The Abernethy Law Firm, P.C.Matthew E. Abernethy, Esq.

President

Matthew E. Abernethy received his BSBA in Finance from Auburn University in 2007. Mr. Abernethyearned his Juris Doctorate from Georgia State University School of Law in 2011. He particularly excelledin the area of tax during law school, receiving the prestigious State Bar of Georgia Tax Scholar Award in2010-2011. He now practices in the areas of Tax Planning, Estate Planning, Captive Insurance,Conservation Easements, Asset Protection, Bankruptcy, Tax Dispute Resolution, Banking/Finance, andFamily Business Succession Planning. Mr. Abernethy mainly serves small businesses and high netwealth individuals.

In 2011 and 2012, under the mentoring of Professor Beckett G. Cantley, Mr. Abernethy assisted in thecomposition and editing of a series of articles on Captive Insurance and Conservation Easements.

The University of Richmond Journal of Global Law and Business published an article in which Mr.Abernethy assisted in the research, editing, and composition, entitled “The Forgotten TaxationLandmine: Application of the Accumulated Earnings Tax to IRC § 831(b) Captive InsuranceCompanies”. See 11 Rich. J. Global L. & Bus. 159 (2012).

The University of California-Davis Business Law Journal also published an article in which Mr.Abernethy assisted in the research, editing, and composition, entitled “Repeat as Necessary:Historical IRS Policy Weapons to Combat Conduit Captive Insurance Company DeductiblePurchases of Life Insurance”. See 13 U.C. Davis Bus. L. J. 1 (2012).

The University of California-Hastings West-Northwest Journal of Environmental Law and Policypublished an article in which Mr. Abernethy assisted in the research, editing, and composition,entitled “Environmental Preservation and the Fifth Amendment: The Use and Limits ofConservation Easements by Regulatory Taking and Eminent Domain”. See 20 Hastings W.-N.W. J.Envtl. L. & Pol’y 2015 (2014).

Generally speaking, a Captive Insurance Company(“Captive” or “CIC”) is formalized self-insurance. ACaptive is a C Corporation licensed to practice thebusiness of insurance in a domicile that has statutoryauthority to license and regulate Captives. Unlikecommercial insurers, captives do not generally insurethe general public. Instead, Captives will generally onlycover the customized risks of captive owners andaffiliated businesses.

Captives have been very popular with Fortune 500companies since the 1970s. Relatively recent legislation,most notably IRC § 831(b), has popularized the use ofmicro captives to level the risk management playingfield for small businesses.

Lowers Insurance Costs

Commercial insurance companies charge a premium formarketing and sales. Most commercial insurers spendbetween 6-8% of premiums collected on marketing andsales. A captive insurance company, because itprimarily insures only related risks, faces very littlecosts in the way of marketing and sales. These savingsare passed on to you, the parent business or family ofbusiness, under a Captive strategy.

Since a Captive is a licensed insurance company, aCaptive can directly access the reinsurance marketplace.Essentially, the reinsurance marketplace is to thecommercial marketplace as wholesale is to retail.

Expands Actual Insurance Coverage

Most commercial insurance policies contain innumerable exclusions andexceptions, creating large gaps in coverage. Also, some needed coverage islargely commercially uninsurable (i.e. cyber terrorism, product recall).Therefore, many businesses are already unintentionally self-insuring for a lotof these risks (in a tax-disadvantaged manner, as well). CICs may hand-craftpolicies for the particular situations facing its parent businesses, largelyavoiding these unintentional gaps in coverage (and doing so in a tax-advantaged manner—discussed in greater detail in the following slides).

Most commercial insurance policies also generally require the payment of asubstantial deductible. CICs may avoid the requirement of deductibles.Furthermore, where some commercial insurance coverage is retained, CICsmay be used to supplement coverage by insuring against the risk that youwill have to pay a deductible on a commercial policy claim.

The parent business or family of businesses employ the captive managers atwill. Therefore, CIC owners have indirect control over the claims handlingprocess.

