HOW CAPTIVE INSURANCE, LIFE INSURANCE AND

RETIREMENT PLANS AID IN ASSET PROTECTION

PLANNINGF. Hale Stewart, JD, LLM, CAM, CWM, CTEP

Author of the book U.S. Captive Insurance LawWhere Finance, Economics and Law Meet

For The Law Office of Hale Stewart,HS Captive Management

INITIAL CONCEPTS

WHAT IS ASSET PROTECTION?

Asset protection is not a formally recognized legal discipline; you can’t go to law school or graduate school and obtain an asset protection specialty. However, it involves fairly disparate areas of law: Business entities Taxation Estate Planning Debtor/Creditor Law International Tax Law Bankruptcy

WHAT IS ASSET PROTECTION?

There are several events which can negatively impact an individual’s financial well-being.  In general, these are bankruptcy, litigation, divorce, physical/mental incapacitation and death .  Asset protection looks at each of these events, and then asks this fundamental question: "how can we mitigate the financial damage these events have the potential to cause?"  Or, put another way, asset protection is the legal discipline of mitigating , or attempting to mitigate, the negative impact of various financially and legally catastrophic events.

WHEN CAN WE ENGAGE IN ASSET PROTECTION PLANNING?

In general, we can’t engage in asset protection when we know with a pretty high degree of certainty that a judgment, debt, payment, bankruptcy or the like is right around the corner.

Put another way, we can only engage in asset protection when things are going well.

ASSET PROTECTION 101

One of the primary tools asset protection planners utilize is “target minimization,” or “firewalling,” which is the practice of separating and compartmentalizing risk.

For example, instead of a company owning its intellectual property outright, it forms a second company that owns the IP and then licenses the IP from the new company.

TAX PLANNING

The Eight Tools Three are derived from the tax code

Exemption: (For example – the proceeds of life insurance) Deduction: (For example – payments to some retirement

plans) Credit

Five are more “terms of art,” which require advanced planning

Deferral: Why pay today when you might pay tomorrow? Conversion: Changing ordinary income into capital gain Compression (Usually accomplished with a FLiP) Freezing: (Usually accomplished with a GRAT or IDGT) Arbitrage: Playing one tax jurisdiction against the other

Asset Protection and

Bankruptcy

BANKRUPTCY AND LIFE INSURANCE In general, all property owned by the

debtor becomes property of the bankruptcy estate:

The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held: (1) Except as provided in subsections (b) and

(c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.

BANKRUPTCY AND LIFE INSURANCE

But, there are exceptions: 26 USC 522(d)(7) Any unmatured life insurance

contract owned by the debtor, other than a credit life insurance contract.

See also, Ohio Rev. Code Section 3911.10: All contracts of life or endowment insurance or annuities upon the life of any person, or any interest therein, which may hereafter mature and which have been taken out for the benefit of, or made payable by change of beneficiary, transfer, or assignment to, the spouse or children, or any persons dependent upon such person

BANKRUPTCY AND RETIREMENT PLANES

The following are excluded from the bankruptcy estate: 26 USC 522(d)(10)(E) a payment under a stock

bonus, pension, profitsharing, annuity, or similar plan or contract on account of illness, disability, death, age, or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor, unless—

(iii) such plan or contract does not qualify under section 401(a), 403(a), 403(b), or 408 of the Internal Revenue Code of 1986.

BANKRUPTCY AND NONQUALIFIED DEFERRED COMPENSATION PLANNING

While non-qualified deferred compensation planning does not enjoy ERISA exemption, there are still ways to structure these programs to minimize the effect of bankruptcy. For example, if the employee and not the employer has a higher risk of bankruptcy, a NQDC plan owned by the employer may be appropriate.

QUICK SUMMATION OF ASSET PROTECTION AND BANKRUPTCY

The bankruptcy estate includes (essentially) every asset owned by the debtor, wherever and however owned.

Under the bankruptcy code, the following assets are exempt from the bankruptcy estate, making them good assets to own as part of an asset protection or overall financial plan: Life insurance Retirement plans Some non-qualified deferred compensation plans

CAPTIVE INSURANCE AND ASSET PROTECTION

A captive insurance company is a separate corporate entity from the parent corporation. As such, it is not a party to a suit brought against the parent.

Therefore, assume that a parent plays $1 million in premium to a captive over a 10 year period. Assuming for some payouts, management fees, and prudent risk management, the captive should still the bulk of its assets after a 10 year period.

