment of $5 million or more, only in cash, and is subject to state-imposed investment restrictions.

An alternative to PPLI is a foreign deferred variable annuity (DVA), which may be obtained for a minimum premium commitment of $250,000.

For the years 2011 and 2012, the individual lifetime gift and estate tax exemption is $5 million.  Unfortunately, if the craven politicians of both major U.S. political parties increase estate and gift taxes (cf. Obama’s “Buffett Rule”), future dynasty trusts could be eviscerated.  If a dynasty trust is already established, however, it will (presumably) be protected against prospective changes in the tax laws.

For more detailed info, please consult the articles listed on this website page, or contact this office for a free consultation.