Captive Insurance Companies

Captive insurance companies have been growing by leaps and bounds. A captive is an insurance company that insures the risks of its parent company. It is owned by a parent or, at times, by the shareholders of the parent company. The operating entity insures all or part of its risks with its captive company. The captive may reinsure some or all of such risks, or may retain such risks. The benefits of a captive may be many, but the primary goal is to retain the profit that would have been made by an outside third-party insurance company or to provide coverage where coverage would not be available.

There are many different types of captives depending on the needs of the parent company or its owners are, including Single Parent Captives, Association Captives, Group Captives, Agency Captives, and even Rent-a-Captive, among others.

Captives, like all insurance companies, have specific tax rules that allow them special benefits not available to other companies. An insurance company receives premiums, pays it expenses, and then invests the money it has retained, known as reserves, to pay for future claims. An insurance company receives an income tax deduction for almost all of its funds deemed reserves, and can invest and accumulate these funds. A regular corporation pays income tax on the funds it retains as profits. Yet, as the business of insurance requires the payment of future claims, the accumulation of funds is a necessity for being able to pay such claims.

The amount of reserves that a company can accumulate is determined by an actuarial calculation of the nature and amount of risks it covers, combined with the insurance rules as to the types of allowable investments for company reserves. There are restrictions upon what types of investments and what percentage of assets per investment may be made. The jurisdiction or state of the insurance company's license will also have an effect on its operations and retentions.

A company owning a captive normally receives an income tax deduction for the payments it makes to such captive as an ordinary and necessary business expense within IRC §162. The captive receives such funds, pays its operating expenses and then deducts the allowable amounts of reserves it invests. If a claim is made the reserves are used to pay such claims.

A captive insurance company may provide an opportunity for a company that either self insures certain risks to have a current income tax deduction for payments to another entity it owns, or its shareholders own, that will provide the future funds for what would otherwise have been a non-deductible current assumption of risk. Instead, the income tax deduction is accelerated for the operating company and funds are provided for it by the captive company should the risks transpire. If the risk is true third-party risk, then the requirements of risk shifting and risk distribution would normally be present and such coverage would be deemed insurance.

Not generally known to most business owners is an opportunity in the Internal Revenue Code to not only deduct payments made to a captive, but to also not require the captive to pay any income tax.

The two IRC sections at issue are IRC §501(c)(15) and IRC §831(b).

IRC §501(c)(15) allows a very small property and casualty insurance company to not pay any income tax on the receipt of premium income, and from its investment income, if the total amount of funds received during a year are $600,000 or less and greater than 50 percent of the income received was from premium income.

IRC §831(b) provides an expansion of the amount of annual premiums received which are non taxable to $1,200,000 but provides the company would pay an income tax on its taxable investment income.

For the closely-held business owner, these sections provide an opportunity to expand the closely held company's ability to save funds and retain profitability by owning a captive or a portion of a group captive.

An example of this is with a recent client who self-funded catastrophic medical, as well as disability coverage, for their employees. The client was attempting to accumulate cash within the company to pay out in the event of an employee's disability or medical expense exceeding their policy limits. As the company was self-funding for these risks, it was in essence self-insuring such risks. Self-insurance is unfortunately non-deductible.

The problem the company had was that all income was taxed at the maximum federal corporate income tax rate of 39 percent. All accumulations of income were taxed at the maximum federal corporate income tax rate of 39 percent. As such, they had a difficult time accumulating sufficient funds. The solution was to set up a captive insurance company, owned by the corporate shareholders. The insurance company provided the insurance coverage versus self-assumption of risk. This also provided the operating company with a tax deduction for the premiums paid to shareholder's company. The captive insurance company by virtue of receiving less than $1,200,000 of annual premiums did not have to pay any federal income tax. The insurance company then invested its reserves in tax-free investments, so that no income tax would be due on the insurance company's investment income.

As such, captive can provide an opportunity for a company or its owners to retain profits that might otherwise be earned by a third-party insurance company. Not all risks would be appropriate for a captive to assume, but an actuary familiar with the operation of a captive would be able to assist with a feasibility study to determine if the captive was appropriate for the circumstances at issue. In many cases, the captive provides the opportunity for a current deduction, and, if such captive is profitable, a way to also increase the shareholders net worth by the insurance company increasing in value. The shareholders net worth is further increased by the annual income tax reduction by virtue of the premium payments being deductible, versus self-insurance.

It is recommended that you work with a tax lawyer and a team that is familiar with the structure and operation of captives, since this is an area that is technically complex and combines not only income tax, but insurance law, as well and contains many landmines for the unwary.

Captives can be used for malpractice coverage and almost any property and casualty risk, even if commercial coverage is not available to protect against such risk. Captives properly thought out and funded can be a big win for the business owner.

