Why Closely Held Insurance Companies?

One of the best tax-advantaged risk-management tools for businesses is the so-called closely-held insurance company, or "CHIC". These are simply insurance companies that are set up, owned and controlled by business owners to insure their own businesses (and to take advantage of other underwriting opportunities as they present themselves). These are insurance companies, not merely another insurance product.

The reasons why CHICs are such great risk management tools include:

The owner of the business knows exactly the amount and quality of his insurance company's reserves, so that he doesn't have to worry about whether the insurance company has the financial ability to pay claims.
The owner of the business knows that the insurance company will not wrongly dispute claims, pay slowly, or otherwise act in Bad Faith toward the owner's business.
The business is able to obtain certain types of insurance that are not commonly available.
The business can acquire comparable insurance at more favorable rates.
Congress has given very favorable tax treatment to insurance companies, to induce the formation of new insurance companies and to create stronger competition within the insurance market
Favorable Tax Treatment

To promote the use of insurance companies, Congress has given insurance companies -- and especially "small" property & casualty companies -- very favorable tax treatment. The very best tax treatment given by Congress comes in the form of the IRC § 501(c)(15) company. Essentially, so long as an insurance company is: (1) primarily in the business of insurance; and (2) receives less than $350,000 in annual insurance premiums, the company is tax exempt, subject to certain restrictions. This means that the insurance company may obtain the following tax benefits:

Premium Income Received Is Not Taxed - All insurance premiums are received by the company tax-free.

Passive Investment Income Received Is Not Taxed -- This is the really Big Bang for qualifying 501(c)(15) insurance companies. So long as the company continues to qualify under the Internal Revenue Code, its passive investment income is NOT taxed. What this means for qualifying insurance companies, under certain circumstances is that:

Capital gains are not taxed. This means that if a person has a large appreciated asset, whether a large bloc of IPO stock or appreciated real estate, that they could transfer those assets to the insurance company as reserves and surplus, and the insurance company could liquidate and diversify those assets with NO tax immediately payable.

Short-term capital gains, dividends earned by stock held by the company, etc., as reserves and surplus, are not taxed.

Royalty streams, such as income streams from patents, copyrights, and trademarks which have been contributed to the insurance company as reserves and surplus, are not taxed. [Caution: There are very complicated rules for contributing such intangibles to the insurance company, and the failure to follow these rules correctly can lead to unfavorable results.]

All Taxes Deferred -- Although the 501(c)(15) insurance company typically pays no taxes, the owner of the company will pay taxes: (1) whenever a distribution is made or a salary or management fee paid, at ordinary income tax rates; and (2) when the insurance company is sold or liquidated long-term capital gains rates will be paid (assuming the insurance company has been held for a significant amount of time. But note that, at worst, the owner of a 501(c)(15) insurance company has converted ordinary income (premiums received) and non-long term capital gains investment income, into long-term capital gains which are deferred until the company is sold, etc.

CAVEATS

The insurance company tax rules are full of "tax landmines", which you can easily explode if you or your planner are not familiar with this area of the Internal Revenue Code (very few planners have any experience with insurance company taxation). If you hit a "tax landmine" you may end up with worse tax consequences than if you had done nothing at all.

In particular, the 501(c)(15) insurance company is an oddity, because it is a for-profit insurance company which falls into rules for the tax-exempt organizations (such as charities and other non-profit organizations). This creates some additional tax traps, including the following:

It limits the types of assets which can be placed into the insurance company, and the methods of placing them there.

A 501(c)(15) company will be taxed on income from a non-qualifying subsidiary or on other "active" income, i.e., you cannot put an active business into a 501(c)(15) and claim that the income from the business is tax exempt.

The primary business purpose of the insurance company must be insurance, and not some other purpose, such as investing.

The surplus and reserves must make sense based upon actuarial calculations. Simply declaring that the policy premium will be "X" doesn't work.

There are a myriad of state and federal regulatory issues that must be addressed.

CHICs vs. Captives

Certain insurance companies are called "captive" insurance companies because most of the insurance they underwrite is exclusively that of a related business, i.e., the insurance company is "captive" to the insurance needs of the related business. CHICs are not restricted to underwriting insurance for any related company, except in the sole discretion of the common owner, and certain tax and regulatory restrictions. Many CHICs are formed to be stand-alone insurance companies, and intended to grow into separate and valuable profit centers for their owners. Some CHICs may never underwrite so-called related party risks.