Ensures Continuity of Insurance Coverage

Certain commercial insurance sub-industries, particularlytrucking commercial insurers, are notorious for untimelycoverage cancellations that can prevent the lawfuloperation of a truck or even an entire fleet. Temporaryloss of trucking coverage can create disastrous supply-chain consequences, potentially bringing your business toits proverbial knees. The use of a CIC, even if only to frontand then re-insure trucking risks, can help ensurecontinuity of coverage where there exists an indemnityand reinsurance agreement that only places the credit riskon the reinsure—there would exist no practical reason tocancel.

Retains Underwriting Income When your insurance claims

experience beats actuarialprojections, your insurer receivesmore premium than it pays inclaims—creating underwritingincome. If you have strong internalcontrols and a spotless claimshistory, why would you want athird party to retain underwritingincome that could remain in yourbusiness coffers? A CIC strategyallows for the retention of suchunderwriting income within thefamily of businesses.

Increases Asset Portfolio Liquidity A Captive must maintain sufficient liquidity to pay claims

as they are projected to occur, in order to be consideredan insurance company for federal income tax purposes.Therefore, a Captive will generally have to maintain alarge amount of its reserves in cash or relatively liquid,risk-free assets (such as T-bills or AAA rated, blue-chippublicly-traded securities. These holdings will increasethe overall liquidity of the business family’s portfolio ofassets (and on a tax-advantaged basis—discussed ingreater detail in the following slides). Increasing assetportfolio liquidity is important for accessing new andcheaper forms of financing, fostering growth andexpansion of the business family.

Ability to Control Investment Decisions for CIC Reserves Since CIC owners control the compensation of captive managers, the

CIC owners may have significant influence on the investmentdecisions of CIC reserves.

However, while captive managers will generally accommodatereasonable investment choices, captive managers must maintain theCIC’s status as an insurance company, for federal income taxpurposes. Therefore, captive managers must make investmentdecisions as would a reasonable insurance company (i.e. mustmaintain sufficient liquidity to pay claims as they are actuariallyprojected to come due).

It should also be noted that some investments, such as certain lifeinsurance arrangements within a CIC (e.g. non-key man life, any splitdollar arrangements, etc.), should be avoided due to concern over theapplication of various judicial tax doctrines that would destroy thefederal income tax benefits discussed in greater detail in the comingslides

Income Tax Benefits

So long as the CIC is considered an insurance company and the policies written areconsidered insurance, for federal income tax purposes, ordinary and necessary premiumspaid would be currently deductible to the paying parent businesses under IRC §§ 162 and482. This is also true of payments to commercial insurers; however, true self insurance(other than as formalized with a Captive) is not currently deductible—it would only bedeductible as a claim arises.

IRC § 831(b) provides that a micro captive (that qualifies with and makes an electionunder such section) may exclude up to $1.2 million of premium, annually, from incomefor federal income tax purposes. Therefore, so long as a CIC does not receive more than$1.2 million in premium per year, it does not pay federal income tax onpremium/underwriting income.

A captive must pay federal income tax on its investment income (at its applicable Ccorporation tax rates); however, investment decisions may be made to defer, minimize,and/or avoid the recognition of investment income altogether (e.g. municipal bonds, realestate, certain whole life insurance, equities). Once again, it must be noted that theinvestment choices of a CIC are limited to those that would be made by a reasonable,similarly-situated commercial insurance company (i.e. the timing of returns mustmaintain sufficient liquidity to pay projected claims).

Income Tax Benefits (Continued) When you consider all of these federal income tax benefits in

combination (deductibility of premiums, non-recognition ofunderwriting income, and avoidance of investment incomethrough limiting investment to municipal bonds), it is possiblethat no federal income tax will be paid on earnings until suchearnings are distributed to CIC shareholder-beneficiaries.

Even then, upon distribution of earnings to CIC shareholder-beneficiaries (e.g. owners, family, key executives, etc.), such adistribution would likely be taxed as a capital gain where suchshareholder-beneficiary has met the requisite holding period.

An appropriate CIC strategy may effectively take what wouldotherwise be considered ordinary income of the parent entity,defer the recognition of such income until a subsequent CICdistribution, use the pre-tax dollars to invest in tax-advantagedinvestment vehicles, and ultimately recharacterize the incomeas capital in nature!