WHO SHOULD FORM A CAPTIVE?

A company that has an above-average risk profile.

A company or individual with the financial resources to contribute to the captive.

Finally, a company should have a good combination of income and risk

◦ Ideally, a company should have $3 million in gross revenue

◦ But a company that has $1-$3 million may have enough risk to warrant looking at a captive.

◦ Please call if you have questions

WHAT COMPANIES ARE MORE LIKELY TO BENEFIT FROM A CAPTIVE Doctors and other professionals Manufacturers Exporters and Importers Dry Cleaning Construction Related Professions

◦ Contractors◦ HVAC◦ Plumbing

Oil and Gas Hotels, Motels, Restaurants and Inns Transportation Companies

WHAT ARE THE BENEFITS OF FORMING A CAPTIVE?

Custom Insurance Policies The Beech Case Using Individual loss experience in determining

insurance rates Gives the insured negotiating leverage with

third party insurers Third party insurer insures standard risk The captive underwrites specialty risk

Captives can be used as wealth transfer vehicles

Small Insurance Companies are Taxed Advantaged 831(b)

WHAT ARE THE BENEFITS TO FORMING A CAPTIVE, CON’T? Underneath the insurance and risk

management purposes of a captive insurance company is a great tax arbitrage opportunity. In the current year, the insured lowers his taxable

income through the payment of insurance premiums. In forming the captive, the insured is most likely insuring a large amount of risk which was previously “self-insured,” meaning the insured paid for losses out of current earnings and savings.

The premiums are placed into a tax-advantaged vehicle – remember that small insurance companies are taxed on their current portfolio income rather than their current earnings.

When the insured sells his captive shares, the transaction is taxed as a capital gains transaction rather than as an ordinary income transaction.

WHAT ARE THE STEPS TO FORMING A CAPTIVE? After a company decides to form a

captive, the next step is to perform a feasibility study, which has three objectives. It provides a blueprint for the entire

captive program. Second, it aids in compliance. Third, the study can aid in selling

important decision-makers within the organization on the plan.

WHAT ARE THE STEPS TO FORMING A CAPTIVE?

The jurisdiction where the captive is being formed must determine if forming the captive is in the jurisdiction’s best interest. To do that, they will consider◦ (i) The character, reputation, financial

standing and purposes of the incorporators;◦ (ii) The character, reputation, financial

responsibility, insurance experience and business qualifications of the officers and directors; and

◦ (iii) Such other aspects as the commissioner shall deem advisable.

WHAT ARE THE STEPS IN FORMING A CAPTIVE, CON’T Next, the applicant must make a formal

application to open an insurance company. The application must typically contain the following information (A) The amount and description of its assets relative to

the risks to be assumed; (B) The adequacy of the expertise, experience, and

character of the person or persons who will manage it; (C) The overall soundness of its plan of operation; (D) The adequacy of the loss-prevention programs of its

parent, member organizations, or industrial insureds, as applicable; and

(E) Other factors considered relevant by the commissioner in ascertaining whether the proposed captive insurance company will be able to meet its policy obligations

Finally, there is the issue of original capital and surplus.

RUNNING THE CAPTIVE

Domicile manager Legal counsel Audit Actuarial Services Investment manager

SHUTTING DOWN THE CAPTIVE

In most states, one of the following seven reasons will allow a state regulator to shut down a captive:◦ 1. Insolvency or impairment of capital and surplus.◦ 2. Refusal or failure to submit an annual report … or

any other report or statement required by law or by lawful order of the director.

◦ 3. Failure to comply with the provisions of its own articles of incorporation, bylaws or other organizational document.

◦ 4. Failure to submit to an examination or any legal obligation related to the examination.

◦ 5. Refusal or failure to pay the cost of an examination.◦ 6. Use of methods that, although not otherwise

specifically prohibited by law, render its operation hazardous or its condition unsound with respect to the public or to its policyholders.

◦ 7. Failure otherwise to comply with the captive statute.

CONCLUSIONS/SUMMATION

Asset protection attempts to minimize the negative impact of catastrophic events such as litigation or bankruptcy.

Tax planning allows us to determine the year in which we recognize income, and, in some situations, change the nature of the income received.

The following financial assets are excluded from the bankruptcy estate Life Insurance Retirement plans Some Non-Qualified Deferred Compensation