Self-Insuring & Third-Party Insurance

An insurance company which shares common ownership with another business may typically underwrite the other business's insurance needs so long as the premiums charged are actuarially (read: statistically) reasonable. The business that is purchasing insurance from the insurance company should -- if the insurance is real and the premiums are reasonable -- get a deduction for the premiums paid. However, for the premiums to be deductible to the other business, the insurance company must also sell some insurance to other unrelated third-parties. The premiums charged must also be reasonable, which is usually proven by way of actuarial assessments. If the premiums are not reasonable, the arrangement is subject to challenge. In the famous UPS case, UPS's captive insurance company charged three times the going rate for a particular type of commonly-available insurance. The Tax Court ruled that the premiums in this context were not reasonable, and disallowed the deduction for the premiums paid.

Location, Location, Location

Many captive insurance companies are formed offshore -- not for tax reasons, as much as avoiding the bureaucracy of state insurance regulators. It is not uncommon for captive insurance companies to actually elect U.S. taxation, so as to take advantage of the very favorable U.S. tax treatment of insurance companies. Keep in mind that although there insurance company is formed offshore, there is no requirement that assets be moved offshore, or placed in the control of an offshore person. Indeed, assets are typically invested in the U.S.

Control, Control, Control

One of the benefits of CHICs is that both the insurance company and the insurance company's assets are kept directly in control by the client as the insurance company's owner. There is no reason or need to obfuscate ownership or control, to or trust some other person with ownership or control.

Beware Shoddy Insurance Company Creators and Managers

Because of the tremendous tax benefits of CHICs, combined with tough new tax rules for offshore corporations and offshore trusts, there has been a steady growth in the number of CHICs formed, and in the number of people who think they have the expertise to create them. Unfortunately, as to the latter, there has been no corresponding increase in quality. Too many "offshore service providers" are now offering CHICs. Their pitch is that they can get a company "licensed", which is mostly irrelevant under the U.S. Tax Code. The IRS simply doesn't care (at least very much) whether the insurance company is "licensed" or not - the key inquiry is simply whether the company is primarily in the business of insurance or not, and not whether the company simply has a license or not. For an insurance company to be in the "business of insurance" it must at a minimum:

Conduct real insurance underwriting to third parties
Spread and share risks
Be staffed with actuaries, underwriters, and insurance managers
Be adequately reserved and capitalized
Have an insurance purpose, and a long-term insurance business plan
To qualify for treatment under 501(c)(15), the insurance company must additionally make a number of difficult elections, and make several key statements on its tax returns. If the company fails to make these elections, it may result in taxation upon capitalization, whether the assets are sold or not. It may also be treated as a Controlled Foreign Corporation (CFC), a Passive Foreign Investment Company (PFIC), Foreign Passive Holding Company (FPHC), or several other types of "bad" tax entities, also with disastrous tax consequences. (If the company makes the correct series of elections, it is treated as a domestic company and thus avoids all the "bad" foreign company tax issues.)

Unfortunately, most offshore providers and unqualified U.S. providers either fail to make these elections, or fail to make these elections in the correct sequence, which as shown leads to potentially disastrous tax treatment. Similarly, a number of U.S. Circuit Court of Appeals cases have definitively established that to obtain the favored tax treatment, the company must underwrite some third party insurance. Thus, one of the most critical steps is to ensure that the insurance company is underwriting real, valid unrelated third-party risks (not some phony offshore IBC that somebody has set up somewhere), and the offshore service providers who have belated entered the "captive" game typically lack the sources and the experience to obtain this type of insurance, correctly evaluate the insurance, or correctly place it into the insurance company. Therefore, unlike regular corporations or trusts, which are relatively simplistic, these insurance companies are complex entities and if you rely on a typical "offshore service provider" to assist you with these types of companies you are likely to come to serious tax grief (despite the "lowball" prices for these companies they are likely to quote you).

Although we have simplified the tax issues above, insurance company taxation is a particularly complex topic - a fact that typical planners fail to grasp. If an offshore trust is the Wright Brothers' biplane, the 501(c)(15) insurance company is an F-15 fighter - sophisticated and capable, but having multiple complex components making it difficult to manufacture and fly. There is a steep learning curve for these companies, and many landmines. The planner who is creating his first couple of companies will more likely than not fail to make the necessary elections, place insurance, or do the dozens of other things which are critically necessary for the company to qualify.