Introduction to Micro Captives & the 831(b) Election

Introduction to Micro

Presenters:

• Tom Ullrich – Captive Resources • Ernie Achtien – Captive Resources

• Matthew Howard – Moore, Ingram, Johnson & Steele • Doug Butler – Moore, Ingram, Johnson & Steele

• Bill Johnson – Moore, Ingram, Johnson & Steele • Joe Herbers – Pinnacle Actuarial Resources

831(b) Election

831(b) Election

Under Section 831(b) of the Internal Revenue

Code, insurance companies that write $1.2 million or less in annual premium only pay income tax on

investment income. This means that underwriting profits can accumulate in the

Qualifying Factors

Qualifying Factors

 First & foremost : this is an insurance company

 $1.2 million ceiling on annual premium income

 Design the insurance to fit individual needs

 Pre-Tax earnings of at least $1.5 million

How does the

captive

work?

7

Captive Insurance Companies

Presented by:

MATTHEW J. HOWARD, JD, LL.M.

MOORE INGRAM JOHNSON & STEELE, LLP

Emerson Overlook 326 Roswell St Marietta GA 30060

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Captive vs. Small Companies



“Captive” means the insureds of insurance

company are affiliated with the owners of the

insured company(ies)



“Small” means the insurance company falls

under one of the sections of the tax code

IRC Sec. 831(b)

 831(b) Alternative tax for certain small companies  (1) In general

 In lieu of the tax otherwise applicable under subsection (a), there is hereby

imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable

investment income of such company for such taxable year by the rates provided in section 11 (b).

 (2) Companies to which this subsection applies  (A) In general

 This subsection shall apply to every insurance company other than life (including

interinsurers and reciprocal underwriters) if—

 (i) the net written premiums (or, if greater, direct written premiums) for the

taxable year do not exceed $1,200,000, and

 (ii) such company elects the application of this subsection for such taxable year.  The election under clause (ii) shall apply to the taxable year for which made and

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CIC Taxation

 Insurance companies with less than $1.2

million of annual premium pay $0 income tax on insurance profits.

 Investment income is taxed as income to C-corporation

 831(b) must be timely elected and cannot be revoked without the permission of the

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

Profitable business pays up to $1,200,000 in

premiums each year



Premiums may be deductible under sec. 162

Profitable

Business

Tax Treatment of Premiums

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Captive Insurance Company – 831(b)

Provides insurance coverage for various

risks

$500k* to $1.2 million of annual insurance

premiums

* Practical not statutory

Business

CIC

Business Owners Business

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Economic Family Doctrine

 Adopted by the IRS in 1977 (Rev. Rul. 77-316)

 Parent corporations and their subsidiaries form an

economic family.

 If the ultimate burden of loss is retained in the family, there

is no risk shifting or risk distribution (requirements to be considered insurance as set forth by the Supreme Court in Helvering v. LeGierse, 312 U.S. 531 (1941))

 Therefore, premium payments are treated as capital

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Economic Family Doctrine

 IRS’ economic family doctrine was not accepted by the courts (See Humana Inc., 881 F. 2d 247)

 IRS abandoned doctrine in Rev. Rul. 2001-31

 Adopted instead a facts and circumstances approach

for determining if transactions constitute insurance (See Malone & Hyde, Inc., 62 F.3d 835, 76 AFTR2d

95-5962 (CA-6, 1995), rev’g TCM 1993-585)

15

Risk Distribution

 Risk Distribution – does the insurance company distribute its

risk to other insureds?

