Part I of this series focusing on tax reduction and deferral strategies for trial attorneys with contingent fee income examined the use of private placement variable deferred annuities in lieu of fixed annuities for structured settlement payments to trial attorneys. Part 2 of this series will focus on the use of closely held insurance companies (aka captive insurance arrangements) to provide tax reduction and deferral on contingency fee income. The captive insurer can function as a multi-line insurer (property and casualty as well as life insurance) and issue the structured settlement annuities for contingency fee deferrals referenced in Part I of this series.
Trial attorneys representing plaintiffs are among the mostly highly compensated professionals in our Society. These lawyers are very entrepreneurial from both a legal and financial perspective. The majority of their income is from contingency fees – 30-40 percent in most cases. Trial attorneys are only compensated if they win a jury verdict or favorably settle the case for the plaintiff. Some of these cases take years to settle and the financial investment of the law firm in expert witness and other expenses is significant. In the aggregate, trial lawyers nationally earn $50 – 70 billion per year. In [i]many cases, trial attorneys have “spiked” income events as a result of a settlement or jury verdict every two-three years, but the income can be quite substantial.
Trial attorneys are limited in their ability to reduce and defer taxable income. Deferred income in qualified plans such as a defined contribution plan has a contribution limit of $50,000 in 2012 and a salary cap of $250,000. Most trial attorneys have not utilized structured settlement annuities which are conservative fixed deferred annuity products issued by large life insurers. The trial attorney forfeits investment control and flexibility through the structured settlement annuity purchase. Part I of this series advocated the use of a private placement variable deferred annuity (PPVA) as a vehicle for structured settlement annuities. PPVAs are institutionally priced and provide for unlimited investment flexibility.
Additionally, many successful and wealthy trial attorneys own other businesses outside of the law firm. Many of these businesses are successful in generating additional income as well and become valuable assets on the trial attorney’s balance sheet.
The closely held insurance company is an insurance based strategy that reduces current taxable income as well as providing for long-term tax deferral. The strategy can also provide powerful estate and gift tax planning benefits.
II What is a Closely Held Insurance Company?
A closely held insurance company (captive insurer) is an actual insurance company or reinsurance company with reserves for claims, surplus, policies, policyholders and claims. The main purpose of the insurance company is to insure the risks of the operating companies that are owned by the captive’s owner, the trial attorney and partners of the law firm.
Traditional captive insurers have been primarily viewed as an insurance solution to reduce insurance costs or provide coverage not available in the commercial marketplace. The focus of the captive insurer for the trial attorney is to insure the under-insured and uninsured property and casualty risks of the law firm as well as other businesses of the trial attorney. Additionally, the captive insurer may also serve as a multi-line insurer, i.e. an insurer that insures property and casualty risks as well as issues annuities and life insurance.
III Taxation of Closely Held Insurance Companies.
Small insurers (life or property and casualty) receive preferential tax treatment in the Internal Revenue Code. Additionally, an insurer has the benefit of taking a tax deduction for contributions to its reserves, its actuarial determination of future claims.
Some captives are able to make an election under IRC Sec 501(c) (15) to be treated as tax-exempt organizations. These captives have less than $600,000 in gross receipts; fifty percent must be insurance premiums.[ii] Due to tax abuse of these captives, Congress has created more stringent requirements to meet the requirements for tax-free status. However, in the context of the trial attorney law firm, this election may have viability due to the ability of partners within the law firm of owning their own captive cell which is treated as an insurance company. Each captive cell in turn underwrites or reinsures risks for the law firm.
Slightly larger captives that exceed the threshold of the IRC Sec 501(c)(15) election may that take in less than $1.2 million of premiums annually, may make an election under IRC Sec 831(b). The captive is not taxed on premium income but only the captive’s investment income. This type of captive must have a minimum of at least $350,000 in annual premiums to qualify for these tax benefits. Many Partners will be able to qualify for the IRC Sec 831(b) election. Contributions in excess of this limit are not problematic. The captive can manage its reserves and timing of income within the captive. A future IRC Sec 831(b) election can be made as assets are released and become taxable to the captive.
A captive may also be structured as a multi-line insurer, i.e. a company that underwrites property and casualty risks as well as life insurance and annuities. The small life insurance company under provisions in IRC Sec 806 and IRC Sec 816 that provide a special tax deduction for “small life insurance” companies of sixty percent. The company’s reserves related to life and health insurance must represent at least 51 percent of the reserves. The company size cannot exceed $500 million in assets. The company’s taxable income cannot exceed $3 million. The special provisions provide the company with an effective rate of 15 percent for federal tax purposes.
In order to be treated as an insurance company for federal tax purposes, the captive insurer must have a certain percentage of unrelated risks. The federal safe harbor is fifty percent. The amount of unrelated risk in case law is 30 percent.[iii]
IV The Strategy
The partners of the law firm will form a closely held insurance company as a property and casualty company or small life insurer operating as a multi-line insurer. Alternatively, the partners of the law firm may each own a captive cell which is treated as an insurance company for tax purposes.
The offshore company will be formed in an offshore jurisdiction in the BVI and make an election to be treated as a U.S. taxpayer. The offshore domiciles are among the most highly flexible domiciles from an investment standpoint that allow the trial attorney to invest all or most of the Company’s assets with existing investment advisors. The shares of the insurance company may be owned outside of the partners’ for estate for tax purposes.