Improves Cash Flow andIncreases Profits

The parent business or family ofbusinesses will greatly improve cashflow and profitability by: 1) loweringthe cost of insurance; 2) limitingexclusions, exceptions, anddeductibles; 3) retainingunderwriting income; 4) investingsuch underwriting income; and 5)deferring the recognition of andrecharacterizing business income.

Asset Protection As previously stated, captive insurance is essentially

formalized self-insurance that allows for tax-advantaged re-investment. If, instead of using CIC reserve accumulations toself-insure, you were to self-insure “on-the-books” of theoperating business entity, these funds would clearly be subjectto the general liabilities of the operating business (andpotentially even its partners). A CIC, as a separate and distinctC Corporation, would only be subjected to the liabilities of theoperating businesses and/or the CIC shareholder-ownerswhere the obligee can successfully “pierce the corporate veil”to get to the CIC reserves. The requirement of “piercing thecorporate veil” adds extra layers of expense and uncertainty inpursuing claims against the CIC reserves.

Estate Planning and Business Succession Planning Benefits

Captives are excellent estate and business succession planning tools where family membersand/or business successors of the original owners of the operating businesses are named asshareholder-beneficiaries of the CIC.

Because reasonable, arms-length premiums are paid in the ordinary and necessary course ofbusiness, by a parent to a Captive, such transfers (which may result in reserve accumulation)are not subject to the estate and gift taxation regimes. If the parent entities pay the maximum$1.2 million in premiums and experience no claims in a given year, there is a possibility thatthe full $1.2 million will ultimately be transferred to the heirs, free of any estate or gift tax(that’s significantly more than the $14,000 (or $28,000 for couples) per heir allowed tootherwise be transferred free of estate and gift taxes under current law!). However,expectations must be tempered because it is very difficult to continually beat actuarialprojections, absent significant claims control procedures and internal controls. Also, it shouldbe noted that any heir who has not yet reached the age of 21 should have his or her interestas a shareholder-beneficiary of the CIC held in dynasty trust with a generation-skippingtransfer tax provision (so as to avoid the application of family attribution rules).

The universal difficulties involved in business succession planning are transitioning votingpower/operation control and funding an eventual buyout. A CIC provides a non-operationalentity in which a departing owner-executive can maintain control over profits while allowinga younger family member or business successor to hold the ownership of and executivepositions in the operating business. Furthermore, a CIC may be used to actively fund andimplement the buyout.

Commercial General Liability Coverage Commercial Liability Umbrella Coverage Commercial Policy Deductibles Coverage Commercial Policy Exclusions & Exceptions

Coverage Commercial Property & Casualty Coverage Machinery Coverage Commercial Auto/Carrier Coverage GAP Auto Coverage Health Insurance Coverage Disability Insurance Coverage Worker’s Compensation Coverage Employer Liability Coverage Malpractice Liability Coverage Professional Liability Coverage Crime & Fiduciary Coverage Director & Officer Errors and Omissions

Coverage Negligence/Reckless Occurrence Coverage Employee Intentional Acts Coverage

Breach of Contract Coverage Bad Debt and Collections Coverage Business Disruption Coverage Supply-Chain Disruption Coverage Inventory Risks Coverage Loss of Key Man Coverage Loss of Key Contract Coverage Loss of Key Customer Coverage Intellectual Property Risks Coverage Litigation Risks Coverage Products Liability Coverage Currency, Interest Rate and Other

Economic Risks Coverage Business Continuity, Succession and

Transfer Financing Coverage Loss of Goodwill Coverage Natural Disaster Coverage IT & Information Security Risks Coverage

Expanded Lines of Coverage:

