Dont Be Held Captive: Go Captive to Manage Your Risk and Expenses

Presented by
Stuart Anolik, Esq. Managing Director, CBIZ MHM, LLC.

Strategic Edge Series

Seven Core Principles to Maximize the Value of Your Business During Its Life and Upon its Sale May 18th Creative Compensation Strategies to Maintain Morale and Retain Talent June 22nd Dont Be Held Captive: Go Captive to Manage Your Risk and Expenses July 20th Federal Incentives That Can Show You the Money August 17th Protecting Your Legacy with Succession Planning September 21st State Tax Nexus: No Physical Presence Required October 26th

All these webinars are from 2:00 3:00 ET. Here is the link for registration for any of these webinars - www.cbiz.com/strategicedge
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Agenda
1. 2. 3. 4. Introduction to Captive Insurance Why CBIZ Tax Issues Related to Captive Insurance Opportunities

Definition of a Captive
An insurance company owned and controlled by its policy holders.

Captive Illustration
Owner

Premiums Operating Business (Insured) Insurance Policies Captive Insurance Company (Captive)

CBIZ MHM Captive Insurance Services

CBIZ MHM is uniquely qualified to provide turn-key consulting services in regard to captive insurance as a result of its expertise in (i) accounting and tax for captive insurance companies through its Financial Services group and (ii) property and casualty insurance services through its Employee Services group, which includes our property and casualty professionals. CBIZ MHM can therefore develop and implement captive insurance solutions for traditional insurance coverages as well as for supplemental or non traditional coverages such as business interruption

Captive Benefits
Reduced Insurance Costs: Retention of underwriting profits Claims Settlement Casualty premiums are deductible Self-insurance is funded with after-tax dollars. Risk Management: Customized coverages. Not available in commercial markets Overly expensive Claims Management Wealth Preservation: Asset protection Owner control of stand-alone captive Flexible ownership structure

How Does Captive Insurance work?

Independent actuary determines premiums Independent actuary underwrites coverages Generally, casualty premiums are tax deductible Owner directs investments Insured submits claims to captive Captive controls claims management and settlement Owner retains underwriting profit and investment income Dividends can be paid to owner

Examples of Non Traditional Risks

Accounts Receivable Administrative actions Business interruption Deductibles/Exclusions Earthquake Intellectual Property Litigation expenses

Loss of key customer Loss of key employee Loss of key supplier Mold Product recalls/warranty Subcontractor default Terrorism

Tax Implications

Insurance companies, including Stand Alone Captives

Anticipated loss reserves (subject to certain discounts) allowed as a deduction against underwriting income and investment income Have up to $1,200,000 Premiums. Are taxed on investment income and NOT underwriting profits - Tax rate is 36%. See IRC Section 831(b). Beneficial for most medium sized companies.

Small P&C Companies

Key Issue: Premium Deductibility

Treas. Reg. Section 1.162-1(a): Business expenses deductible from gross income included the ordinary and necessary expenditures directly connected with the taxpayers trade or business. Among the items included in business expenses are advertising and other selling expenses, together with insurance premiums. No definition in the Internal Revenue Code or regulations of insurance. Rely on judicial interpretation-Helvering v. LeGierse, 312 U.S. 531 (1941), must be risk shifting and risk distribution of insurance risk. Self Insurance is not deductible, unless loss sustained.

Risk Shifting and Distribution

Risk Shifting- the transfer of the risk to separate party Risk Distribution- enough independent risks are being pooled to invoke the actuarial law of large numbers (e.g., spread risk among a large group)

Risk Shifting
Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by the insurance payment IRS will look to facts and circumstances Parental Guarantees

Risk Distribution
Pooling of Premiums Risk distribution entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks When a company insures unrelated risks, the arrangement constitutes insurance if a significant percentage of unrelated risks exists See, Ocean Drilling & Exploration Co, 988 F2d 1135, 1152-53 (Fed Cir 1993); Sears, Roebuck & Co, 96 T.C. 61, 100-02; Harper Group v Comr, 96 T.C. 45, 58 (1991) Brother-sister subsidiary corporations (i.e., subsidiary corporations of the same parent) may establish an arrangement and qualify as insurance for federal income tax purposes even if there are no insured policy-holders outside the affiliated group so long as risk shifting and risk distribution are present Rev. Rul. 2008-8 citing Humana, Inc, 881 F.2d 247 (6th Cir 1989); Kidde Industries v US, 40 Fed Cl (1997); Rev. Rul. 2002-89 A parent corporation with a direct arrangement with its own insurance subsidiary will still require sufficient risk pooling See Humana, Inc, at 257 (6th Cir 1989)

IRSs Historical Position The Economic Family Doctrine

Rev. Rul. 77-316, IRS position that risk shifting and distribution do not exist in the context of a single economic family (i.e., parent-subsidiary) Exception: In Rev. Rul. 78-338, the IRS conceded that sufficient risk shifting and distribution are present where 31 unrelated parties pool risks In Rev. Rul. 2001-31, the IRS abandoned its position that risk shifting and distribution do not exist in the context of a single economic family It now appears arms length premium and loss reserve deductions attributable to brother-sister risk (i.e., other affiliates of the parent) will be accepted by the IRS But premium and loss reserve deductions attributable to parent risk will not be allowed without presence of significant unrelated party risk measured by premiums (30%?)(50%?)

