535 Fifth Avenue, 30th Floor
New York, NY 10010
Phone: 212.785.9700

3458 Ocean View Boulevard
Glendale, CA 91208
Phone: 818.634.2276

info@kbl.com

NEWS

NEWS





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.

 

Logo
Main Office For more information please contact
535 Fifth Avenue,
16th Floor New York,
NY 10017
Richard Levychin
Telephone: 212.785.9700,
E mail: rlevychin@kbl.com
Websites www.kbl.com Contact us at info@kbl.com
Our Areas of Practice
Audit and Assurance
Valuations
Tax Advisory and Compliance
Business Advisory Services
Internal Audit & Risk Management
Finance & Accounting Outsourcing
Mergers & Acquisitions Advisory
Litigation Consulting & Forensic Accounting
Private Wealth Advisory
Corporate Finance & Due Diligence
Services Provided To
Emerging Businesses
Publicly Held Companies
Fortune 500 Companies
Closely Held Businesses
Global Enterprises
Government & Municipalities

Not-For-Profit
Sports, Media, & Entertainment
High Net Worth Individuals
Retirement Plans
Family Owned Enterprises
Investment Community

 

 

IRS audits of businesses have dropped in 2016 to just 0.49% of all business tax returns, the lowest level since 2004. IRS audits of large corporations have also dropped. The IRS audited 6,458 large corporations, which are entities with assets exceeding $10 million. Four years ago, the IRS audited over 10,000.

Tax audits of individual by the IRS declined for the fifth straight year in 2016. The IRS audited just 0.7% of tax returns, which represents 1 in every 143 individual tax returns, down from 1 in 90 back in 2000. In 2016, the IRS audited 5.83% of high-income households, which is defined as returns with income over $1 million, down from 9.55% in 2015, which represents the lowest audit rate for that income group since 2008.

The above drop in audit rates are a result of budgets cuts at the IRS, which has lost 30% of its enforcement staffing since 2010. Expect Republicans to continue cutting the agency’s budget as part of broader spending cuts and the continued lowering of IRS audit rates.

The rules for the collection of New York State sales tax as it relates to computer software are quite complex.  In this article we look to explain how sales tax applies to sales of computer software and related services.

Prewritten computer software is taxable as tangible personal property, whether it is sold as part of a package or as a separate component, regardless of how the software is conveyed to the purchaser. Therefore, prewritten computer software is taxable whether sold:

  • on a disk or other physical medium;
  • by electronic transmission; or
  • by remote access.

Prewritten computer software includes any computer software that is not designed and developed to the specifications of a particular purchaser. This includes software created by combining two or more prewritten programs or portions of prewritten programs.

Custom software is not subject to tax provided it is designed and developed to the specifications of a particular purchaser. If the custom software is sold or otherwise transferred to someone other than the person for whom it was originally designed and developed, it becomes subject to tax.

Prewritten software that is modified or enhanced to the specifications of a particular purchaser is subject to tax. However, if the charge for the custom modification or enhancement is reasonable and separately stated on the invoice, then the charge for the modification or enhancement is not subject to tax.

Computer software services

Many services related to computer software are exempt. Examples of these services include:

  • training
  • consulting
  • instruction
  • troubleshooting
  • installing
  • programming
  • systems analysis
  • repairing
  • maintaining
  • servicing

However, when these otherwise exempt services are provided in conjunction with the sale of prewritten software, the charge for the service is exempt from tax only when the charge for the service is reasonable and separately stated on the invoice or billing statement given to the customer.

Sales of software upgrades

Generally, the sale of a revision or upgrade of prewritten software is subject to tax as the sale of prewritten software. If, however, the software upgrade is designed and developed to the specifications of a particular purchaser, its sale to that specific purchaser is exempt as a sale of custom software.

Remotely accessed software

A sale of computer software includes any transfer of title or possession or both, including a license to use.

When a purchaser remotely accesses software over the Internet, the seller has transferred possession of the software because the purchaser gains constructive possession of the software and the right to use or control the software.

Accordingly, the sale to a purchaser in New York of a license to remotely access software is subject to state and local sales tax. The situs of the sale for purposes of determining the proper local tax rate and jurisdiction is the location from which the purchaser uses or directs the use of the software, not the location of the code embodying the software. Therefore, if a purchaser has employees who use the software located both in and outside of New York State, the seller of the software should collect tax based on the portion of the receipt attributable to the users located in New York.

Software maintenance agreements

Separately stated and reasonable charges for maintaining, servicing, or repairing software are exempt from sales tax. However, if a software maintenance agreement provides for the sale of both taxable elements (such as upgrades to prewritten software) and nontaxable elements, the charge for the entire maintenance agreement is subject to tax unless the charges for the nontaxable elements are:

  • reasonable and separately stated in the maintenance agreement, and
  • billed separately on the invoice or other document of sale given to the purchaser.