Tax Planning/

Asset Protection

Estate Planning/

Retirement & Business

Succession Planning

Captive

Insurance

Insurance/Risk Management

Sounds too good to be true, right?! Well, the benefits section of thispresentation is over. Now it’s time to talk about why every small business isn’talready using Captive Insurance. Captive Insurance is expensive to implement,requiring immense upfront costs and a team of professionals. Realistically, aMicro Captive will need the services of: 1) a Captive Manager; 2) an Actuary; 3)a CPA; 4) a federal income and estate tax advisor; and 5) a Reinsurance Broker.A simple, pure Micro Captive can generally be formed and operated forbetween 6-10% of premiums.* More typical group and fronted Micro Captivearrangements; however, have formation and operating expenses that rangebetween 12-28% of premiums. Of course these operating expenses do not reflectclaims losses, simply Captive overhead. These high up-front and continuingoverhead expenses mean that Captive Insurance is not economically practicalfor all small businesses. Furthermore, the risk of facing a catastrophic claim inexcess of premiums paid is simply too much for some conservative investors tostomach.

*The all-in fees for the services required for a simple, pure IRC § 831(b) Micro Captive typically run from between $50,000 & $100,000for formation and between $40,000 & $80,000 for annual maintenance & filings (depending on the level of premiums and quality ofcounsel). Some so-called “Captive Cowboys” often attempt to undercut these prices with cookie-cutter Captive mills; however,Captives require much expertise and individual attention. Failing to choose appropriate counsel can have disastrous consequences.

The Costs

Companies with at least $250,000, but ideally $1MM+in annual profits.

Profitable enterprise families of businesses involving 12or more separate entities.

Companies who are currently severely underinsured(whether it be unavailability or unaffordability ofcommercial insurance, high deductibles, and/orinnumerable policy exclusions & exceptions).

Companies with an established low insurance claimspayment history and excellent internal controls.

Companies looking to grow their operations andaccumulate wealth in a comprehensive manner.

Companies with an appetite for risk and an expectationof long-term investment.

(1) Hire an actuary and a federal income and estate tax advisor.(2) Conduct a Feasibility Study to determine what risk the Micro Captive should consider insuring.(3) Determine the appropriate type of Micro Captive (pure, group, cell, fronted, etc.).(4) Determine who will be the shareholders of the Micro Captive—businesses, trusts, and/or individuals.(5) Determine the appropriate jurisdiction for the Micro Captive. Choice of jurisdiction can greatly affect capitalization,

reporting, and regulatory requirements.(6) Hire a Captive Management Company (or “Captive Manager”) that is licensed in such jurisdiction to handle the day-to-

day insurance operations of the Micro Captive (sometimes this step will occur sooner if the Captive Manager is involved inthe Feasibility Study—some Captive Managers will conduct a Feasibility Study in-house for free if you sign an agreementguaranteeing them your business if/when you pursue a Micro Captive program).

(7) Incorporate a C Corporation in the appropriate jurisdiction, publish notice of incorporation, draft bylaws, hold annualshareholder and director meetings (complete with minutes), obtain a federal EIN, obtain a state taxpayer ID, and open acorporate bank account.

(8) Make an IRC § 831(b) election to be taxed as a small Micro Captive insurance company. The IRC § 831(b) election is madeby attaching a statement to the Captive’s tax return. An IRC § 831(b) election will apply to an insurance company as longas the company’s premiums do not exceed $1.2 million or until the election is revoked with the consent of the IRS. The IRSgenerally does not consent to the revocation of an election unless a material change in circumstances is shown.

(9) For offshore Micro Captives, consider whether an IRC § 953(d) election should be made to treat the CIC as a U.S. taxpayer.(10) Arrange for adequate capitalization prior to applying for an insurance license.(11) Conduct underwriting and develop individual policies with the assistance of the Captive Manager, Actuary, and federal

income and estate tax advisor.(12) Obtain one or more insurance licenses, as is appropriate for the relevant Micro Captive jurisdiction. You may be required

to have a business plan, a budget, and the audited proforma financial statements of the parent(s) to obtain a license. Mayalso be required to file an anti-money laundering affidavit.

