Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at a question about what are 831(b) Captive Insurance Companies (CICs), whether they are a legitimate planning strategy or just an insurance scam, and what to watch out for and consider.
Comment/Question: I just had a client stump me yesterday by asking what I thought about him forming an 831(b) Captive Insurance Company. I didn’t feel too stupid because his corporate attorney had never heard of such a thing either. I've since done some research on it, and found this apparently reliable source online from the NY Times, but was wondering if this is a strategy you have ever come across or evaluated for your clients?
Indeed, the 831(b) captive insurance company (CIC for short) is definitely a legitimate strategy, though CICs have generally been the domain of much larger businesses and are only more recently coming “downstream” in the past few years. That NYTimes article does a very good job covering them, and Jay Adkisson (cited heavily in the article) is a very high quality and credible source on the subject.
As the article notes, the basic concept of a CIC is pretty straightforward - instead of paying premiums to an insurance company to cover your risks, you pay the premiums into your own "captive" insurance company instead. The premiums may not be any different, but to the extent that you don't have any claims (and/or the claims are less than the premiums), the excess profits flow back to you as the owner of the CIC, instead of the shareholders of a publicly traded insurance company. In some cases, the CIC might be owned by the next generation as a way to indirectly transfer money/value to them from an estate planning perspective. In other scenarios, it's simply a way for profits of the main business to be redirected to the CIC and then distributed from the CIC as a dividend (which may be more favorable than drawing the profits directly from the original business, especially if it's a pass-through entity subject to ordinary income tax rates), or maintained in the CIC in a more asset-protected manner. And small CICs with less than $1.2M in premiums have some tax preferences of their own to mitigate the impact of double-taxation of the CIC (once at the corporate level and again as a dividend). Sometimes a CIC is simply a way to try to insure a risk that can't otherwise be insured in the marketplace.
The primary challenge to these in mind my is simply the acknowledgement that ultimately, all you’re doing is setting aside your own money to pay your own claims. That’s only insurance in the loosest sense of the word. As a business owner, I can put aside $100,000/year (or whatever amount I want) into my “emergency reserves” or into my CIC, but the fact remains that if I have a $100,000 expense/claim because something bad happens, whether I liquidate my emergency reserves or take a claim from my CIC, all I’m doing is spending my own money. And with CICs, they're often billed as a way to "save" on insurance premiums, but there can be a risk that, for serious events, the CIC might not have enough in premiums set aside yet to even cover the claim, in which case the client is in serious trouble with what is essentially an undercapitalized insurance company (at least if the CIC didn’t reinsure, and while reinsurance can often be obtained at cost-effective rates for the risk, it's yet another cost that reduces the relative efficacy of the strategy). In general, be very wary of tax schemes that do nothing more than help people pay their own expenses with what would have been their own money in the first place. Yes, you can make deductible contributions to the CIC and receive the claims tax free, but the net is that may ultimately be the exact same result as just keeping the money and using it in a deductible manner for the business expense (that was paid as a claim) anyway.
The appeal for larger organizations is that insurance is generally run on a for-profit basis, has some administrative costs, and can be reasonably predictable in large numbers – those are situations where a larger company having a CIC becomes appealing. In the very small business owner context, I’m still largely unconvinced. I rarely find the tax savings – which ultimately is just tax deferral, and maybe converting some income from ordinary to qualified dividends – is really worthwhile, unless literally the business already pays hundreds of thousands (or millions?) in insurance premiums for various risks (which is true for a 100-person company but not a 5-person small business and certainly not a sole proprietor). As the NY Times article notes, a lot of these are pitched from a pure tax perspective, and most I find don’t hold up at all once the math is really scrutinized, unless it’s a business with many millions in revenue (by the time there's a million+ in insurance expenses already the math starts to get interesting). The fatal flaw is the setup and ongoing costs of the insurance company (which the NY Times article notes can be $25,000 up front for setup and $36,000 annually to maintain!), often to just get a tax deduction that the business would have gotten just by keeping the money and spending it on future needs anyway - again, unless the business is sizable, administrative costs can be managed, and claims can get reasonably predictable.
Done right, though, the 831(b) captive insurance company strategy is definitely legitimate, and can work. I've seen a number of scenarios for businesses with dozens or a few hundred employees, and a few million of profit (on tens of millions of revenue) where the math worked and it made sense. But for a lot of “mere millionaires” scenarios (i.e., businesses $1M to $5M of value on what may only be a million dollars or less of profits, and not all that much really spent on insurance premiums anyway), it's harder to find scenarios where numbers ultimately hold up and are justified once accounting for the costs and recognizing that the strategy often doesn't save taxes but merely defers them (which isn't worth nearly as much).
For an extended credible source on the subject, I highly recommend Jay Adkisson's "Captive Insurance Companies: An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups" book. Adkisson also supports an additional database and forum for information on CICs here.