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Captive insurance companies are often used by large corporations to lower their insurance costs and are often created in offshore tax havens. However, small, closely held companies can take advantage of a number of tax and business benefits if they set up their own captives. These captives can be set up in the jurisdiction that makes the most sense for the captives business.

Captive insurance companies are formed for both economic and risk management purposes. For example, by forming a captive insurance company, a business can dramatically lower insurance costs in comparison to premiums paid to a conventional property and casualty insurance company. By establishing ones own insurance vehicle, costs for overhead, marketing, agent commissions, advertising, etc., may result in significant savings in the form of underwriting profits, which can be retained by the owner of the captive company.

Additionally, a captive insurance company can provide protection against risks which prove to be too costly in commercial markets or may be generally unavailable. The inability to obtain specialized types of coverage from commercial third-party insurers is another reason why clients may choose to establish a captive insurance company. With a captive insurance company, a business owner can address their self-insured risks by paying tax deductible premium payments to their captive insurance company. To the extent the captive generates profits, those dollars belong to the owner of the captive.

In general, your captive insurance company will be capable of delivering better service to your operating company than a commercial insurance company can

The formation of a captive insurance company is a lengthy process including feasibility studies, financial projections, determining domicile, and, finally, preparing and submitting the application for an insurance license. A professional captive manager, risk management expert and actuary should be engaged to help you to determine the best balance between coverage retained from commercial carriers and your captive insurance carrier, and an appropriate amount of premium to be paid for the coverage being provided. Premium payments made by the operating company to the captive insurance company for property and casualty insurance coverage should be tax-deductible as an ordinary and necessary business expense, just as they would be treated had they been made to a traditional insurance company.

The use of a captive should be considered for entities that meet the following criteria:

  • Profitable business entities seeking substantial annual adjustable tax deductions;
  • Businesses with multiple entities or those that can create multiple operating subsidiaries or affiliates;
  • Businesses with $500,000 or more in sustainable operating profits;
  • Businesses with requisite risk currently uninsured or underinsured;
  • Business owners interested in personal wealth accumulation and/or family wealth transfer strategies;
  • Businesses where owner(s) are looking for asset protection.

The tax benefits associated with captives can sometimes cause business owners to forget that the captive must operate as a true insurance company. The use of an experienced and capable captive management company is an essential element of the normal operations of such an entity. The need for annual actuarial reviews, annual financial statement audits, continuing tax compliance oversight, claims management, and other regulatory compliance needs puts the day-to-day management of a captive insurance company beyond the skills of most general business people. Likewise, the involvement of the management company in the investment activities of the captive is essential from a planning perspective to assure that the captives liquidity needs are met.

Tax Benefits

A properly structured and managed captive insurance company could provide the following tax and nontax benefits:

  • Tax deduction for the parent company for the insurance premium paid to the captive;
  • Various other tax savings opportunities, including gift and estate tax savings for the shareholders and income tax savings for both the captive and the parent;
  • Opportunity to accumulate wealth in a tax-favored vehicle;
  • Distributions to captive owners at favorable income tax rates.

For the premium payment to the captive to be deductible as an insurance expense, the captive must be able to prove that it is a valid insurance company (payments for self-insurance generally are not). Besides obtaining an insurance license from a state or a foreign jurisdiction, the captive must provide insurance to the operating company or its affiliates. Insurance is defined for tax purposes as including elements of risk shifting and risk distribution. To meet the risk-shifting requirement, the operating company must show that it has transferred specific risks to the captive insurance company in exchange for a reasonable premium.

Internal Revenue Code Section 831(b) provides that captive insurance companies are taxed only on their investment income, and do not pay income taxes on the premiums they collect, providing premiums to the captive do not exceed $1.2 million per year. Legislation signed into law on December 18, 2015 has increased the premium limitation from $1.2 million to $2.2 million per year for taxable years beginning after December 31, 2016. This new limit will be indexed for inflation annually.

The higher limit is an opportunity for captive owners to place more risks in their captives, such as cyber, earthquake, wind and flood, pollution liability and cleanup, and property mold. While the new law increases the premium income that is exempt from taxation, it also imposes stricter rules on the ownership structures of 831(b) captives.

Captive that try to massage their premium income need to be very careful because they are putting their tax election at risk as well as potentially putting the captive in jeopardy and the subject of potential scrutiny by the IRS.

As discussed above the captive may retain surplus from underwriting profits within reserve accounts, free from income tax. It can also generate profits by controlling or eliminating costs for overhead, marketing, advertising, agent commissions, profits, etc., items normally built into the premiums charged by traditional insurance companies. After adjustment for expenses and claim payments, net underwriting profits are retained within the captive insurance company. Over the years, profits and surplus may accumulate to sizeable amounts, and may be distributed to the owners of the captive company, under favorable income tax rates as either dividends or long-term capital gains.