 Rev. Ruls. 2002-89 (50%); 2002-90 (12 subs or no more than 15%

of total premium); 2002-91 (Group Captive-7 unrelated insureds)

 Harper Group and Includable Subsidiaries v. Commissioner, 96

T.C. 45 (1991): Because the CIC had at least 30% unrelated third party risk, the arrangement constituted insurance

 Rev. Rul. 2005-40: risk distribution requirement is met if CIC has

12 or more insureds (10% risk distribution insufficient; DRE disregarded for RD)

 Affiliated companies count, but not single-member LLCs

 Compare to Humana, Inc. v. Commissioner, 881 F.2d 247 (6th

Cir. 1989) in which sums paid to parent company’s Captive Insurance subsidiary, on behalf of several dozen parent

company subsidiaries was sufficient risk distribution to constitute insurance

Achieving Risk Distribution under Revenue Ruling 2002-89 Operating Business A Terrorism Insurance Provider (“Pool”) Operating Business A’s Captive Operating Business B Operating Business B’s Captive Operating Business C’s Captive Operating Business C Operating Business D Operating Business D’s Captive

• Each Operating Business will pay 50%+ of its captive premium to the Pool in return for terrorism coverage.

• The Pool then reinsures its risk with each Operating Business Captive in the same percentage that the Operating business’s premium represents.

Achieving Risk Distribution under Revenue Ruling 2002-90 Related Entity 2* Related Entity 4* Related Entity 3* Related Entity 1* _Related Entity 5* Related Entity 6* Related Entity 7* Captive Insurance Company (“Captive”)

•Related entities pay premiums directly to the Captive for various lines of P&C insurance.

•Each Related Entities premium cannot be less than 5% nor more than 15% of the total premiums received by the Captive.

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Recent IRS Guidance

 December 31, 2004 - IRS releases rulings

showing non-sham, bona fide captive insurance companies (TAMs 200453012 & 200453013)  Rev. Rul. 2005-40, 2005-2 CB 4. A company

Recent IRS Guidance (cont)

 Ltr. Rul. 200644047. An insurance subsidiary insured the risks of

its parent. Although various physicians performing work for the parent were also insured, the Service concluded that the risks insured were essentially that of the parent. (Rev. Rul. 2005-40)

 TAM 200816029. For purposes of applying Rev. Rul. 2005-40,

the common GP of several ltd. partnerships is treated as one insured.

 PLR 200907006. Service concluded that there was adequate risk

Recent IRS Guidance (cont)

 PLR’s 200950016 & 200950017. Service finds reinsurance pools

adequately satisfy risk distribution requirements as provided in Rev. Rul. 2002-90.

 PLR 201030014. Service finds that a Small Captive (831(b)) is

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Why Own a Small Insurance Company?

 Estate Planning

 Best practice: CIC owned by dynastic trust for heirs

 Jurisdiction shopping for unlimited Rule Against Perpetuities:

AK,DE,FL(360 yrs)

 Can structure to allow client shared access to investments

 Buy-out Retirement Planning

 CIC can tie into a business buy-out/retirement plan/employee

benefits

 More tax efficient than traditional methods

 Tax Planning

 Premiums can be tax deductible

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Risk Management Concept

Each business or practice has risks that it currently does not insure against, including:

 Deductibles & co-payments in existing policies:

 Medical malpractice  Excess Liability

 Environmental Liability  E&O, D&O, and others

 Liability risks for which there is no coverage

 Employee claims, partnership liability, government liability, etc.

 Economic risks for which there is no coverage

 Loss of income, revenue cutbacks, loss of key person, loss of a

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CIC with Advanced Planning

Insurance coverage

$500k to $1.2 million premiums

Business

CIC

Owned by

Dynastic Trust for Heirs

Business Owners

Can be structured for efficient estate planning,

retirement access and partner buy outs, etc.

Investment LLC for CIC

Assets

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Buy-Out and Retirement Concept

efficient ways to transfer wealth during buy-ins of younger partners and buy-outs of older ones.

 A business can create an internal buy-out plan using the CIC reserves.

 With particular structures, funds can be accessed by senior (retiring) partners during their lifetime in a tax-favored

manner.

 The total retirement benefit from such arrangements can be significant.

 Operating business or practice will pay tax deductible

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Tax Planning Benefits

 Assuming premiums are market comparable or can be valued by an actuary

2. Taxation of CIC’s profits

 831(b) provides tax exemption from premium tax and from underwriting profit.

 831 (b) must be elected timely and cannot be revoked without permission of Secretary

 Federal Tax on investment income only 3. Retirement

 Certain investments and structures could allow client to access CIC invested funds tax efficiently.