(13) Issuing purchase orders for captive lines of coverage.(14) Be sure to satisfy local reporting requirements, including the payment of any relevant state or local premium or self-

procurement taxes.(15) Establish a uniform claims handling procedure.(16) Hire a CPA to handle the accounting work and implement the accounting system. A Captive operating as a small property

and casualty company must file a Form 1120-PC income tax return and report its income on Schedule B.(17) Meet regularly with your captive manager, federal income & estate tax advisor, actuary, and CPA team to ensure that the

Captive maintains regulatory compliance and obtains the benefits discussed herein.

Lack of Risk Shifting and/or Risk Distribution

Excessive Premiums

Accumulated Earnings Tax (“AET”)

Lack of Economic Substance Improper Investments

Excessive Loan-Backs

Investment Portfolio Illiquidity

Life Insurance

In order to obtain the tax benefits described herein, a Captive must be considered an “insurance company” and thepolicies written by the Captive must be considered “insurance”, for federal income tax purposes. The Internal RevenueCode (“IRC”) does not provide a definition for the term “insurance.” However, in Helvering v. Le Gierse,* the U.S. SupremeCourt set forth the standard that true insurance must have risk shifting and risk distribution. Risk shifting is the actualtransfer of the risk from the insured to the Captive insurance company. Risk distribution is the Captive insurancecompany’s exposure to adequate third-party risk to obtain the risk-pooling effect had by most traditional insurancecompanies. After the IRS abandoned the “economic family doctrine”, IRS safe harbor provisions have helped clarify theareas of risk shifting and risk distribution. These guidelines and safe harbors, if followed, should protect a Captive in theevent of an IRS challenge.

One safe harbor provision, Rev. Rul. 2002-90, provides that 12 non-disregarded subsidiaries, with each subsidiary havingno more than 15% and no less than 5% of the total risk insured, which are paying premiums to an affiliated Captiveinsurance company was enough for appropriate risk distribution and risk shifting to have occurred.

The other major safe harbor provision provides that sufficient risk distribution and risk shifting will have occurred wherea Captive takes on at least 30% of unrelated insurance risk (meaning no family, no common owners). To acquire 30% ofunrelated premium, a Captive may participate in a “risk distribution pool”. A risk distribution pool is formed for theexchange of insurance business among Captives to spread risk and enhance participation in a non-related business. A riskdistribution pool combines the investments of many Captives into a single account that is held by a reinsurance company.Risk is transferred from each individual Captive through a quota share reinsurance agreement whereby the reinsureraccepts a stated percentage of each and every risk within a defined category of business on a pro rata basis. This quotashare agreement provides a fixed and certain risk for all Captives that bought coverage from the reinsurance company. Acontract is issued between the reinsurance company and each Captive for the reinsurance company to retain funds in itstrust account for a certain period.

In Rev. Rul. 2009-26, the IRS stated that when determining risk distribution and risk shifting in a reinsurance contract, therisks of the ultimate insured must be examined. This contract would be the primary (underlying) insurance policy.

*Essentially, Helvering v. Le Gierse held that true insurance does not exist where the insured, absent tax benefits, remains in the same economic position—where there exists no degree of fortuity or uncertainty.

Under IRC § 162(a) and Treas. Reg. § 1.162-1(a), insurance premiums paid by a taxpayer are deductible if they are connected directlywith the taxpayer’s trade or business. However, the insurance premiums must be an ordinary and necessary business expense inorder to be deductible. Therefore, a business must be able to prove that any premiums paid to a Captive are an ordinary andnecessary business expense in the event of a challenge by the IRS. The IRS has challenged premiums as being “excessive” and not anordinary and necessary business expense on two grounds. First, taxpayers that pay overly high premiums for the insurance they arereceiving will not be able to deduct those premiums. Second, taxpayers that are suddenly obtaining a significantly higher andunnecessary level of insurance will not be able to deduct those premiums.