Amounts set aside as reserves for potential claims payments, plus capital surplus, should be maintained in safe, liquid asset classes so that the captive has adequate solvency to pay claims when called upon. The formation of the captive and eventual issuance of a certificate of authority to do business, are subject to approval by the insurance regulators in the jurisdiction where the insurance captive is formed. The insurance regulators will also oversee the organization and ongoing operation of the captive insurance company to assure ongoing compliance with the rules for that jurisdiction.

The planning, formation, and management of a captive are complex undertakings, and compliance with the formalities of running a true insurance company is mandatory. Establishing a captive insurance company is not feasible for all companies but, where appropriate, it can provide substantial tax and nontax benefits to successful shareholders and their families.

 

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IRS to Target Specific S Corporation Areas as Part of New Compliance Campaign

The Internal Revenue Service’s Large Business and International Division has approved five new compliance campaigns in several areas including specific areas related to S corporations. The LB&I Division has been moving toward issue-based examinations and a compliance campaign process in which it decides which compliance issues present enough of a risk to require a response in the form of one or multiple treatment streams to achieve tax compliance objectives. The five new campaigns were identified through data analysis and suggestions from IRS employees. The goal is to improve return selection, identify issues representing a risk of non-compliance, and make the best use of the division’s limited resources.

As part of the S corporation campaign, the IRS noted that S corporations and their shareholders are supposed to properly report the tax consequences of distributions. The service has targeted three issues as part of this campaign:

  • When an S corporation fails to report gain upon the distribution of appreciated property to a shareholder.
  • When an S corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend; and,
  • When a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation.

For this campaign, the IRS plans to conduct issue-based examinations, suggest changes to tax forms, and conduct stakeholder outreach.

As part of the campaign, any examinations that result from this campaign will probably touch upon other S corporation related issues including the methods S corporations use to determine reasonable compensation and its impact on potential under-reported FICA taxes.

Taxation of Cryptocurrency Mining Activities

There are new rules which the US Congress passed in December 2017 that change the way the IRS treats cryptocurrency. Before the US Congress put forth a clearer ruling in 2017, the classification category of cryptocurrency assets was up for interpretation according to many tax experts. That’s because many cryptocurrency miners and traders treated cryptocurrency similar to real-estate for tax purposes by citing the like-kind exchange rules of IRS Code Section 1031.

Following this ruling a miner could theoretically trade a mined cryptocurrency for another cryptocurrency without having to pay taxes. With 1031 exchanges limited to real estate transactions under the recent tax act this treatment is now out the window. Now anyone with cryptocurrency mining operations in 2018 will have to pay taxes beginning in 2019.

There are a couple of things to consider when paying taxes for cryptocurrency mining. You have two different income streams to consider. The first taxable event occurs whenever a miner mines a new coin. The IRS considers this to be income even if the miner decides to only hold the coins as “inventory”. When you mine the coins, you have income on the day the coin is "created" in your account at that day's exchange value. If you are reporting activity as an individual taxpayer, you can report the income as a hobby or as self-employment. If you report as a hobby, you include the value of the coins as "other income" on line 21 of form 1040. Your ability to deduct any expenses is limited -- expenses are itemized deductions subject to the 2% rule.

If you report as self-employment income (you are doing work with the intent of earning a profit) then you report the income on schedule C. You can fully deduct your expenses. The net profit is subject to income tax and self-employment tax. Similar treatment occurs if you operate as a multi-member LLC except that the transactions are reported on the LLC’s tax return with the individual members having their shares of the net profits or losses reported on individual K-1s.

Your second income stream comes when you actually sell the coins to someone else for dollars or other currency. Then you have a capital gain or a capital loss.

Finally, if you immediately sell the coins for cash, then you only have income from the creation and you don't also have a capital gain or loss.

Now, as far as expenses are concerned, if you are doing this as a business, you can take an expense deduction for computer equipment you buy (as depreciation) and your other expenses (for example electricity and other business expenses). But if you are doing this as a home-based business you need to be able to prove those expenses, such as with a separate electric meter or at least having your computer equipment plugged into a portable electric meter so you can tell how much of your electric bill was used in your business. Unless your expenses are very high, they won't offset the extra self-employment tax, so you will probably pay less tax if you report the income as hobby income and forget about the expenses.