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Deducting Car Expenses

With the soaring price of gasoline, the deduction for business use of your car is more important than ever. You have two options: Write-off the actual costs related to your business travel, or claim an IRS-fixed standard mileage rate for the number of business miles driven during the year. Assuming you're eligible for either option, use the one that produces the larger deduction.

Standard mileage rate

The standard mileage rate takes the place of tracking costs, such as gas and oil, repairs, and insurance, relieving you of having to keep receipts for every gas purchase and other car-related expense. The standard mileage rate can be used whether you own or lease your car.

The IRS-set rate for 2008 is 50.5 cents per mile for the first half of the year and 58.5 cents per mile for the second half of the year. The IRS increased the rate in mid-2008 in light of ever-higher gasoline costs. Changing the rate during the year is a highly unusual step that the IRS had only done twice before -- in 1999, and again in 2005. However, even the higher rate may not fully reflect your costs.

Whether you deduct actual cost or the standard mileage rate, you can also deduct parking and tolls.

Recordkeeping is critical

You can't deduct any car costs without adequate substantiation. The tax law says that you must make contemporaneous records and dictates exactly what information you have to keep in order to deduct car expenses. Regardless of which method you use -- actual costs or standard mileage rate -- you need to record:

- The date of travel
- The business purpose of travel
- Mileage for each business use (and total miles for the year)

If you use the actual cost method, you'll also need to keep receipts for any relevant expenses. As a practical matter, since you won't know whether the standard mileage rate or actual expense method results in a larger deduction for the year, it's advisable to retain your receipts so you can make an informed choice when you file your return.

Recordkeeping is tedious and time-consuming. Use techniques that help to simplify this chore:

- Rely on software to help automate your recordkeeping. For instance, use software for PDAs (there are commercial and share-ware options available) that enable you to note your mileage electronically and then transfer the information to your computer.
- Use sampling, an IRS-approved method in which you only track your mileage for a representative period of time (say the first three months of the year, or the first week of every month) and then extrapolate mileage for the rest of the year. To use sampling, you must show that the period in which you kept records is representative of travel throughout the year.

Personal travel

Minimal personal use during a business outing in your car does not disqualify the trip. For instance, if you stop for lunch by yourself between business appointments (a personal activity), you can ignore the fact that you stopped; treat the outing as one continuous trip.

No deduction can be claimed for a car used for commuting to and from work. However, if you work from home in an office that qualifies for a deduction (it's your principal place of business), then any business travel to and from your home becomes a deductible business expense.

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New Tax Legislation

A bevy of small-business tax bills were enacted before the holiday break. Here's three you need to know.

Just before Congress adjourned for the holidays, a bevy of tax bills made their way to the President's desk. Here's three small-business owners need to know.

The Tax Increase Prevention Act of 2007 hiked the exemption amounts for the alternative minimum tax, or AMT, for individuals in 2007, keeping more than 20 million taxpayers from owing this tax, which only applies when it is higher than the regular tax. Sole proprietors and owners of pass-through entities -- partnerships, limited liability companies, and S corporations -- take business-generated tax preferences and adjustment into account when computing their personal AMT, so they will see relief. (Caution: Exemption amounts for 2008 are set to revert to substantially lower levels unless Congress takes additional action.)

The Mortgage Forgiveness Debt Relief Act of 2007 is designed primarily to provide tax help for homeowner who refinance their loans and obtain debt relief in the process. It exempts from income the debt relief on qualified home loans.

To help pay for this relief, the failure-to-file penalty for partnership returns is increased from $50 to $85 per partner per month for up to 12 months. The same rule applies to S corporation returns.

The Energy Independence and Security Act of 2007 creates new energy standards for automobiles and home appliances. Important tax provisions were stripped from the Act at the last minute. However, the Act did extend the additional 0.2 percent FUTA surtax, for a total FUTA rate of 6.2 percent. This surtax was originally introduced in the 1970s and had expired at the end of 2007.

What Wasn't Enacted
Congress failed to extend a number of important tax breaks that expired at the end of 2007, including the research credit, the 15-year amortization period for leasehold and restaurant property, and the ability to expense environmental remediation costs.

These and other tax measures will need to be considered by Congress in 2008.

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Tax Resolutions for the New Year

It's never too soon to start thinking about how to trim your tax bill for the year ahead.

The holidays are over. It's time to start putting your tax resolutions for the new year into effect. Here are a few simple ideas to get you started:

Keep better records. Create a file system to store business receipts. Track your odometer readings for every business trip taken in your personal vehicle, noting the destination and purpose of the trip. Protect your financial data by implementing backup systems, such as automated online backup solutions.

