What is a Captive Insurance Company ("CIC")?

A CIC is just what it sounds like. Literally, it is a client's own insurance company that can sell insurance to a number of different people or entities. (Although most of the time, the CIC will sell insurance to the client's own small business.)

Physician Medical Malpractice Insurance

One of the biggest expenses for a medical practice today is the cost of professional liability coverage. After the market crash of 1998-2000, insurance rates for malpractice coverage for physicians doubled, tripled and sometimes quadrupled. It was not uncommon for rates to have gone from $10,000 per year to $40,000 per year for $1 million/$3 million in coverage.

Imagine having a five-doctor orthopedic clinic where the annual premiums exceed $150,000, or as high as $250,000 per year in some states. Do you think such a client would be receptive to paying premiums to its own captive?

Since the vast majority of claims in the medical malpractice field come from a small number of physicians' recurring claims, physicians who have had no or few claims have been frustrated by the increasing rates caused by others.

The Finances of CICs

While CICs are an extremely powerful, tax-favored wealth-building tool, many small business owners cannot afford the annual premiums needed to make them viable ($100,000 for a very unique small CIC structure and more than $250,000 for a traditional CIC).

On the other hand, many physicians can afford to pay their premiums into a CIC for normal wealth building. And, if you couple that with a viable medical malpractice CIC structure, even more physicians can afford them.

How can a CIC work to transfer wealth to the next generation gift and estate tax free? Let's look at an example:

Mr. Smith owns 100 percent of his manufacturing company which generates $1,000,000 of take-home income after expenses from his company and he does not need all of the money to live on. Smith is 58 years old with a spouse, three children, and a net worth, including the value of his company, of $7,000,000.

Smith could set up a CIC that could be owned entirely by his children (or an irrevocable trust for their benefit). Smith's company would then purchase a minimum of $300,000 to $500,000 worth of insurance from the CIC for various types of insurance coverage -- coverage the company would normally not buy, but could.

With Smith's company paying this tax-deductible annual premium, Smith would have accomplished several good things:

• Smith would have transferred $300,000-$500,000 into an offshore CIC, which is owned by his children (or a trust for their benefit). This transfer was done without gift taxes and, with a good claims history, the children will be able to keep that money.



• Smith would not have had to take the money home and pay income taxes on it.



• Smith would not have had to figure out how to protect from creditors his after-tax accumulations, since the money would have not only been transferred to the children's CIC, but to an offshore CIC.



• The money in the CIC would have been available in the event there had been any insurance claims; but, realistically, that money would be used by the children personally.

Risk Retention Groups (RRG)

One of the problems with a stand-alone CIC for medical malpractice insurance is that one large claim could wipe out the captive's reserves. This can, and should be, mitigated by layering in "reinsurance." Reinsurance is coverage that picks up after the primary coverage has been exhausted.

A classic example of a CIC with reinsurance is one that will have the CIC responsible for claims up to, let's say, the first $75,000, and then the reinsurance responsible for claims up to the limit of $1 million/$3 million.

Obviously, there is a cost to reinsurance that affects the financial viability of the CIC. One way to drive down the costs of reinsurance is to form an RRG. An RRG is a pooling of CICs to buy their reinsurance from the same source. Because the pool is deeper and the premium dollars are larger, the RRG can negotiate better reinsurance rates, helping the financial viability of the structure.

How can CICs be used to sell life insurance?

Today, CICs are usually set up where the investment gains on accumulated premiums are taxable. Many clients do not want growth on the money in the CIC taxed, and the main tool to avoid this tax is life insurance. Now, with the advent of high cash value indexed UL products, life insurance is even easier to use as the primary investment in a CIC.

Additionally, for many clients, the CIC will be a wealth transfer tool and, as many people are aware, life insurance is the tool of choice when trying to transfer the maximum amount of guaranteed wealth to the next generation.

Summary

CICs can be one of the most powerful wealth building tools at your client's disposal.

CICs are not for everyone due to setup and annual costs. CICs for medical malpractice insurance can work so long as the client has a good claims history, and appropriate reinsurance coverage; it helps to work with an RRG to drive down costs.

For more information regarding this topic, please e-mail your requests to Randall A. Denha, or call Randy at (248) 457-7205.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

Prior to leaving for the August Congressional recess, Senators John Kerry and Charles Grassley introduced the "Empowered at Home Act," a bill that seeks to increase access to home and community-based services by giving states new incentives to make these services more available. If passed, the bill would significantly impact Michigan's Medicaid home and community-based services program (i.e., the Michigan Choice Waiver Program), which has waiting lists of up to two years in some counties due to insufficient funding.