Supreme Court Rules States Have Authority To Require Online Retailers To Collect Sales Taxes

The U.S. Supreme Court, in a 5-4 decision, has held that states can assert nexus for sales and use tax purposes without requiring a seller’s physical presence in the state, thereby granting states greater power to require out-of-state retailers to collect sales tax on sales to in-state residents. The decision in South Dakota v. Wayfair, Inc., et al overturns prior Supreme Court precedent in the 1992 decision Quill Corp. v. North Dakota which had required retailers to have a physical presence in a state beyond merely shipping goods into a state after an order from an in-state resident before a state could require the seller to collect sales taxes from in-state customers. That was before the surge of online sales, and states have been trying since then to find constitutional ways to collect tax revenue from remote sellers into their state.

The Court noted: “When the day-to-day functions of marketing and distribution in the modern economy are considered, it is all the more evident that the physical presence rule is artificial in its entirety”. The Court also rejected arguments that the physical presence test aids interstate commerce by preventing states from imposing burdensome taxes or tax collection obligations on small or startup businesses. The Court concluded that South Dakota’s tax collection plan was designed to avoid burdening small businesses and that there would be other means of protecting these businesses than upholding Quill.

In his dissenting opinion, Chief Justice John Roberts argued that, although he agreed that the enormous growth in internet commerce in the interim years has changed the economy greatly, Congress was the correct branch of government to establish tax rules for this new economy. He also took issue with the majority’s conclusion that the burden on small businesses would be minimal.

Prior to the decision, many states had already begun planning for the possible overturn of Quill.

Congress may now decide to move ahead with legislation on this issue to provide a national standard for online sales and use tax collection, such as the Remote Transactions Parity Act or Marketplace Fairness Act, or a proposal by Rep. Bob Goodlatte, R-Va., that would make the sales tax a business obligation rather than a consumer obligation. Under that proposal, sales tax would be collected based on the tax rate where the company is located but would be remitted to the jurisdiction where the customer is located.

 

C Corp vs S Corp or LLC:
How The Tax Cuts and Jobs Act Impacts This Decision

The Qualified Business Income Deduction section of the Tax Cuts and Jobs Act included a new deduction meant for S corps, LLCs, partnerships and sole proprietorships (commonly referred to as pass-through entities). The deduction is calculated at 20% of the trade/business income of these entities. There are limitations based on owner’s taxable income, W-2 salaries of the business, assets in the business and whether or not the business is a service or non-service entity.

Accordingly, not all pass-through entities will qualify for the 20% deduction.

The Tax Cuts and Jobs Act has also dropped the C corporation tax rate to 21% and a lot of questions have arisen from closely held business owners about converting their limited liability company (LLC) or S corporation (S corp) to a C corporation (C corp) including questions from the owners of entities that don't qualify for the 20% deduction. Does it make sense to switch to or start a C corp? The answer is not that simple. Much depends on your business and the business model you operate under.

While the federal tax rate for C corps has dropped favorably to a flat 21%, there are still limitations to a C corp’s tax structure. C corps are subject to double tax. When a C corp issues dividends on their profits, the shareholders receiving the dividends are then taxed on their personal tax return, while the C corp receives no deductions for these payments. Whereas, if you are structured as an LLC or an S corp, you are taxed on the net taxable income that flows through to the owner’s individual tax return and you can distribute the funds out of your company, without double tax. If the goal of the business is to reinvest the earnings back into the company, C corps are a favorable option to take advantage of the lower tax rates.

As a practical matter, for current operations, closely held C corporations do not normally pay dividends. Owners in these entities are often active in the business and draw a salary. The corporation gets a deduction for the salaries, but owners receiving the salary pay federal tax on that salary at a rate as high as 37%.

Upon exiting a closely held business, the sale of the assets of the business are, normally, the only viable option. Very few buyers will want to buy the ownership interest in a closely held business. If you decide to sell your business as a C corp, income generated from the sale of assets is taxed at the corporate level first and then taxed again when the net cash is distributed out to the shareholders.

Also, consider the timing issues when switching to and from a C corporation. Let’s say your business is currently structured as an S corp. You and your shareholders deem your business is better suited as a C corp and you want to convert your organization. It is fairly easy to switch to a C corp. But there is a “buyer beware” with that enterprise. You must wait five years after the switch to a C corp to switch back to an S corp. Once you switch back to an S corp, you could be subject to double taxation on built-in gains (unrealized appreciation on assets held while the entity is a C corporation) for an additional five years after the switch. At a minimum, you will need to live with the possibility of some degree of double taxation for up to ten years.

So what is the bottom line on all of this?

If you have a business that you plan on keeping fairly small, with fewer than 100 shareholders and located in the U. S, you probably want to be an S corp or an LLC. But if your goal is to reinvest profits back into your business to finance future organic growth then the C corporation is probably a good fit. If you have big plans for growing your company to position it for future sale or to go public, you might want the flexibility to take on investors, raise capital, issue different kinds of stock, and invite foreign investors into your business as a C corp.

As always, it is best to consult your advisors before commencing any changes in business structure.