4. Estate/Gift Taxes

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 Premiums and policies must be market-comparable  Actuarial support needed

 Insurance formalities complied with  Risk distribution must be present

 Initial Capitalization required

 4:1 (premiums to capital) with certain minimums  Gift tax return Form 709

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Domicile Considerations



Form CIC in US Domicile, which would include

several states such as KY, DE, HI, UT or MT.



Favorable Captive legislation regarding fees and

investment options

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Captive Insurance Company Policies

 Everything a business currently self-insures:

 Deductibles

 Excess losses above coverage limits  Environmental Liability

 Loss of income as a result of:

 Losing key employee/salesperson

 Loss of license/professional risks (professionals)  Loss of a key contract (Gov’t. contractors)

 Weather, terrorism, etc.

 Liability defense expenses:

 Employee lawsuits – sexual harassment, wrongful termination,

discrimination, etc.

 Environmental issues  Professional claims

Examples of Captive Insurance

Policies Written

 Professional liability Gap Coverage  HIPAA/Billing Audit Liability  Contractual Liability

 Cyber Liability

 Environmental Liability

 Excess Environmental Liability  Labor Shortage/Strike Loss

Reimbursement

 Employment Practices  Employee Dishonesty

 Patent Infringement/Intellectual Property

 General Liability Gap

 Property Management Professional  Professional Misconduct

 Product Recall

 FDA Administrative Actions Liability  Product Liability Gap

 Directors and Officers Liability  Punitive Damages

 Loss of Key Employee

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Greater Leverage for Larger Clients

 Each child (or trust) can own one CIC (children under age 21 are attributed to their parent)

 Client can still be the manager of the CIC and control the investments of CIC

 Effectively, this option saves current income taxes (35%-47%) to client and future estate taxes (35%) on net proceeds

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Highly Profitable Business

Insurance Company #1

Trust for Child #1 or for Children

of Owner #1

Insurance Company #2

Trust for Child #2 or for Children

of Owner #2

Insurance Company #3

Trust for Child #3 or for Children

of Owner #3

Parent’s Business could pay up to $1.2 million per year into EACH child’s CIC or into a CIC for each owner’s children. §1563 attribution rules apply . Children under age 21 are attributed to the parent.

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Real Life Example – Results

Do Nothing with $1.2M

 No risk management, profit, asset protection, buy-out/retirement

benefits of CIC

 Earn money, income taxes  Taxable/tax deferred

investments

 Die, pay estate taxes

CAPTIVE 831(B)

Risk management, profit, asset protection, buy-out/retirement benefits of CIC

 Create dynastic trust to

own CIC

 CIC invests in tax

deferred investments

 Tax efficient

Income Tax with No Captive

Filing Status Joint Joint Joint Personal Exemptions 2 2 2

---Ordinary Income 1,200,000 1,200,000 1,200,000

---Adjusted Gross Income 1,200,000 1,200,000 1,200,000

---Standard Deduction 11,600 11,600 9,650

---Taxable Income 1,181,000 1,181,000 1,190,350

---AMTI Net of Exemption 1,200,000 1,200,000 1,200,000

---Schedule or Table Tax 383,222 383,222 435,439 Tentative Minimum Tax 332,500 332,500 332,500

---Net Federal Tax 383,222 383,222 435,439

---State Tax 71,560 71,560 71,560

Income Tax Benefits with Captive

Year 1 Year 2 Year 3 Cash Non-Captive Scenario

Premiums 1,200,000 1,200,000 1,200,000 3,600,000 3,600,000 No Premium paid

Savings Tax (tab 2) 460,000 460,000 510,000 1,430,000 (1,430,000)Tax Costs

Mgmt Fees (90,100) (83,500) (83,500) (257,100) Tax benefit 36,040 33,400 33,400 102,840

Net Savings 405,940 409,900 459,900 1,275,740

Projected Earnings @ 3% 36,000 36,000 - 72,000 151,900 Earning @ 7% on after tax dollars