A reliable actuarial method is required to avoid a challenge for excessive premiums. In Gulf Oil Corp., the Tax Court decided thatinsurance premiums charged by a CIC and the amount of insurance provided by the CIC must be based on a reliable actuarialestimation of the risk of loss. Having premiums that are consistently in great excess of the actual losses paid is an indicator that oneof two things is occurring. First, the taxpayer could be attempting to evade taxes by taking advantage of the Section 831(b)exclusion. Second, the company could, in reality, be retaining the risk, and the IRS might conclude that the Captive was not actuallyproviding insurance. As a practical matter, the Captive should actually pay claims to its insureds every year. A red flag for the IRShas also been when the Captive is charging exactly $1.2 million in premiums. Under IRC § 831(b), a small insurance company candeduct up to $1.2 million dollars in insurance premiums. If a Captive is charging exactly that amount, it may suggest to the IRS thatan actuarial method was not used and that the Captive is a tax sham.

If the IRS or a court determines that the insurance premiums being charged by the Captive are excessive, undesirable consequencesfollow. First, the premium-paying company loses the income tax deduction and, most likely, also has to pay interest and penalties.Second, the Captive may have taxable income. There also could be gift tax issues with the transfer for Captive business structureswhere the Captive is owned by the business owner’s descendants or trusts. If the taxpayer-owner did not file a gift tax return, thetaxpayer may be subjected to failure to file penalties, as well as other penalties. For this reason, the client may consider filing a gifttax return every year a premium is paid to a Captive. By filing the Form 709 and making proper disclosure, the gift tax statute oflimitations will begin to run, and, thus, the transfer tax risk should be reduced.

To avoid a determination that the premium payments are excessive and at the same time increase the deduction available, thecompany can attempt to find insurable risks for which third-party insurance is not commercially available or not commerciallyaffordable. An insurable risk must have some degree of fortuity or uncertainty. Traditional business or investment risks do not havethe necessary degree of fortuity and thus, are not insurable. By obtaining insurance on risks that the company would not normallybe able to insure through a third-party insurer, the company will potentially be able to pay higher premiums without the insuranceor the premiums becoming excessive. This may result in the justification for a higher income tax deduction under IRC § 162(a).

The Accumulated Earnings Tax is a penalty tax “designed to prevent corporations fromunreasonably retaining after-tax” earnings and profits “in lieu of paying current dividends toshareholders,” where such income would be taxed for a second time as ordinary income atapplicable shareholder tax rates. If a CIC is liable for the AET under IRC § 532(a), a fifteen percenttax is imposed for each taxable year on the corporation’s accumulated taxable income. The AET isimposed in addition to any other taxes imposed under the IRC.

A CIC is only penalized under the AET if it retains earnings and profits in excess of reasonablebusiness needs with the intent to avoid shareholder taxes. The fact that a CIC accumulatedearnings and profits beyond the reasonable needs of the business is “determinative of thepurpose to avoid income tax with respect to its shareholders, unless the corporation proves thecontrary by a preponderance of the evidence.”

“The reasonable business needs of a corporation include not only its current needs, but also its‘reasonably anticipated‘ future business needs as well.” “Under the Treasury Regulation, theneeds of the business are determined at the close of the taxable year in issue.” The CIC shouldmake a practice of documenting its current and anticipated future business needs at the end ofeach cycle, but will not be required to show such formal planning if a definite and feasible plancan be otherwise proven. The end of the business cycle is when “management presumablydecides how much cash is needed for normal business operations, and for future adverse risksand contingencies.” The excess should “be distributed to shareholders as dividends, to be taxed asordinary income.”

In 2010, Congress codified the “doctrine of substance overform” and the “step transaction doctrine” into IRC § 7701(o)(the so-called codified Economic Substance Doctrine or“ESD”). IRC § 7701(o) provides that a transaction shall befound to have economic substance only if: (1) the transactionchanges in a meaningful way (apart from federal income taxeffects) the taxpayer’s economic position and (2) the taxpayerhas a substantial business purpose (apart from federalincome tax effects) for entering into the transaction. Newstrict liability penalties starting at 20% apply if a transactionfails to meet the new two-pronged codified EconomicSubstance Doctrine. When designing and operating aCaptive, extra attention is needed to document all non-taxeconomic and business purposes and benefits.