Exempt sales for production or research and development

Prewritten computer software used or consumed directly and predominantly in the production of tangible personal property for sale, or directly and predominantly in research and development, is exempt from tax. The purchaser must provide the seller with a properly completed Form ST-121, New York State and Local Sales and Use Tax Exempt Use Certificate. See Tax Bulletins Exempt Use Certificate (TB-ST-235) and Research and Development (TB-ST-773).

Exempt sales to corporations and partnerships

Custom software is exempt from tax when resold or transferred directly or indirectly by the purchaser of the software to either:

  • a corporation that is a member of an affiliated group of corporations that includes the original purchaser of the custom software; or
  • a partnership in which the original purchaser of the custom software and other members of the affiliated group have at least a 50% interest in capital or profits.

However, the exemption does not apply if the sale or transfer of the custom software is part of a plan having as its principal purpose the avoidance or evasion of tax, or if the sale is prewritten software that is available to be sold to customers in the ordinary course of business.

 

As more companies in the manufacturing industry are becoming involved in foreign transactions, particularly exporting, they need to be aware that they can reduce their U. S. tax liability using an Interest-Charge Domestic International Sales Corporation, more commonly known as an IC-DISC.  The IC-DISC is a federal tax export incentive entity structuring available for U. S. companies that export goods and services to foreign countries.  An IC-DISC creates the opportunity to tax a portion of export related to profits at lower tax rates, and to potentially defer export related income to future years. 

The IC-DISC allows certain U. S. exporters to reduce their overall tax liability through a commission mechanism.  The exporter manufacturing company pays a tax deductible commission, based on qualified export sales, to a newly created corporation that makes an IRS election to be an IC-DISC.  By design, IC-DISCs are exempt from federal tax, and therefore do not pay tax on the commission received.  The IC-DISC then distributes the commission income to the shareholder as a qualified dividend subject to tax at reduced capital gains tax rates.

The IC-DISC entity can be created by the shareholders of the exporter manufacturing company as a brother-sister configuration, typically used when the exporter manufacturing company is a regular corporation for tax purposes.  Or, the IC-DISC can be established by the exporter manufacturing company as a parent-subsidiary configuration when the parent exporter manufacturing company is a pass-through type tax entity.

In either case, the benefit received from utilizing an IC-DISC structuring is dependent on the tax structuring and the effective tax rates of the taxpayers involved in the commission transactions.  The IC-DISC is not required to distribute its accumulated earnings, allowing for the dividend income to be deferred into future years. 

Export sales must meet the following requirements in order to qualify for the IC-DISC benefit:

  1.  Export property must be manufactured in the U. S.
  2.  Export property must be sold for direct use outside the U. S.
  3.  Less than 50 percent of the export property’s sale price must be attributable to imported

In addition to export sales of manufactured property, the following transactions may also qualify for IC-DISC treatment:

  1.  Leasing U. S. manufactured property for use outside of the U. S.
  2.  Export sales of property that is extracted, produced, or grown in the U. S., including crops and 
  3.  Engineering and architectural services provided for construction projects located outside the U. S.

 

 

The Research and Development Tax Credit Program, or RTCP, was introduced into the Internal Revenue Code to encourage businesses to invest in significant research and development efforts with the high expectation that such an advantageous tax incentive program would help stimulate economic growth and investment throughout the United States and prevent further jobs from being outsourced to other countries.

In December 2015 the Protecting Americans from Tax Hikes Act of 2015, or PATH Act, made the RTCP a permanent tax incentive within the Code and considerably restructured the program to allow eligible “small businesses” (i.e., $50 million or less in gross receipts) to claim the RTC against the Alternative Minimum Tax for tax years beginning on January 1, 2016.

Businesses with average annual gross receipts of less than $50 million for the three taxable year period preceding the current taxable year are now eligible to offset both their regular income tax and their AMT with RTCs. Before the enactment of the PATH Act, businesses in AMT positions were unable to utilize their RTCs to offset their tax liability. Regardless, it is important to point out that RTCs can generally be either carried back 2 years or carried forward up to 20 years before the RTCs could expire unutilized

In addition, PATH allows eligible “start-up companies”, which is defined in this section of the Code as companies with less than $5 million in gross receipts in the current taxable year and that have no gross receipts for any taxable year prior to the five taxable year period ending with the current taxable year, to claim up to $250,000 of the RTC against the company’s federal payroll tax for tax years beginning on January 1, 2016.