For many businesses in the United States, there is excitement in the air, and rightly so. 2017 was characterized by increased corporate earnings and an improving labor market with real wage growth. Consumer confidence reached a 17-year high. And, not surprisingly, the Stock Market benefited from the passage of the Tax Cuts and Jobs Act, which reduces corporate tax rates to 21% for C Corporations and lowers individual tax rates.
However, the initial stated aim of the Republican Tax Cuts and Jobs Act was to simplify the tax code, “so most tax returns could be filled out on a post card.” Don’t buy stock in any post card manufacturers, because that’s not happening. While providing tax relief to many individuals and businesses, the new tax law is anything but simple.
So, what does the new tax law mean for the captive insurance industry? The following is Part 1 of our series on the new tax law and its impact on captive insurance and businesses and business owners that own their own captive insurance company.
Step Right Up - Every Captive Is A Winner!
First, it’s worth noting that all captive insurance companies being taxed in the United States benefit from the new tax law. All insurance companies, including captives, are C Corporations.
“Small” captive insurance companies that make an 831(b) tax election will still be taxed at zero percent (0%) on their underwriting profits (no change from the prior year). Captives may be defined as “small” and make an 831(b) tax election if they receive annual insurance premiums of $2.3 million or less. However, unlike in prior years, small captives now have the added benefit of having their investment income taxed at the lower 21% corporate rate (when it was previously taxed at rates as high as 35%).
“Large” captive insurance companies are taxed under IRC Code section 831(a). Under the new tax law large captives receive a two-fold benefit. First, their tax on underwriting profits is reduced from as high as 35% to only 21%. Second, their tax on investment income is also reduced to 21%.
What Isn’t Affected?
The risk management benefits of captive insurance companies are unaffected by the new tax law. Captive insurance policies and the coverages they provide are not impacted either. Fronting, reinsurance, and risk pooling commonly employed by captive insurance companies remain unchanged.
As mentioned previously, the 831(b) tax election for small captive insurance companies still applies. Small captives are still taxed at 0% on their underwriting profits.
Impact Of The New Tax Law
First, it should be reemphasized that captive insurance companies and captive taxation are not negatively impacted by these rate changes. However, the tax benefits captives provide may be reduced (but not eliminated), as the new tax law decreases parent company taxation for most businesses. This lower benefit will vary in impact from business to business and is best understood as a potential reduction in the tax arbitrage between the parent company (insured) and the captive (insurer).
C Corporations
Most C Corporations will have their taxes cut to 21%. Hence, the tax benefit to most C-Corps of paying premiums to a captive insurance company making an 831(b) election will be reduced. However, C Corporation profits are subject to double taxation when dividends are paid out to owners / shareholders, so the tax benefits of 831(b) captives combined with the right Captive Exit Strategies are still substantial.
Pass-Through Entities
Pass-through entities (S Corporations, Limited Liability Companies, Partnerships, Sole Proprietorships, etc.) are a bit more complex, depending on the business (service versus manufacturing and product sales). The highest tax bracket for owners of pass-through entities in 2017 was 39.6%. For 2018, the highest tax bracket for owners of pass-through entities will be 37% (for most). Some pass-through entities will be allowed to deduct 20% of their income. This deduction applies largely to manufacturing and businesses that sell durable products. Specific service industries, such as health, law, and professional services, are excluded and may not take the 20% deduction.
The impact of Tax Cuts and Jobs Law on the tax benefits of captive insurance companies is illustrated in the table below. Whereas an 831(b) election would have saved 39.6% in taxes in 2017, it would only save 37% or 29.6% in 2018. Hence the impact of the 831(b) election will be decreased by 6.6% to 25.3%.
Pass-Through 831(b) Difference
Tax Rate (%) Tax Rate (%) Vs. 2017
2017 39.6 0 Baseline
2018 Without Deduction 37 0 -6.6%
2018 With 20% Deduction 29.6 0 -25.3%
For most businesses, the benefits of improved risk management, improved asset protection and tax savings that a captive provides will not be sufficiently negated. Captives remain a powerful and logical choice.
Scratching The Surface
Clearly, more illustrations are needed due to the complexity of the new tax law. We will provide a wider range of more specific illustrations in Part 2 of our series on the new tax law and its impact on captives.
What The Future Holds - Additional Perspective On Captives And The 831(b) Election
The 831(b) tax election was created in 1986, and the U.S. insurance market is likely to mirror 1986 in the future. The Reagan Tax Cuts were passed in the 1980s and created significant economic growth. The result was a very hard insurance market fueled by the flow of capital out of the reinsurance markets and into the economy at large. Businesses grew, new businesses were created and business activity significantly increased, swelling the overall insurance exposure. More total risk exposure and fewer reinsurance reserves led to an insurance crisis, and many businesses could not obtain insurance. This environment spawned 831(b) as Congress moved to provide small and mid-sized businesses with a viable tool for self-insurance.