Projected Cash Balance Prior to liquidation 3,517,740

Capital Gain Tax on Liquidation (703,548)

Net Cash Available 2,814,192 2,321,900

Estate Tax Obligation - (812,665)

Net Cash After All Taxes 2,814,192 1,509,235

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MIJS Implementation Team

 MIJS Captive Management, LLC, KY LLC

 Matthew J. Howard, JD, LL.M., Senior Tax Partner, Moore

Ingram Johnson & Steele, LLP

 Bill Johnson, JD, liability attorney; Moore Ingram Johnson

& Steele, LLP

 Alec Galloway, JD, liability attorney; Moore Ingram

Johnson & Steele, LLP

 Douglas W. Butler, Jr, JD, corporate/trusts and estate

Matthew J. Howard, JD, LL.M,

MIJS, LLP Partner

William R. Johnson

MIJS, LLP Partner

Bill has been a practicing attorney since 1983 and involved with

insurance coverage and captive insurance companies since that

Alexander T. (“Alec”) Galloway III

MIJS, LLP Partner

Alec has been a practicing attorney since 1993 and involved with

insurance coverage and captive insurance companies since that

Doug W. Butler

Doug worked in the life insurance

industry before becoming an attorney in 2009. Since that time he has worked in MIJS’s corporate and tax

departments and has been involved in formation and management of all of MIJS’s micro captive insurance

Adon J. Solomon

Adon has been practicing law since 2008 and joined Moore Ingram

Johnson & Steele in 2010 focusing his practice in the areas of trusts and

estates, tax and asset protection

planning, along with assisting clients in the formation and management of

Bram L. Scharf

Bram was admitted to practice law in Florida on January 5, 1995. As part of the Captive Insurance Team at

Insured

Captive Resources

Captive Resources

 Independent consultant to the captive

 Coordinate/oversee all activities and service providers

 Underwriting coordination and assist in pricing development

 Financial services- oversee financial process and tax reporting

 Board meeting facilitation

 Develop and implement program enhancements

Captive Flow

Captive Flow

Broker

 _{Oversees insurance program}

 Provides Current Policies to MIJS  Bills premiums

 Prospect development

Pinnacle Actuarial Resources

 Leading U.S. Property & Casualty Actuarial Consulting Firm

 Actuary to all Captive Resources/Kensington group captives

 Key Personnel

Joe Herbers Rob Walling Managing Principal Principal

 Microcaptive/831(b) Services

 Funding Studies to 831(b) and Pooling Mechanism

 Loss Reserve Analyses

what is my

investment?

Capitalization

Capitalization

Capitalization

Cash or Letter of Credit (“LOC”) Minimum 4:1 Ratio

$1,000,000 Premium $250,000 Capital*

About the Captive

About the Captive

 Annual Board meeting conducted via teleconference

 Focusing on DE as common domicile

 Owner of captive need not be insured corporation

 Investments individually managed, but must meet regulatory guidelines

 Utilizing Ernst & Young for 831(b) tax preparation

what’s

Underwriting Process

Underwriting Process

 Copies of All Current Policies

 Complete MIJS Application

 Company Brochures

 Current Financial Statements

(With Current Clients’ Consent we can have these forwarded by John Flanagan)

Underwriting Process

Underwriting Process

Expenses

Expenses

 Initial feasibility study at no charge

 Implementation costs: $85,000 to $90,000

 Annual costs: $80,000 to $85,000

your

questions?

53

Captive Insurance Companies:

Frequently Asked Questions

Presented By:

Matthew J. Howard, JD, LLM

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Frequently Asked Questions

 Q: What is the minimum number of affiliated entities I need to have to achieve adequate risk distribution? What happens if I do not have enough affiliated

entities? Can I still utilize a Micro-Captive?

 A: An insured with at least 7 entities can achieve

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Frequently Asked Questions



Q: Can my Micro-Captive insure the risks of

unaffiliated entities or entities affiliated with a

Group Captive program I participate in? Could

this help me achieve adequate risk distribution,

if allowed?



