Succession Planning after ATRA 2012 – Captives With Exit

By September 16, 2013 October 25th, 2018 Business Blog, Fred Whitaker

Fred Whitaker

Throughout the previous blog posts, we have been examining the use of a Captive Insurance Company – specifically, Internal Revenue Code Section 831(b) small insurance company captive to save current taxation.  In summary, you can self-insure company risks and pay premiums to your own wholly owned insurance captive.  Instead of paying tax on profits, you receive a deduction for premiums.  Your Section 831(b) small insurance company is allowed to earn up to $1.2mm per year in premiums without paying any federal income tax on them.  It only pays tax on the investment income.

Last blog post, we showed that life insurance can be a tax efficient investment vehicle for the Captive.  Since the premiums paid to the Captive are not taxed, but the investment income is taxed, tax free growth inside a life insurance policy can be very attractive.  This month we will wrap up the discussion of Captives with exit and succession planning.  In other words, several years down the road, how do we tax efficiently exit?

When an insurance company has no claims and builds up too many reserves, it is required by law to do one of two things – provide return premiums to the insured, or pay dividends to the shareholders.  If we return premiums to your operating company that creates taxable income where we took a deduction.  Not very efficient. It can work when you need cash back in the operating company and don’t mind the taxable income.  The deferral of taxation has some value. However, the best exit strategy is to instead pay a dividend to the shareholders of the Captive.  In the top income tax brackets under ATRA 2012, the Federal tax rate is 20%.  You just took profits taxable at 39.5% Federal and paid no tax on them for several years, then took them out at almost 20% less in taxation.   If the next generation are the owner’s of the captive, we have added succession to the exit by moving the without the 40% gift and estate tax.  We also protected it from your creditors.

The final exit/succession benefit is in the transition. If you intend to pass the operating company down to the next generation, the years of premiums depressing earnings have depressed the value, helping reduce estate and gift tax and/or lowering the sales price.  If you intend to sell to a 3rd party, you can demonstrate the free cash flow from discontinued premiums, increasing the sale price. So you took out profits without tax, but can still harvest the value.   Nothing in the current law beats captives for the amount of tax value.

In my next blog post, we’ll look at the tax affects of the Affordable Care Act and how to mitigate them.

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IRS Circular 230 Disclosure:

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.