Add more to your retirement plan. The annual deduction limits for profit-sharing and simplified employee pensions (SEPs) are higher, so why not save more if you're eligible. The more you put into the plan, the greater your tax deduction and retirement savings will be.

Upgrade your business equipment. Whether you can buy a new computer system or other needed equipment outright or must finance the purchase, you'll be rewarded in two ways: A tax deduction and more operating efficiency.

Save energy. Look into taking advantage of federal and state tax incentives to go green. Hybrid vehicles, solar energy, and energy conservation practices are some ways you'll save taxes and fuel costs.

Lose weight. The perennial New Year's vow can pay off in better health and a tax deduction. While the cost of a personal weight loss program for general good health is not deduction, you can treat as a deductible itemized medical expense any doctor-prescribed programs to alleviate a specific medical condition, such as hypertension or obesity. Or look into adding wellness programs at your company to benefit you and your staff.

Do strategic planning. Review your business and marketing plans to see if you're on track. Schedule an appointment with your accountant and other business advisors to create a game plan for the coming year.

Maybe all of these resolutions aren't for you. Write down the ones that are and be sure to look at your list periodically throughout the year to stay on track. Happy New Year!

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Safeguarding Intellectual Property

Trademarks, copyrights and patents aren't just for big corporations. Everything from your company's name to its management style is worth protecting.
Your most valuable real estate may be your intellectual property -- a name, a process, or something else so unique that it's worth protecting. Determine whether you have such assets that need protection and which type of protection is necessary so you can secure your legal rights.

Trademarks
Creating a company or product name, slogan, design, or even a sound or smell that is so identified with a company's brand are assets that can be trademarked. You aren't required to register a trademark, but doing so gives you the presumption of ownership, which means you have the exclusive right to use the mark or license it for 10 years, with 10-year renewals. Unauthorized use of your mark can entitle you to damages.

A trademark is shown by displaying the symbol '„¢; once federal protection is obtained, the symbol ® can be used.

Copyrights
Creative works -- literary, musical, and artistic -- can usually be protected for the life of the creator, plus 70 years. Copyright protection is shown by displaying the © or word "copyright," the year that the work was first published, and the name of the copyright owner (e.g., © 2007 Barbara Weltman).

Copyright protection isn't limited to the arts and can extend to Web sites, computer software, architectural designs and even recipes and formulas if accompanied by substantial literary explanation. You can't copyright information that is common knowledge and has no original authorship, such as height and weight charts and public documents.

Patents
Previously thought of only in connection with inventions (Thomas Edison held 1,093 patents for inventions such as the electric light bulb, phonograph, and motion picture camera) and medications, today patents can be used to obtain financial advantage for creating processes as well. Examples: Burpee's patents for asexual reproduction of plants, culinary inventions (printing pictures of food on edible paper), and even tax strategies (although Congress may soon restrict this last class of patenting). Patents cannot be obtained for an idea or suggestion; there must be some technical merit worthy of protection.

Application and Fees
Obtaining a patent for an invention gives the owner the exclusive right to make, use, or sell the invention for a set number of years (usually 17 years from the date the patent is granted or 20 years from the filing, whichever is longer). During the patent process, show the public that you're in the process of filing by displaying "Patent Pending" or "Patent Applied for."

Once you believe you have something worth protecting and determine which type of protection is appropriate, move ahead. Learn about your rights for IP property at:
U.S. Patent and Trademark Office (www.uspto.gov). Patent fees can be pricey -- there are fees for a search, an examination, maintenance fees, and various miscellaneous fees that can total several hundred dollars or run into the thousands. The basic trademark application filing fee is $310 ($155 for a "small entity"), though there are many additional fees.

Copyright applications are filed with the Library of Congress. The basic registration fee per work is $45. You should note that this protection is only valid within the U.S. To protect your IP overseas, you'll need to take additional action.

Because IP property is so valuable, it's usually wise to invest in the assistance of a knowledgeable attorney. While not legally required, rely on an attorney to advise you and help you secure your legal rights.

After you receive legal protection for your IP property, it's up to you to monitor that your rights aren't being violated (i.e., someone is using your trademark without your permission). Police the Internet and send "cease and desist" letters to violators. If you fail to protect your trademarked brand name, for example, and allow it to fall into generic use, you'll lose your rights.

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House Rules

Don't assume your home-based business is exempt from taxes and labor laws -- even if you hire your teenager.

Working at home sounds ideal: Roll out of bed and in a few minutes you're at work.

Indeed, there are many advantages to working from home, including saving time and commuting costs, gaining the flexibility to combine work with family responsibilities, and the opportunity to be highly profitable (home-based businesses typically show a 36 percent rate of return compared with 21 percent for non-home-based businesses, due to lower expenses). But there are also a number of legal issues to address so you can stay out of trouble. Here are a key few:

Zoning
Determine whether local zoning law allows you to run your business activity from your home in a residential area. While there's usually no problem for a freelancer or Web designer, there can be limitations on a car detailer parking customer vehicles on the front lawn.