Revenue Ruling 2002-89 Unrelated Risk Ruling

Single parent captive otherwise properly formed and operated (adequate capital, no parent guarantees, loan backs, etc.) Not insurance if 90% of risks/premiums come from the parent Insurance if less than 50% come from the parent and the remainder are from unrelated parties

If your captive can have 50% 3rd party risk, may apply for a favorable tax ruling from IRS

Revenue Ruling 2002-90 IRS Sibling Ruling

Single parent captive otherwise properly formed and operated (adequate capital, no parent guarantees, loan backs, etc.) Insures 12 domestic subs - parent a holding company; no sub accounts for less than 5% or over 15% of total risk/premium Insurance under brother/sister doctrine

Revenue Ruling 2002-91 Group Captive Ruling Facts:

Industry group liability captive; exact number of participants not specified No member owns over 15%; has over 15% of vote; or accounts for over 15% of risk/premium; implies 7 equal owners OK No assessments or refunds Valid non-tax business purpose was a key factor IRS reinforces prior rulings on group captive insurance arrangements

IRS Holding: Captive constitutes an insurance company and premiums paid by participants are deductible

Revenue Ruling 2005-40

In Ruling 2005-40, the IRS gave four situations showing specific examples of what did or did not represent insurance

In situation 1, the IRS said there was no insurance if there is only one insured The same is true if there are two insureds - - one of which has at least 90% of the insurance

This was true for Situations 1 and 2 even if the parties were completely unrelated and all formalities were otherwise met The IRS ruled that single member LLCs that are disregarded for all other tax purposes are not counted as insureds Showed that single member LLCs that elect to be treated as corporations are counted as insureds

Caveats
The captive must still establish:

Presence of risk distribution That the captive should be respected as a separate and distinct taxable entity, i.e., it is not a sham

Non-Sham Status

Insurance status continues to require respect for the captive as an entity separate and distinct from its economic family:

Valid non-tax business purpose Adequate capitalization No parental support agreements Limited loan backs of captive assets to parent or affiliates (circularity of cash flow) Formation of captive in other than a weakly or non-regulated offshore domicile

Notice 2005-49

In Notice 200549, the IRS asked for public comment on:

the circumstances under which qualification of an arrangement between related parties as insurance may be affected by a loan back of the amounts paid as premiums.

Notice 2005-49

The comments state that if each of these four factors are present in a loan back, there is insurance (if insurance otherwise exists):

Bona fide indebtedness (enforceable; reasonable terms and rates; appropriate security) Permitted or approved by the regulators Sufficient liquidity of the insurance company Sufficient liquidity of the borrower

Notice 2005-49

If less than all four factors are present, the comments state that the facts and circumstances must be reviewed to determine if the investment function undermines the essence of insurance

Cell Company Structure

POOLED LAYER - CORE CAPITAL

Cell A

Cell B

Cell C

Cell D

Cell Captives-Revenue Ruling 2008-8

IRS guidance of when a cell of a protected cell company can enter into a transaction which is treated as insurance for federal income tax purposes, and when amounts paid to these cells is deductible as insurance premiums under Section 162. Example 1: X, a corporation that owns Cell X, enters into a contract hereby Cell X insures professional liability risks of X. Cell X does not enter into any arrangements with entities other than X. IRS finds the arrangement between X and Cell X is akin to a parent and its wholly owned subsidiary, and in the absence of unrelated risk, lacks the requisite risk shifting and risk distribution to constitute insurance.

Cell Captives-Revenue Ruling 2008-8

Example 2: Y, a corporation, owns all stock of Cell Y, as well as all the stock of 12 subsidiaries. (Mirrors facts of Rev. Rul. 2002-90). The 12 subs have a significant volume of independent, homogenous risks, insured into Cell Y. No sub has coverage for less than 5% nor more than 15% of the total risk insured by Cell Y. IRS finds the subsidiaries have shifted the liability risks to Cell Y. The premiums are pooled such that a loss by one sub is not in substantial part paid from its own premiums. Had the subs of Y entered into identical arrangements with a sibling corporation that was regulated as an insurance company, the arrangements would constitute insurance and the premiums would be deductible under Section 162.

Captive Insurance Companies IRS Notice 2008-19

Notice 2008-19 requests comments on further guidance to address issues that arise if those arrangements do constitute insurance The Notice provides guidance that would address (a) when a cell of a Protected Cell Company is treated as an insurance company for federal income tax purposes, and (b) some of the consequences of the treatment of a cell as an insurance company. The proposed guidance would include a rule that a cell of a would be treated as an insurance company separate from any other entity if: the assets and liabilities of the cell are segregated from the assets and liabilities of any other cells and from the assets and liabilities of the Protected Cell Company based on all the facts and circumstances, the activities of the cell, if conducted by a corporation, would result in its being classified as an insurance company within the meaning of 816(a) or 831(c).

