Captive Insurance and Other Tax Reduction Strategies – The Good, Bad, and Ugly

By Lance Wallach      

Every accountant knows that increased cash flow and cost savings are critical for businesses in 2008. What is uncertain is the best path to
recommend to garner these benefits.  

Over the past decade business owners have been overwhelmed by a plethora of choices designed to reduce the cost of providing employee
benefits while increasing their own retirement savings. The solutions ranged from traditional pension and profit sharing plans to more
advanced strategies.  

Some strategies, such as IRS section 419 and 412(i) plans, used life insurance as vehicles to bring about benefits. Unfortunately, the high life
insurance commissions (often 90% of the contribution, or more) fostered an environment that led to aggressive and non-compliant plans.  

The result has been thousands of audits and an IRS task force seeking out tax shelter promotion. For unknowing clients, the tax
consequences are enormous. For their accountant advisors, the liability may be equally extreme.  

Recently, there has been an explosion in the marketing of a financial product called Captive Insurance. These so called “Captives” are
typically small insurance companies designed to insure the risks of an individual business under IRS code section 831(b). When properly
designed, a business can make tax-deductible premium payments to a related-party insurance company. Depending on circumstances,
underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed as capital
gains.  

While captives can be a great cost saving tool, they also are expensive to build and manage. Also, captives are allowed to garner tax benefits
because they operate as real insurance companies. Advisors and business owners who misuse captives or market them as estate planning
tools, asset protection vehicles, tax deferral or other benefits not related to the true business purpose of an insurance company face grave
regulatory and tax consequences.  

A recent concern is the integration of small captives with life insurance policies. Small captives under section 831(b) have no statutory
authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable
at corporate rates, and then will be taxable again when distributed.  The consequence of this double taxation is to devastate the efficacy of the
life insurance, and it extends serious liability to any accountant who recommends the plan or even signs the tax return of the business that
pays premiums to the captive.

The IRS is aware that several large insurance companies are promoting their life insurance policies as investments with small captives. The
outcome looks eerily like that of the 419 and 412(i) plans mentioned above.  

Remember, if something looks too good to be true, it usually is. There are safe and conservative ways to use captive insurance structures to
lower costs and obtain benefits for businesses. And, some types of captive insurance products do have statutory protection for deducting life
insurance premiums (although not 831(b) captives). Learning what works and is safe is the first step an accountant should take in helping his
or her clients use these powerful, but highly technical insurance tools.  

Lance Wallach speaks and writes extensively about VEBAs, retirement plans, and tax reduction strategies.  He speaks at more than 70
conventions annually, writes for 50 publications, and was the National Society of Accountants Speaker of the Year.  Contact him at
516.938.5007 or visit www.vebaplan.com.

The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other
entity.  You should contact an appropriate professional for any such advice.
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