Also check on community restrictions if you live in a planned community or cooperative apartment. Covenants, conditions, and restrictions created by a homeowner's association or co-op board can be the last word on whether you can run a business from your home.

Business Formation
Decide how to set up your business from a legal perspective. You may dress casual in your home office, but you don't necessarily want to run your business in a casual manner. Decide, for example, whether to incorporate or form a limited liability company, even if you're the only owner -- a step that gives your business structure and credibility and you gain personal liability protection for your home and other personal assets in case of lawsuits or creditor claims.

Where appropriate, obtain trademark protection for your company name. Learn whether you need this legal protection and how to obtain it through the U.S. Patent and Trademark Office (www.upsto.gov).

Taxes
Running a business from home doesn't exempt you from any federal, state, or local tax responsibilities. Whether your business involves providing a service, selling online, or some other activity, be sure to pay required income taxes. Obtain a federal employer identification number (EIN) for your home-based activity (or check whether it can use your personal Social Security number for this purpose) by viewing IRS online information.

In addition to income taxes, make sure to collect and remit sales taxes under the law in your area. Of course, working from your residence means you may be eligible to claim a home office deduction and cut your taxes.

Licenses
A trade or profession, a contracting business, and many other activities require permits or licenses to operate legally -- home-based businesses are not exempt. Check on requirements in your area through Business.gov (www.business.gov/topic/Licenses_and_Permits).

Hiring help
If you need a hand in running your business, don't think legal requirements stop at your front door. Check with your state labor department on employer obligations, such as carrying workers compensation for employees.

If you want to hire your teenager, follow child labor laws, which limit the number of hours children can work and the type of activities they can and cannot do (www.dol.gov/dol/topic/youthlabor).

Double check zoning laws. While you may be permitted to work from home, there may be limits on hiring non-household members. Learn about federal tax obligations for employers in IRS Circular E, which is Publication 15 (www.irs.gov).

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More Hidden Tax Savings

Need a new company car? Why not get Uncle Sam to help pay for it?

For business owners, there are many hidden savings in the tax code. Take that new company car, for instance. If you're willing to jump through a few hoops, you can use the Internal Revenue Code to get the government to pay 40 percent or more of the cost of your new luxury car.

Here's how it's done. First, you need to own an interest in an active trade or business -- active meaning that it's some type of operating company or active business entity. You'll also need to create a new entity, a leasing company, that will purchase the vehicle and lease it to your active company. This entity must have flow-through taxation, preferably an S corporation, though other types of business entities without a federal level of taxation will work.

Your operating company can then enter into a fair market written lease agreement with your leasing company for the vehicle. The dealer that sold you the car can assist you in what the cost would be to lease it, and you must have more than a single car in your leasing company.

So far, so good. Let's use a hypothetical example to show what happens next. Let's say you own a profitable operating company and have a second entity, or create a second entity, that owns your office equipment, computer equipment, other personal property, maybe even an office building that you will or are currently leasing to your operating company. You have done well and decide to reward yourself with a vehicle that you only use for business. The vehicle's purchase price is $125,000 -- though it could be any type of vehicle and at any price, so long as the maximum first-year depreciation for 2007 is $125,000. Your leasing company purchases this vehicle and enters into a lease with your operating company to lease the car. Since you have exceptional credit, the bank does not require any down payment for your vehicle, or you have the company take a conventional loan.

On your 2007 leasing company income tax return, you have net leasing income, before the automobile purchase, in this example of $125,000. The $125,000 of net leasing income will end up on your personal income tax return, as it is an S corporation, and cause you to incur $50,000 of income tax -- that is, $125,000 of income at a 40 percent tax rate.

Since the leasing company purchased the vehicle and has it in service by Dec. 31, 2007, you can use a first-year bonus depreciation, IRC §179, and deduct the full vehicle's purchase, up to $125,000, in 2007. This depreciation deduction, reduces your leasing company's income by $125,000 to $0. Since your income has been reduced, your corresponding income tax has been reduced in 2007.

Your income tax, in this example, has now been reduced by $50,000 for 2007. In other words, you get the car and the government just allowed you to reduce your current year's taxation by $50,000. Just like that.

What's the bigger lesson here? Any time you do a business transaction, remember to look at how it can be structured to give you a tax benefit. Many times it means you'll need an experienced tax lawyer to read through and interpret the tax code in order to determine how this complex jigsaw puzzle gets put together. Often there are unexpected savings -- like $50,000 off a new luxury car -- open to business owners. The tax code is a massive, complicated document, and you'll be surprised what you can find in it.

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