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Income Tax Deductions Profitable Business Owners Should Consider before Year End (A Defined Benefit Plan / Captive Insurance Company)

Income Tax Deductions Profitable Business Owners Should Consider before Year End

(A Defined Benefit Plan / Captive Insurance Company)

Income tax rates are very high and likely will go higher. High income individuals residing in New York City can expect a marginal income tax rate of greater than 52%. With fewer and fewer allowable deductions available to taxpayers, it is as important now as ever to reduce income tax liability using techniques which are still permitted by law. Profitable business owners have many opportunities to generate sizeable income tax deductions. Two such strategies would be establishing a defined benefit plan and/or creating a captive insurance company.

A Defined Benefit Plan:

Qualified retirement plans generate income tax deductions under the Internal Revenue Code. A defined benefit plan is a qualified retirement plan that in many cases allow for above the line annual income tax deductions of several hundred thousand dollars for small business owners. All contributions into qualified defined benefit plans are completely tax deductible. Since these plans generate “above the line” deductions, use of a qualified defined benefit plan is a great way to reduce your current year income tax liability on the federal, state and local levels, while also increasing retirement savings. For example, a taxpayer earning $1.5 million per year with a defined benefit plan contribution of $300,000 would only have $1.2 million in adjusted gross income, potentially saving $150,000 in current income tax liabilities!

If you qualify, your defined benefit plan also allows for significantly larger contributions than typical 401(k), profit sharing and/or money purchase plans. Given the right situation and employee demographics, individuals over the age of 50 can potentially contribute more than $300,000 per year. The purpose is to maximize owner contributions while minimizing employee cost. Complying with IRS rules requires contributions to be calculated actuarially based on an employee’s age, income, expected age of retirement and the plan’s expected and actual investment performance.

Under current law, a defined benefit payment can be designed to pay as much as $210,000 to the plan participant per year for life. As discussed, since the size of the contribution (and therefore the deduction) is essentially based on the business owner’s age, the number of years until retirement, life expectancy and the presumed rate of return the largest contributions will be made by those taxpayers who have less time before retirement. For example, an owner with 10 years of plan participation could theoretically retire at age 62 with a lump sum of $2,480,000 given the right salary and coverage with effective investment guidance. This figure could increase to $3.7 million if the plan adjusts payouts for cost of living increases. In addition, an equivalent amount can be set aside for the owner’s spouse if the spouse is also an employee of the business and earns at least $260,000 per year. These benefits simply cannot be achieved with an ordinary 401(k) or profit sharing plan, where contributions are limited to only $52,000 per year.

A Captive Insurance Company (“CIC”):

Another method to generate a massive income tax deduction is through the use of a CIC. CICs are bona fide regulated insurance companies that underwrite insurance policies for under- or uninsured risks of a company that are not likely to occur (loss of licenses, reputational damage, kidnapping or terrorism for example). Almost all Fortune 500 companies make use of CICs because of their numerous advantages. Much of the cost of insurance premiums goes to making an insurance company profitable. In this case, the owner of the CIC (the business owner or a trust for the benefit of the business owner’s family) will reap the profits, which is only the tip of the iceberg.

Making insurance payments to third party insurance companies are allowed as income tax deductions, but self-insuring is not deductible. A CIC is usually funded with as little as $250,000 and must be taxed as a C Corporation (although the ownership structure may be in the form of a partnership or LLC), and as long as the risk is properly shifted and distributed, Internal Revenue Code §831(b) allows an income tax deduction of up to $1.2 million per year. So in addition to allowing the company to select which risk to insure against for a lower premium than an outside insurance company (or to insure against risks not otherwise available), the business generates an immediate deduction. In addition, the insurance payment is not considered income by the CIC. Instead, the CIC only pays income tax on investment income. This characteristic creates an incredible wealth transfer opportunity. Further, if distributions are made to the owner of the CIC (the business owner or a trust), the distributions are treated as capital gains (and not ordinary income), thereby incurring an income tax at a much lower bracket and enjoying a deferral for as long as the money was left in the CIC in the first place.

It is important that a CIC meet all regulatory procedures, such as making sure that more than 50% of its business is involved in issuing insurance (but not life insurance) or annuity contracts and paying valid claims. Also, having at least 12 subsidiaries to spread the risk (or if not, joining a pooled fund) may be necessary to make sure they are compliant with the law. As a result, there are annual compliance fees in addition to the start-up costs, but the tremendous advantages created by a CIC more than outweigh those costs.

Defined benefit plans and/or captive insurance companies may be appropriate for you, but they can be time-consuming to get started. If you want to take advantage of the massive income tax deductions these vehicles can produce in 2014, it is imperative you get to work on implementing your preferred strategy now.

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