IRS Notice 2008-19

Effect of insurance company treatment at the cell level under the proposed rule: Any tax elections that are available by reason of a cells status as an insurance company would be made by the cell; The cell would be required to receive an employer identification number (EIN) if it is subject to U.S. tax jurisdiction; The activities of the cell would be disregarded for purposes of determining the status of the Protected Cell Company as an insurance company for federal income tax purposes; The cell would be required to file all applicable federal income tax returns and pay all required taxes with respect to its income; and A Protected Cell Company would not take into account any items of income, deduction, reserve or credit with respect to any cell that is treated as an insurance company under the proposed rule making.

Internal Revenue Bulletin: 2010-45 November 8, 2010 - Series LLC

IRS issued proposed regulations regarding the classification for Federal tax purposes of a series of a domestic series limited liability company (LLC), a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business. The proposed regulations provide that, whether or not a series of a domestic series LLC, a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business is a juridical person for local law purposes, for Federal tax purposes it is treated as an entity formed under local law. Classification of a series or cell that is treated as a separate entity for Federal tax purposes generally is determined under the same rules that govern the classification of other types of separate entities. The proposed regulations provide examples illustrating the application of the rule.

Foreign Captives

A Foreign Captive pays US Income Taxes.

Sec. 953(c)(3)(C) and(d) election

If the Captive is an offshore domiciled insurance company a Sec. 953(d) election to be taxed as a US Insurance Company may be made. It has these advantages:

Captive is NOT a Controlled Foreign Corporation US tax rates for Insurance Companies are as low as 15% No Federal excise Tax, Pass-through of income or Branch Profits Taxes Captive becomes a U.S. domestic corporation for all purposes of the U.S. tax code Captive files U.S. tax return and pays income tax (Form 5471 no longer required for shareholders) Eliminates U.S. trade or business concerns

Estate Planning Opportunities

Initial Presumptions:
The fundamental presumption in captive insurance planning is that the client has substantial non-tax insurance needs that can be satisfied by a captive without regard to any potential tax benefits. Thus, captives must serve a valid business purpose and should provide significant cost savings. The following discussion only outlines the potential ancillary estate planning benefits of a captive formed for substantial non-tax casualty, loss and liability purposes. The discussion assumes that the captive is formed properly and operated and is respected as an insurance company for federal tax purposes and that premiums paid to the captive are arms length and determined in accordance with proper underwriting standards.

Estate Planning Opportunities

Family Dynasty Trust
Independent Trustee
Trustee uses trust funds to create and capitalize captive as sole owner

Creates and funds trust

Client

Build up in value benefits trust. Unused reserves can be distributed to trust as dividends.

Captive
Pays premiums to captive (deductible; not subject to gift tax)

Client Company

Estate Planning Opportunities

Potential Transfer Tax Benefits:
Reasonable premiums paid by the insured to the captive should not create gift, estate or GST tax exposure to the insureds owner.
The premiums, however, must constitute full and adequate consideration for insurance coverage (e.g., arms length and determined in accordance with underwriting standards).

When the insureds actual claims are less than actuarially predicted, the captives reserves will grow.
If family members directly or indirectly own shares in the captive (e.g., through the dynasty trust structure), they benefit from this increase in value without any transfer tax liability.

In addition, the captive can distribute unused reserves to the captive shareholders (e.g., the dynasty trust) as a dividend (currently taxed at capital gains rates) or as a capital gain distribution upon complete liquidation of the captive.
The trust can distribute the income, if needed, for the trust beneficiaries.

Why CBIZ
CBIZ MHM has both the insurance expertise through its Employee Services (which includes our Property and Casualty professionals as well as the tax and accounting expertise to provide clients with fully integrated and seamless captive insurance services that are truly turn-key

Courtney W. Claflin joined CBIZ in January 2011. He has a 28 year career in Commercial Insurance Sales and has successfully designed hundreds of Alternative Risk Arrangements
Courtney brings with him a team of specialists to further CBIZs expertise in the captive insurance area.

Summary/Key Takeaways
Captive insurance solutions provides mid sized companies the benefits of maintaining underwriting profit in its group, control over risk management matters, control over claims management, thus creating potential significant savings in its costs of insurance Captive insurance provides mid-sized companies with flexibility in ownership thus allowing potential estate and wealth preservation opportunities CBIZ can provide a seamless, turnkey captive insurance solutions due to its expertise in (i) insurance tax and accounting and (ii) property and casualty and alternative risk

QUESTIONS?

CBIZ MHM, LLC Contacts

Stuart Anolik
Managing Director 301.951.3636 sanolik@cbiz.com

Thank You