The Company will underwrite and issue low risk specialty property and casualty coverage for the law firm. These risks may include the following:
(1) Business interruption
(2) Reimbursement for time lost and out of pocket expenses incurred to support litigation
(3) Loss of Professional License
(4) Uncollectible Advances to Clients
(5) Unfavorable Change in State or Federal Law
(6) Computer Technology and Privacy Coverage
The law firm should pay premiums for this coverage on a tax deductible basis to the Insurer. The premium payments will not be subject to gift taxes. Premium payments for excess disability coverage may be made on an after-tax basis so that any claim may be received tax-free. Company assets will be protected from the attorney’s personal and business creditors.
The captive may also be licensed to issue life insurance and annuities in the jurisdiction. The insurer may also form an assignment company allowing the company to issue structured settlement annuities allowing partners to defer the payment of contingency fees. A trial attorney may agree in his fee agreement with the Plaintiff to defer some or all of his contingency fees.
At the time of settlement, the fee obligation is transferred to an Assignment Company which is a wholly owned subsidiary of the life insurance company. The Assignment Company is the applicant, owner, and beneficiary of the annuity contract. The Assignment Company is a Barbados domiciled company in order to take advantage of the favorable annuity provisions of the U.S. – Barbados Income Tax Treaty.[iv]
The annuity contract contains traditional settlement options (life only, joint and last survivor) along with customized options for a specific payment date. The investment performance of the annuity contract is dictated by the investment performance of general account assets. The offshore life insurer has greater regulatory flexibility to consider a wider array of investment options.
VI Strategy Example
A. The Facts
Joe Smith, age 50, is a partner is a plaintiff’s law firm. Joe has a professional corporation. He is married and has three children. He has accumulated $1 million in the firm’s qualified retirement plans. His combined marginal tax bracket for federal, state and city purposes is 40 percent. His annual income after bonuses has averaged $3.5 million per year. Joe’s lifestyle requires a net income of $500,000 per year.
He has a family trust that owns a life insurance policy on his life for $2.5 million. Joe expects to earn an additional $5 million this year from a contingency fee on a medical malpractice case. Joe believes that he could make premium contributions to a captive insurer of $1 million per year for property and casualty insurance.
Joe practices law until he is age 70. It is assumed that contingency fees of $2.5 million per year will be deferred each for year with payments being guaranteed by Good Insurance’s wholly owned assignment company.
Joe and the Smith Family Trust create a new insurance company, Acme Insurance Ltd. (Acme), that is licensed in Barbados. The company is capitalized with $250,000. The shares will be owned by the Smith Family Trust which is an irrevocable trust which is domiciled in Delaware. The company makes an IRC Sec 953(d) election to be treated as a U.S. taxpayer for federal tax purposes.
The company will be licensed as a life insurance company and may offer property and casualty insurance as well. The company will qualify as a small life insurance company under IRC Sec 806(a). The company will be exempt from taxes in Barbados. The company will also own an assignment company. Joe’s investment advisor will manage captive investments to minimize current taxation.
Joe modifies his fee agreement with his client to provide for the deferral of any contingency fees. At the time of settlement of the malpractice case, the assignment company enters into an agreement with the defendant to assume liability of payment of attorney’s fees for Joe Smith. The assignment company purchases a deferred fixed annuity from Acme Insurance. The annuity is deferred and provides for payments is four years when Joe’s daughter enters college. The annuity after that period will provide for life only payments beginning at age 80.
Joe hires Acme Captive Management (ACM) do perform a feasibility study for the captive and identify a portfolio of new coverage for the captive. ACM develops the policy forms as well as performs an actuarial review to determine the appropriate pricing. The projected premiums per year are $1 million.
Over the next five years, $5 million of income will be paid to the captive on a tax-deductible basis. The premium income will not be taxed. The investment income of the captive will be taxed. The premium payments are not subject to gift taxes. The growth of the captive which is wholly owned by the Smith Family Trust, an irrevocable trust, will escape federal estate taxes.
At age 70, the amount of accumulated deferred contingency income is approximately $115 million assuming an eight percent rate of return. At age 79, the amount has doubled to $230 million. Joe has amassed a significant net worth independent of these deferred contingency fees. He elects to annuitize the annuity selecting the life only option.
At his death at age 82, the balance of the unrecovered annuity is not included in his taxable estate producing estate tax savings in excess of $115 million. The unrecovered annuity balance is also not taxable for income tax purposes. The profit is captured within Good Insurance which is owned in the family trust.
Nothing in the current landscape – economic or tax – suggests that plaintiff’s attorneys will make less money due to tort reform or that taxes will be lower. The closely held insurance company strategy provides a unique approach to manage high taxation from contingency fee income. The captive insurer as a multi-line insurer provides a dual approach to reduce and defer current taxation. The insurer may underwrite under-insured or uninsured risks facing the trial lawyer and his firm. The captive insurer which is also licensed as a life insurer may also issue structured settlement annuities.
The attorney’s management control of the insurer should provide a greater degree of incentive and confidence in the arrangement. Ultimately, significant estate tax savings can be achieved using a “life only” annuity payout. The “unrecovered” gain from the annuity payout reverts to the insurance company owned with the family trust as profit. Not only does the trial attorney defer taxation for decades, the deferred income is transferred without estate taxation.