The bill has four basic parts:

1. It seeks to improve the federal Medicaid Home and Community-Based Services (HCBS) State Plan Amendment Option by giving states more flexibility in determining eligibility for which services they can offer under the program, creating greater options for individuals in need of home and community-based services, and providing additional funding to assist states in making the transition.



2. For those opting for home and community-based services, it would require the same spousal impoverishment protections as currently offered to nursing home residents. In addition, low-income recipients of home and community-based services would be able to keep more of their assets when they become eligible for Medicaid, allowing them to stay in the community longer.



3. It would offer tax-related provisions to support family caregivers and promote the purchase of private long-term care insurance.



4. It would provide grants for states to invest in organizations and systems to help ensure a sufficient supply of high-quality workers, promote health, and transform home and community-based care to be more consumer-centered.

Home and community-based services allow individuals in need of long-term care to maintain dignity and independence by remaining at home. But, Medicaid currently continues to favor nursing homes, even though institutional care is the most expensive form of Medicaid-funded long-term care. This bill would encourage states to even the playing field between institutional care and home health care.

For more information regarding this topic, please e-mail your requests to Brenna D. Mansfield, or call Brenna at (248) 457- 7227.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

As we reported in our March 2007 E-update article entitled, "The Income Taxation Consequences of Demutualization", the Court of Federal Claims had denied competing motions from the Internal Revenue Service and the trustee of an irrevocable trust challenging the income taxability of the sale proceeds of financial services stock received upon demutualization of an insurance company. The Court denied both motions and scheduled a 2007 trial date. On August 6, 2008, the Court released its opinion and, ultimately, held against the Internal Revenue Service and its long-standing position assigning zero basis to stock received in insurance company demutualizations.

In Eugene A. Fisher, et al. v United States; No. 1:04-cv-01726, the Court held that an irrevocable trust was allowed a refund of taxes paid on the sale of stock received upon Sun Life Assurance Company's demutualization. The Court held that the amount the trust received for its stock was exceeded by its total cost basis in the life insurance policy. Consequently, the trust did not receive taxable income. Stated another way, the Court held that the amount received for the stock was less than the trust's cost basis in the insurance policy as a whole and, therefore, no income was realized.

The Court held that basis should be allocated equally to the amount of the sales price of the stock under the "open transaction" doctrine.

If your clients have sold stock received in a demutualization for any year in which the three-year statute of limitations is open, be sure to advise them to file a refund claim using Form 1040X. If a client extended a 2004 return, the deadline to file a claim is August 15 (or October 15 if there was a second extension).

However, it is not likely that the Court of Federal Claims' decision is the final word on this issue. It is expected that the Service will appeal to the U.S. Court of Appeals for the Federal Circuit and, if it does so, is not expected to issue the requested refunds anytime soon.

For more information regarding this topic, please e-mail your requests to Thomas P. Cavanaugh, or call Tom at (248) 457- 7218.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

Internal Revenue Code Section 409A has made very substantial changes to the rules governing the taxation of nonqualified deferred compensation. Generally, under Section 409A, non- qualified plan distributions are permitted only in the event of separation from service, disability, death, a change in employer control, or an unforeseeable emergency. Distributions can also be made at a specified time or under a fixed schedule, as stated in the plan at the time of deferral. The law also permits plans to make accelerated distributions, but only under certain circumstances. In addition, definitions are provided for disability, change of control, and unforeseeable emergencies.

While operational compliance with Section 409A began on January 1, 2008, IRS Notice 2007-78 extended documentary compliance until December 31, 2008. Failure to amend (in writing) a plan covered by Section 409A (to bring it into compliance with that Section) by the end of this year will require the employee to immediately include in income any amounts vested under the plan, along with interest and a 20% penalty tax.

For more information regarding this topic, please e-mail your requests to Julius H. Giarmarco, or call Julius at (248) 457- 7200.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

	Annual	Semi-Annual	Quarterly	Monthly
Short Term AFRs (Term 3 Years or Less)	2.19%	2.18%	2.17%	2.17%
Mid Term AFRs (Term More Than 3 Years and 9 Years or Less)	3.16%	3.14%	3.13%	3.12%
Long Term AFRs (Term More Than 9 Years)	4.32%	4.27%	4.25%	4.23%
Section 7520 Rate	3.8%