Captive Insurance Company – Reduce Taxes and Build Wealth

For business owners paying taxes in the United States, captive insurance companies reduce taxes, build wealth and improve insurance protection. A captive insurance company (CIC) is similar in many ways to any other insurance company. It is referred to as “captive” because it generally provides insurance to one or more related operating businesses. With captive insurance, premiums paid by a business are retained in the same “economic family”, instead of being paid to an outsider.

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 increased 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. As a practical matter, a CIC makes economic sense when its annual receipt of premiums is about $300,000 or more. Also, a business’s total payments of insurance premiums should not exceed 10 percent of its annual revenues. 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 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.

Copyright 2011 – Thomas Swenson

Is Legal Onshoring the New Legal Outsourcing in the US?

Legal onshoring is a trend that is gaining momentum as an alternative to traditional Legal Process Outsourcing. In the US, a growing number of law firms are exploring onshoring or a hybrid of onshore and offshore legal teams to handle work that was once performed in-house.

How Onshoring Fits into the LPO Mix:

Onshoring involves the outsourcing of work domestically. The onshore LPO model is a viable alternative for legal professionals who are unwilling or unable to send work to outside jurisdictions, and allows LPO vendors to expand their delivery capabilities and service portfolios to new geographies.

Unlike the offshoring model, which focuses on reassigning legal work to lower-cost service providers overseas, onshoring transfers work to lower-income, lower-cost rural communities. Like typical LPO, onshoring allows law firms and corporations in major metropolitan areas to maximize productivity and minimize legal fees. It is no surprise that some big city law firms are sending work to small towns in Texas, the Midwest and the Pacific Northwest, or even to virtual America where costs are lower.

Why Choose to Onshore Legal Work?

US law firms are recognizing that American onshore providers may be a better fit for some complex projects that require a higher degree of expertise and collaboration. The skill, knowledge, and experience of US attorneys are attractive to law firms and legal departments looking to outsource. These attorneys understand the nuances and complexities of the US legal system, which can be an advantage in litigation, IP, and M&A matters. And, while the level of expertise is high, the costs are typically lower. Furthermore, should a problem arise, onshoring is extremely beneficial because the laws of the United States will be enforced. For these reasons, many firms are reevaluating their decision to ship projects overseas, opting instead for US-based outsourcing companies.

Offshore LPOs Come Ashore

As a further evolution of the Legal Process Outsourcing industry, some offshore LPOs, predominantly in India, have opened offices in the US and even employ American lawyers. These onshore service delivery centers are in cities such as North Dakota, Texas, Kansas City and Chicago. Additionally, some LPOs are ramping up the hiring of American lawyers to handle more sensitive client matters, such as military contracts, export control work and patent matters, here in the US.

Expanding Geographic/Jurisdictional Reach

The growth of onshore LPO is a result of third-party vendor investment in onshore solutions as well as captive centers created by major law firms. The onshoring trend illustrates the value of LPO beyond simple labor arbitrage. With the popularity of onshoring as yet another legal outsourcing option, LPO will be viewed as a flexible, effective strategy for delivering legal services to a global business community.

Need For 2nd Level Legal Offshoring

Everybody thought the growth of legal outsourcing would multiply but it didn’t grow as it was expected. In the first level of legal outsourcing, eyes were set on cost cutting.

Despite excellent projections it couldn’t come out of its infancy stage. The proximity of clients and vendors could not increase. Many LPO’s were born like bubbles and vanished identically. All the way it was a good signal to show there was a gap between two ends. The said gap could be bridged if some better means were discovered.

The first level of legal Outsourcing consisted of Captive centers and off shoring of the services to LPO’s.

The Captive Centers started closing down not because of the same were un-economical but primarily due to other problems connected with the working. The stress taken by a company in running the Captive Unit had started becoming a nuisance to them. The very purpose of setting up Captive Unit came under attack whereby its future was sluggish. Though a good number of captive centers have been efficiently working yet most of them could not prove to be economical. Factors like investment, employee attrition rate, changes in Government Policies and day to day running problems discouraged companies to open their Captive Unit.

The mushrooming of LPO’s had put the clients into a saga of disbelief. It had become very tough to settle down with third party vendors. It was inevitable that confidentiality would be bridged and exit policy was tough.

There was a need to find better ways for offshoring legal and paralegal services. The important key points of offshoring decisions include: – The reputation of the company, the non compromising attitude towards confidentiality, keeping control on the working and having cost savings. Law firms of UK / US were divided on off shoring and subsequently about the nature of services to be offshore. The mist had become so heavy whereby the answers could not be found for off shoring while keeping in mind the key points. There came the need of 2nd level outsourcing. The solution to these problems lies in attaining the benefits of Captive Unit at the price of Third Party vendors and this is required to be dealt with “aptly”.