In Depth: The one article Uncle Sam doesn’t want you to read! | Plastic Surgery Practice August 2014
When you decide to retire and close down your Captive, you receive capital gains treatment on the cumulative retained capital.
By Salvadore R. Salvo, CEBA
Physicians are part of a select group of professional service businesses that the rules of the Internal Revenue Service (IRS) do not seem to favor. However, the rules of the IRS do favor the insurance industry.
Enter the creation of a Captive Insurance Company.
If leveraged correctly, a Captive offers physicians protection by covering the gaps in their general liability commercial policies, and can be used as a wealth-accumulation entity with several tax benefits.
By setting up a Captive, you are essentially creating a company that provides risk-mitigation services for your practice. For many years, the benefits of a Captive were mostly enjoyed by large public corporations. Recently, however, the implementation has been simplified and has become more cost-effective for smaller, closely held businesses.
As a result, physicians can:
Put up to $1,200,000 in insurance premiums annually into their Captive Insurance Company and receive a tax deduction for the full amount, thereby saving on their income taxes.
Under code section 135(B), you’re allowed to put up to $1,200,000 of insurance premiums annually into your Captive Insurance Company and receive a complete tax deduction. Further, the $1,200,000 that goes into your insurance company is tax-free to your insurance company.
For example, if a physician makes $1 million of income and can save $500,000 a year, that money could be put into a Captive Insurance Company as a premium to cover liabilities that are not covered now. Without the Captive, assuming you make $1 million of income, federal tax alone would make you liable for about $327,000 in income tax. With a Captive and assuming you pay $500,000 in premium, your tax bill goes down to $152,000. That’s a tax savings of $175,000 every year that you do this.
Accumulate a war chest for payment of insurance claims in a tax-advantaged manner to cover the hidden gaps in general liability commercial policies.
Every physician we’ve worked with has somewhere between three to seven uninsured risks that can threaten their overall business with potential financial ruin. Many are not even aware that these uninsured risks are the result of hidden gaps in their general liability commercial insurance policies.
When Hurricane Sandy hit New Jersey in October 2012, we had a physician group that was forced to close their practice for 8 days because of the storm. They estimated a loss of $350,000 in revenue during that time and filed a claim. The insurance company sent a team of auditors in. After 2½ hours of going through all the numbers, they settled on $253,000.
The physicians said, “OK, at least we get some remuneration.” Two weeks later, they get a check in the mail for $25,000. Their coverage had a cap that stated that if the cause of business interruption was the loss of electricity from the power company, $25,000 is the maximum allowed.
Insurers work very diligently at limiting the actual risks they cover. Their first line of defense in paying claims is strict contract interpretation, backed by a whole army of lawyers. In contrast, a Captive can be written in broader contract language that applies to a wider range of circumstances and specialty risks so that in the event that something happens, physicians can be indemnified for the loss they sustained.
There are several common areas of exposure that are not included in general liability commercial policies, including employee liability, employee fidelity, statutory/regulatory change, administrative actions, accounts receivable defaults, loss of professional license, and loss of visiting privileges. Physicians can protect themselves from these areas with a Captive.
Assuming there is a reasonable claim history, physicians can:
Create a tax-efficient entity for wealth accumulation.
Let’s assume you capitalize your Captive with $250,000 (it must be kept liquid, but you could use a letter of credit for this requirement rather than cash). You pay an initial one-time setup fee that is less than $30,000 (this would include an actuarial analysis, insurance policies, corporate documents, application fee, Captive license, written business plan, and written investment policy),
and your premium is $500,000. Additionally, assume you generate a 2% return on your investment. Most of the Captives don’t pay a significant amount of claims.
Let’s assume your annual claims are $100,000 and you have $60,000 in other expenses, totaling $160,000 in expenses on an annual basis. As the tax code is written, you pay tax on the net earnings of your Captive, not the premium income.
In this case, your expenses offset your investment income and you pay no income tax. Your retained capital at the end of the first year is $600,000 in the Captive. This would grow each year, assuming the same rate of return and expenses. At the end of 15 years, the cumulative retained capital would be $6.3 million. In addition to this $6.3 million of cumulative retained capital, you would have saved over $2.6 million in federal income taxes during those 15 years
Take money out of the Captive at long-term capital gains rates for retirement.
When you decide to retire and close down your Captive, you receive capital gains treatment on the cumulative retained capital—in our example, $6.3 million.
Pass their accumulated wealth from their Captive onto heirs and avoid estate taxes.
If you are concerned about passing on your wealth to the next generation, you can actually pass the assets of the Captive to your heirs and avoid state taxes in the process (assuming these funds are not entirely used for retirement and you set up the Captive properly).
Despite the benefits, many physicians will be discouraged from setting up a Captive because they are under the impression that it will create a significant amount of work for them. The individual who sets up the Captive for the physician will take on the administrative work, the policy building, and all of the complexity through a process called “Captive management.” This process also ensures compliance with the law. Importantly, “Captive management” does not take control and autonomy away from the physician.
Salvadore R. Salvo, CEBA, is the co-founder, principal, and senior partner/owner of Summit Financial Resources Inc, Parsippany NJ, and the co-founder of The Institute for Family Wealth Counseling. He can be reached via [email protected]
Disclaimer: Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding US federal, state, or local tax penalties. If you require specific advice, please consult a tax professional.
Original citation for this article: Salvo S. Cosmetic doctors: A captive audience? Plastic Surgery Practice. 2014;(8),20-21.