Will the Tax Cuts and Jobs Act Affect Small Captive Insurance Companies?
The end of 2017 delivered uncertain tidings concerning what effect the Tax Cuts and Jobs Act, the most significant US tax reform in more than 30 years, would have on the captive insurance industry. While the law affects larger captive insurers, or 831(a)s, changes are less significant for smaller captive insurance companies, or 831(b)s.
Generally, 831(b) participants are successful small to midsize business owners with gross revenues of $1 million−$250 million and an annual budgeted premium that may be as low as $100,000, depending on the captive program. Since no significant tax changes are directed explicitly at captives participating in 831(b) solutions, the net result is that, even with the 2017 tax law changes, there are still tax benefits for small captive insurance companies.
The premise for forming a captive should not be tax savings, and captive planning should be driven by a legitimate business need, not to achieve a tax deduction. The principal benefits of a captive insurance arrangement include increased risk awareness, better coverage, and reduced commercial insurance premiums, as well as improved risk management and risk mitigation. Small captive insurance companies should remain confident that, when done for the right reasons, having a captive remains a powerful risk financing tool.
A Review of Personal and Corporate Tax Rates
Did successful small to mid-size business owners have a decrease in their personal tax rates? Yes, however, with the reduction of the top income tax bracket by a few percentage points, many deductions were lost or eliminated on a personal basis. This includes limitations as well as a reduction elimination of various itemized deductions. The following are examples.
- The combination of property and state income taxes are now jointly capped at $10,000 per year.
- Home mortgage deductions for new loans are capped at $750,000 for acquisition indebtedness, and home equity indebtedness is no longer deductible up until 2025.
- Casualty and theft losses, with narrow exceptions, are no longer allowed for individuals.
- Both miscellaneous itemized deductions and work-related expenses have also been eliminated until 2025.
This reduction of itemized deductions will undoubtedly increase taxable income, but combined with a slightly reduced tax rate, the net effect is that taxes for high-income earners will not materially change. Therefore, the tax effects of a captive solution for small business owners still remains.
Simple logic would tell us that if the corporate federal income tax rate drops to 21 percent, an organization's tax rate will also decrease by converting it to a C corporation. Therefore, with reduced business taxation, no additional tools are needed to reduce the overall level of income taxation. However, this logic is incorrect since most business owners that participate in small captive insurance companies want to distribute all or part of their earned or retained profits.
For example, a C corporation business may have earnings of $1 million and decide to self-insure a portion of the risk without utilizing a captive solution. The business owner may believe that with the decreased federal corporate income tax rate (state corporate taxes did not lower), no additional planning would improve the company's tax position. However, the following scenario using the captive option demonstrates otherwise.
- The C corporation would pay 21 percent federal income tax plus state income tax on $1 million of profit which, for illustrative purposes, could be as high as 9 percent. Thus, for this example, we presume a combined federal and state tax rate of 30 percent or $300,000.
- After paying corporate taxes, the owner decides to distribute a $700,000 dividend and lives in a state with an 8 percent individual tax rate, along with the standard 20 percent federal individual income tax rate, amounting to 28 percent or $203,000.
- When combined, the corporate tax of $300,000 and the individual tax rate of $203,000 adds up to $503,000. To complete the illustration, add on Medicare tax in the amount of $45,700 for a total projected tax amount of $548,700, or 54.8 percent. This would be even larger if a portion of this was taxable wages.
- Therefore, even though the tax law reduces C corporation tax rates, based on the illustration above, this decrease will not likely benefit business owners who choose to withdraw the profit from their business instead of preserving it within the corporation. Thus, despite changes to the tax law, captives continue to produce tax advantages for most small, if not large, C corporations.
Much hype surrounds the potentially significant tax breaks for successful business owners, who generally participate in smaller captives. In reality, no material change is evident on the personal tax side for high-income earners, and little has changed relative to the existing tax effects of a captive solution.
In conclusion, captive insurance has been an integral tool for small business owners for many decades, and captive insurance will continue as an excellent business planning and risk financing solution. While having a captive may result in a tax benefit, most importantly, captives provide increased risk awareness, reduced commercial insurance premiums, and improved risk management.