IASA: Captive Insurance 101 VENTURE CAPTIVE MANAGEMENT Developed By Matthew Queen, General Counsel Email: mqueen@venturecaptive.com Phone: 770-255-4907 VENTURE CAPTIVE MANAGEMENT IASA: Captive Insurance 101 venturecaptive.com

SUMMARY The Captive Opportunity 1. What is a captive insurance company? 2. What are the general tax considerations for a captive? 3. How do state & local taxes interplay with captives? 4. Are there any international tax issues to navigate?

WHAT IS CAPTIVE INSURANCE? Captive Insurance is formalized self-insurance Captives work best covering risks that traditional cannot or will not cover Captives are typically C- Corporations licensed to offer insurance in a domicile that has statutory authority Companies may join Group Captives or form their own Single Parent or “Pure” captives

THIRD PARTY RISKS & GROUP CAPTIVES CAPTIVE STRUCTURES THIRD PARTY RISKS & GROUP CAPTIVES BROTHER/SISTER RISKS Parent Parent Premiums Captive Captive Subs Subs Third Party Premiums From Other Employers’ Benefits Programs Premiums Premiums Assume 7-12 complex subsidiaries or affiliated companies Premiums from subs deductible Premiums from parent non-deductible Greatest control & flexibility Assume affiliated group only 50% of captive’s premium Premiums to captive deductible Subs & parent shifted risks & premiums deductible 3rd party premiums add’l income source to captive

CAPTIVE EFFICIENCY How Are Insurance Dollars Spent? Traditional Insurance Captive Insurance $0.40 est. Administration + Profit $0.05 – 0.30 est. Administration Costs $0.60 est. Allocated for Losses $0.70 – 0.95 Allocated for Losses

CAPTIVE IMPACT Decreased costs improve profit potential Reduced claims improve company profit Investment of premiums adds additional line of revenue Absolute control over risk management program Improved IRR for shareholders and other stakeholders

IDEAL CANDIDATES Sufficient organizational risk Strong cash flow Few losses or manageable risk profile Management multiyear commitment Desire to create new profit center

FEDERAL INCOME TAX Model Assumptions: $1.9 million in gross written premium to captive Captive makes the 831(b) election Small captives writing < $2.3m in GWP may elect 831(b) status and not be taxed on underwriting profit Contrast with traditional 831(a) captives which are larger but lack the tax break 37% Federal Income Tax $190,000 annual captive costs

INTERNATIONAL TAX Barring a tax treaty, IRC imposes standard taxation on the effectively connected income of foreign-based companies. IRC § 882. Further taxation under branch profits tax equal to 30% of dividend equivalent amount for foreign-based corp. IRC § 884. Solution to various international tax issues: 953(d) Election 953(d) election taxes offshore captives as if a U.S. domestic company.

INTERNATIONAL TAX 953(d) election requires: 1) Provide the IRS an election statement; 2) Maintain a U.S. office; 3) Show ownership of assets that are physically located in U.S. with adjusted basis equal to 10% of the gross income for the base year. Loss of 953(d) election status results in Controlled Foreign Corporation status subjects captive to 30% withholding tax on effectively connected U.S. income as well as federal insurance excise tax of premiums.

Welcome to the Wild West STATE & LOCAL TAX Welcome to the Wild West Both the Commerce Clause and the Due Process Clause of 14th Amendment control extent to which states may tax economic activity CC provides minimum threshold of economic activity & DP14 requires some definite intent to conduct business within a state “Purposeful Availment” McCarran-Ferguson gives power to states to regulate insurance The messy legacy of Todd Shipyards Frozen trilogy of cases from 19th century applying due process as understood in 1897 to modern cases Huge tax savings if understood properly

When Does a Captive Owe State Tax? STATE & LOCAL TAX When Does a Captive Owe State Tax? Assess whether Todd Shipyards protects taxpayer from remitting tax to the state If facts very similar to TS, then take position of no tax. If differ from TS, assess Commerce Clause & Due Process of 14th Amendment If transaction falls outside CC or DP14, then assess whether a state’s “doing business” laws govern the transaction

When Does a Captive Owe State Tax? Factors to Consider: STATE & LOCAL TAX When Does a Captive Owe State Tax? Factors to Consider: - The insurance covers property owned by a corporation not domiciled in the taxing state; - All of the insurers are domiciled outside of the taxing state; - The insurance agreement is negotiated for, signed, issued, delivered, paid, and accepted outside of the taxing state; - None of the insurers has an agent or office within the taxing state; - No claims are invested or adjusted within the taxing state; - None of the insurers solicit any business within the taxing state; - None of the insurers communicate with the insured; - All decisions regarding the purchase and renewal of insurance occur outside of the taxing state; - All losses are paid out-of-state and all premiums are paid out-of-state.

IRS REQUIREMENTS Business Purpose Risk Shifting Risk Distribution

SUMMARY Alternative Risk Financing provides tremendous economic efficiencies Advantages in state, federal, and international tax areas Captives perfect solution for unique risks