Tax reform – what’s next for captives?

ERM more important than ever

We believe Enterprise Risk Management is more important than ever. The practice of analyzing risks and deciding how best to treat them will never go out of favor. The ability to finance un-insured risks through the use of alternative market solutions like a captive is a hallmark of a well-run company. With all of the changes in external environments from political events, social media growth and new technologies the hidden risks facing every business are not going away.

Will tax reductions make the appeal of the captive much less? While tax should never be a primary reason for creating an insurance captive, it is obviously part of the cost-benefit calculation that every business owner and their advisors will weigh.

Pass Through Income Rates

The major tax effects for small and mid-size companies (SMBs) will likely be in the area of pass through income and how it will be taxed. Many SMBs are organized as ‘S’ Corporations which means that net income is passed through to business owners who pay income tax at regular rates. While much has been made of a new 25% tax on pass-through income, the devil is the details. In fact, both congressional tax plans have proposed solutions to limit the value of this tax rate reduction.

Similar changes to pass-through income in Kansas were a disaster, and were eventually rescinded as most of the population rushed to create pass-through entities and pay less taxes. Congress will attempt to address this unintended consequence by declaring a portion of pass through income (50% – 70%) as wages which will be taxed at regular income tax levels. In addition, service based businesses such as accounting firms and law firms, will not be allowed to take advantage of this change.

At CapAlt, our back of the envelope calculations show us that effective business owner rates might decline by 3% to 7%. But other tax deduction eliminations may actually work to offset this small effect even further. Business owners may lose state income tax deductions, mortgage interest deductions and other common deductions such as student loan interest and medical payments.

Other favorable observations are that no change has been mentioned to Long Term Capital Gains rates, and that the Corporate Tax rate has been reduced to 20% which are favorable for an existing captive which is assessed on its investment income. Of course, none of this takes effect until 2019, and anything – and everything - can happen before then – including rescission by a new Congress.

So, overall, not really too exciting despite the hyperbole.

Regardless of short term tax changes, at CapAlt, we anticipate a rapid and steady increase in new captives, as business owners recognize the long term value of an Enterprise Risk Management solution for their uninsured risks.