A: Yes. Most of our Captives enter into a

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Frequently Asked Questions

 Q: Does my company need to pay the full $1.2M in premiums

a year to the Micro-Captive? What is the minimum amount my company can pay for the Micro-Captive planning to make sense? What if my company can pay over $1.2M in premiums?

 A: The election under IRC Sec 831(b), which permits

premium income to be tax free, requires that the annual net premiums be $1.2M or less. The commitment is year to year under a 12 month policy of insurance. Therefore the amount paid by the operating company, as well as the insurance

coverage can change from year to year. There is no minimum and a business can take up to three years grace period of

paying zero premium and keep the captive in place. We

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Frequently Asked Questions



Q: Are there any requirements as to what type

of entity the Insured must be (C-Corp,

Partnership, LLC)? Does the Micro-Captive

have to be a C-Corp?



A: No. The insured can be any type of entity. C

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Frequently Asked Questions

the Insured the owner? Can the Shareholders of the Insured be the owners? Can key employees or other individuals or entities be an owner?

 A: Anyone can own the Captive. Most of our clients have their captive owned partially or entirely in a

dynasty trust for their heirs to take advantage of the tremendous benefits in avoiding estate and gift tax laws. A captive owned by an LLC with the key

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Frequently Asked Questions

Micro-Captive? Can the Micro-Captive be owned by the ESOP?

 A: Yes. It makes the most sense for a company that is partially owned by an ESOP. Most ESOP owned

companies are S Corps and an S Corp owned 100% by an ESOP is not subject to tax so the 831(b)

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Frequently Asked Questions

insurance risks or liabilities the Micro-Captive can insure? Are there any types of businesses of an

Insured that would disqualify it from setting up a Micro-Captive?

 A: A captive can insure any uninsured risk of any

operating business. As long as there exists a “fortuity of loss” than such loss can be insured. Fortuity, a

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Frequently Asked Questions



Q: Can a Micro-Captive write policies to insure

fines levied by the state or Federal government

(such as OSHA or EPA fines)? Can the

policies insure punitive damages?



A: Yes. These are all insurable and types of

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Frequently Asked Questions

 Q: Can health insurance premiums be included in the Micro-Captive planning? Would it be appropriate for the Micro-Captive to provide Umbrella coverage or excess Umbrella coverages?

 A: No, primarily for two reasons: 1. State laws require certain regulations that would prohibit a micro

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Frequently Asked Questions



Q: What is the role of an agent or broker when

setting up a Micro-Captive?



A: They play a helpful role in helping us

identify uninsured risks of the business and

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Frequently Asked Questions

 Q: What can be done with the premiums received by the Micro-Captive? Can these funds be invested? Are their limitations as to the investments? How are

investments taxes to the Micro-Captive?

 A: The premiums received by the Captive are

invested by the Captive owners. We do not provide investment advice but can certainly make needed

introductions to investment experts. The States we work in, like Delaware, are very liberal in what the captive can invest. The Captive does have to pay

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Frequently Asked Questions

Captive set up? What happens to the Micro-Captive? Can a publicly traded company set up a Micro-Captive?

 A: The Captive usually just ceases to be a licensed insurer and is then a regular corporation with

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Frequently Asked Questions



Q: Who are the other members of the

reinsurance pool? Do we have the opportunity

to exclude members if we feel they are too

great a risk?



A: Our other Captive clients who need risk

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Frequently Asked Questions

domiciled in a US jurisdiction (such as Delaware)

versus a company domiciled offshore (such as in the Cayman Island)

 A: The main difference is the State domiciles are more strict and have more regulations to follow. There is the opportunity for abuse with a micro captive (unlike the large group Captives) and

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Frequently Asked Questions

the Micro-Captive? Who manages the Micro-Captive and ensure it functions correctly and remains in

compliance with all state and federal laws?

 A: Our management company, MIJS Captive

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Frequently Asked Questions



Q: Are there additional capital contributions

required beyond the $250,000.00 initial capital?

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Frequently Asked Questions



Q: What is an estimate of the typical ongoing

fees to maintain the Micro-Captive?



A: $76,000/yr for everything including the