Last time I wrote about Bill, a successful businessman making between $300,000 and $500,000, but who was still struggling to make ends meet. He was able to reduce his tax bite by forming a family “C” corporation.
On the other end of the scale are the big multi-national companies like Exxon and Apple, that put away billions of dollars in untaxed profits. They do that by setting up companies in low or no-tax countries, and allowing the profits of those companies to remain there. If they repatriate those profits they must pay U.S. tax on them. Some legislators are now suggesting a tax holiday for those funds on a one-time basis, to get the trillion dollars or so sitting out there untaxed back into the United States where at least the profits on those funds will eventually be taxed.
But others are looking for a legal way to tax profits in another country. That’s not so easy. Between these two prominent tax-saving opportunities is one that many of the large public companies also use, but is also suitable for smaller companies or even individuals that earn a million dollars or so, at least substantially more than they need for living purposes. This is called a “captive insurance company.”
At one time your legislators decided to put into law an incentive for companies to insure against risks that normal insurance companies will not insure. For example, it would be difficult or impossible to find an insurance company that would insure against the risk of losing your major client. And many malpractice companies have limits of around $3 million, while the risk of a larger judgment against a brain surgeon or large law firm might be much greater.
So the law allows an operating business to establish its own insurance company. Let’s, for example, take the All States Shipping Company, or “All” for short. All is very successful and earns about $3 million net each year after paying a handsome salary to its owner, Sam, who is also the president and chairman of the board. All has been paying about $1 million in tax, and investing the balance each year. To reduce this tax bite, on the advice of its attorney, All has set up a captive insurance company in Delaware. It could have set it up in a number of states, or even in an offshore jurisdiction like Puerto Rico or the Bahamas. However, Delaware has friendly captive legislation, an efficient Department of Insurance and low fees. The cost of setting up the captive was about $50,000, which was tax deductible.
In that same year, All paid $1.2 million as a premium to its captive insurance company. The stock, and therefore the ownership of the captive company, is held by Sam’s family trust. Due to the payment of the $1.2 million premium, All’s state and federal taxes were reduced by about $400,000.
Under the Internal Revenue Code provision governing captive insurance companies, none of the $1.2 million is taxable to the captive. This process can continue each year. Sam plans to continue it for 10 years, by which time All will have saved $4 million in taxes. With any luck, the captive will not have to pay much in claims because the risks it insures are unlikely to occur. Also, All is not required to make claims. So at the end of 10 years there should be about $12 million on hand, plus the after-tax profits it earns from its cash on hand. At an average of $6 million per year invested, earning perhaps 5 percent, that would be an additional $300,000 in after-tax dollars per year, or another $3.6 million, for a total estimated cash on hand (or investments) of $15.6 million dollars. During the 10-year period there will have been annual maintenance costs of, say, $600,000, so about $15 million should be left. Without the captive, All could have invested about $800,000 per year and ended up with $8 million plus about $2 million in after-tax profits, for a total of $10 million in after-tax dollars.
At the end of the 10-year period, Sam can liquidate the captive and pay a capital gain tax on the cash and assets distributed to his trust. The tax will be at the advantageous capital gain rate, which is currently under review but can be estimated to be about 20 percent (federal only) in years to come, or about $3 million, leaving about $12 million instead of $8 million without the captive.
The bottom line is that there was a 10-year period where substantial taxes were deferred and used to build up assets in a wholly owned corporation. The taxes, when paid, were at a rate roughly one-half of what would have otherwise been paid. All was able to take advantage of a very favorable tax provision in the current law. And, as we all know, a penny saved is at least a penny earned.
In addition to income taxes, there are other potential benefits. For example, instead of having Sam’s family trust own the captive, Sam could have the captive owned by his children’s trust. That means that, in effect, each year’s $1.2 million premium was a disguised gift from Sam to his children. As a result, the entire $15 million would be outside of his taxable estate, saving $6 million in estate tax. Also, the $15 million in the captive would be protected from creditors of Sam, All, and his children, a wonderful benefit in our litigious society.
All in all, a tremendous combination of potential benefits.
For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.