Excessive Loan-Backs

A Captive’s lending money back to an operating business that the Captiveinsures is often referred to as a “loan-back”. A loan-back is used to invest Captivefunds in the operating business. The arrangement usually takes the form of abond issuance but is fundamentally no different than a loan. The IRS carefullyscrutinizes loan-backs and has contemplated issuing regulations relating to them.To date, the IRS has issued limited guidance on loan-backs and has not providedan objective standard to determine whether a loan-back will be considered a bonafide debt and thus be found to have non-tax economic substance.

Loan-backs are often analyzed in terms of the loan-back to premiums-paid ratio. Ifa significant portion of the premiums paid are borrowed, concerns of a circularcash flow arise. In a situation where a Captive loaned 97.5% of its assets to theoperating business, the IRS determined the loan-back to be invalid and stated by“loaning out substantially all of its assets to an affiliate, Insurance Subsidiaryresembles an incorporated pocket-book, representing a reserve for self-insurance....” Therefore, a loan-back must be issued with great caution, must be abona fide debt, and should not represent a significant portion of the Captive’sassets or premiums paid.

Investment Portfolio Illiquidity

Where a Captive is undercapitalized, involves risks substantiallycovered through parental guarantees, or fails to maintain sufficientliquidity to pay claims as they are actuarially projected to come due,the arrangement may be challenged on economic substance grounds.The theory is generally that the insurance is a sham transaction,lacking true business purpose. Above all, premiums must beactuarially correct and the Captive must be maintained in a mannerwhich permits it to pay claims as they are actuarially projected tocome due. Therefore, a Captive must primarily maintain itsinvestment reserves in short-term, fairly liquid assets (cash, T-bills,short-term CDs, publicly traded securities, precious metals, etc.).Limited long-term, riskier investments are allowed where suchinvestments are specifically designed to meet long-term liabilities (forexample, a partnership buy-out reserve).

Life Insurance

Since the investment income of a Captive must be taxed as C corporation income, investmentvehicles that are not subject to current income tax are attractive assets for Captives to hold. In thatrespect, permanent life insurance policies would seem an ideal asset for a Captive to considerowning because increases in cash value are not subject to current income taxation. On the otherhand, IRC § 264 states that life insurance premiums cannot be deducted either directly or indirectly.Therefore, when a Captive owns life insurance, the IRS could conceivably attempt to collapse thebusiness’ payment of premiums to the Captive and the Captive’s payment of premiums to the lifeinsurance company, deeming them to be a single payment of premiums directly to the life insurancecompany—a non-deductible transaction that cannot be made deductible via a conduit entity. Suchclassification would result in a determination that any income tax deductions taken for premiumspaid to the Captive were improper. Because there is no authority on this issue, prudence andcommon sense are advisable to reduce any IRS risk. For instance, if life insurance is beingcontemplated as an investment for a Captive, the client should apply for it only after the Captive hasbeen formed. Also, its purchase should be for a significant nontax purpose. When life insurance isnot a primary asset of a Captive, but a minority portion of a diversified investment portfolio, thelikelihood of a successful challenge by the IRS under IRC § 264 should be significantly reduced.

Certain key-man life insurance policies, the premiums from which are otherwise allowed asdeductible business expenses outside of the context of Captives, would not be prohibitedinvestments for Captives.

The core components of a comprehensive feasibility study include: Identifying your organization's risk management goals and concerns Assessing current insurance coverage, gaps and retention Reviewing historical loss data Assessing the types of insurance coverages suitable for a captive Estimating costs of new captive coverages Estimating captive coverage losses Assessing suitable domiciles for your captive Estimating the cost of forming a captive Estimating annual operating expenses of the captive Determining the capital and surplus requirements for the captive Summarizing the cost-benefit analysis Preparing and explaining the financial performance projections for both expected andadverse loss scenarios

Explaining the tax implications, uncertainties, assumptions and elections Explaining proposed coverage lines, limits, rates and policy type in some detail Addressing reinsurance and pooling aspects and requirements if applicable Documenting the business purposes and expected economic benefits Advising as to investment objectives and options of captive

The Abernethy Law Firm, P.C.

Matthew E. Abernethy, Esq.

President

(404) 314-7759

abernethylaw@gmail.com

www.abernethylawfirmpc.com