Overview

The issue of carried interest taxation as obscure an issue as it is, has gotten all kinds of attention in the media over the last several years. Most recently, the issue garnered national attention during the Presidential Election with one of the very wealthy candidates having the marginal tax rate of a recent college graduate. Even one of the World’s richest of men in the country, Warren Buffet, acknowledged that he had a lower tax bracket than his secretary.

Following  passage of the most recent tax bill  at the beginning of the year, I was inclined to believe that the private equity industry and its lobby group (Private Equity Growth Capital Council) had dodged the “silver bullet” again.  After acknowledging the industry’s lobby organization as the most skillful and politically connected lobbying group, I saw an article in the New York Times this week by Jane Sassen stating that the private equity industry  believes that the end of the world (as they knew it) is in sight.

What is at stake is the percentage of carried interest subject to ordinary taxation. Proposals have ranged from 50-100 percent of the carried interest that would be taxed as ordinary income. Also at stake is the tax treatment of “enterprise value”, i.e. the value of a Principal’s interest in the firm. Various proposals seek to treat the gain of “enterprise value” as ordinary income which is more than a bit “heavy handed” as any other business would receive long term capital gains treatment under similar circumstances.

In order to put this into perspective, consider that private equity firms have enjoyed taxation at federal long term capital gain rates of 15 percent. In most cases, states tax long term capital gain income as ordinary rates. Total taxation was in the 20-25 percent.  The impact of tax reform in January 2013 along with a change in the taxation of carried interest would cause carried interest to be taxed at rates ranging from 43.4-55 percent. Needless to say, the tax impact is unimaginable. -

Virtually all private equity funds are structured as pass-through entities such as Limited Liability Companies or Limited Partnerships. The private equity investment management firm operates as the fund’s general partner or managing member. The private equity firm’s compensation is structured as an annual management fee equal to 2% to 3% of assets under management or committed capital per year.

The profits interest is equal to 20% to 30% of the fund’s return. Generally, the profits interest split is 80/20 – 80 percent to investors after returning investor capital plus a preferred investment return and 20 percent to the private equity firm.

This article is designed to introduce the concept of a closely held insurance company, aka captive insurance company, as an integrated risk managed and tax management solution for private equity investment management firms and its principals. 

What are Captive Insurance Companies?

A captive insurance company is an insurance company that insures all or part of the risk of its parent company. The biggest catalyst in the development of captive insurers has been the expense or lack of availability of certain types of insurance in traditional commercial insurance markets.

The private equity firm’s captive insures risks that are excluded from the commercial property and casualty coverage of the investment management firm, It some cases, the investment management firm is under-insured. The captive may cover the deductibles on existing property and casualty coverage as well as low risks that are currently self-insured.

Private equity firms unlike other businesses have yet to integrate captive insurance arrangements as part of the investment management firm’s risk management program. Recent years have also shown that legal claims against investment management firms such as private equity firms and hedge funds can be very substantial.

The Internal Revenue Code favors small property and casualty insurers small. -Captives that take in less than $1.2 million of premiums annually may make an election under Section 831(b). Under that section, the captive is not taxed on premium income but only the captive’s investment income. Insurance companies have a degree of latitude in establishing reserves for the payment of future claims. Additions to reserves are tax deductible expenses for the insurer.

Differences in Jurisdictions for the Captive

A captive may be formed in a U.S. state or in an offshore jurisdiction such as Bermuda or the British Virgin Islands (BVI). Issues for “domicile” selection facing the captive include the following:

1. Permitted Assets. Different jurisdictions have different standards as to what types of investments may be used for reserves (liabilities) as well as capital and surplus. Some jurisdictions recognize 100% of the value of certain investment assets used for reserves while another jurisdiction will only recognize a lower percentage of the same asset class. Risk based capital calculations are as important for small insurers as they are for larger insurers.

A private equity fund manager thinking of investing in the firm’s capital in private equity funds should place significant value on this issue in determining the domicile of the captive. This issue is also a factor in capitalizing the asset with appreciated assets.

Even in Delaware, it is possible for a captive to invest up to seventy percent of its assets into the hedge fund manager’s funds.

2. Conservatism. Newer jurisdictions are generally expected to be more flexible in regulation in order to attract captive insurance business. A more established jurisdiction may be more inflexible in regard to permitted assets and the type of coverage that the captive may underwrite.

3. Records and Meetings. Some domiciles require the captive to maintain records in the domicile. In the case of an offshore jurisdiction, this type of regulation may actually be favorable for the captive owner to protect the captive’s documents from disclosure and discovery. Some domiciles require annual meetings in the domicile while others do not.

4. Licensing Fees and Premium Taxes. All domiciles charge licensing fees which vary from jurisdiction to jurisdiction as well as renewal fees. Some jurisdictions charge premium taxes. These costs are additional factors to consider.

As far as domestic jurisdictions are concerned, Vermont has traditionally been the domicile of choice. States as Delaware Utah, South Carolina, and Hawaii are competing aggressively for this business.

The advantage of an offshore jurisdiction for the captive generally centers on the lower amount of bureaucracy and regulatory flexibility. An offshore jurisdiction provides the captive owner with greater asset protection and greater investment flexibility within the captive.

However, Delaware has emerged as an excellent option for captive insurers as it offers the ability to use its series limited liability company statute for captive insurers.

How Does the Captive Work for a Private Equity or Venture Capital Firm?

The captive is an insurer domiciled in Delaware or offshore jurisdiction such as Bermuda or the British Virgin Islands (BVI). The offshore captive can make an election under Section 953(d) to be treated as a U.S. taxpayer for tax purposes. Depending upon the level of expected premium, the captive might make a Section 831(b) election that will not tax the captive’s premium income under $1.2 million per year.

Delaware with its Series Limited Liability Company legislation has adopted state of the art captive legislation. The ability of the Delaware captive to create Small Business Units (SBU) in separate series of the LLC creates a unique opportunity for a business owner to create multiple captive arrangements.

These SBUs provide the captive with the ability to bifurcate risks not only on the basis of “low risk” and “high risk” but also from the standpoint of ownership by different Principals within the investment management firm ownership structure as well as the IRC Sec 831(b) limits.

Case Study

Facts.

Joe Smith, age 45, is a managing director of a private equity firm, Acme Asset Management. A recent change in tax law has adversely impacted the taxation of the firm’s carried interest in the firm’s funds. The marginal tax bracket for carried interest for the California-based firm will increase from 25 percent to 53.4 percent.

The fund has significant income due to management fees and performance fees. After bonuses to employees, Acme has $3.5 million of taxable income. An existing fund is expecting to make a distribution to investors. The projected carried interest for the firm is $10 million.

Joe would like to minimize the income tax liability associated with his funds and accumulate funds on a more tax-advantaged basis beyond the reach of his personal and corporate creditors.

Strategy.

Joe creates a Delaware captive insurer called Acme Insurance Company (“Acme”).Joe’s shares in the captive will be owned by the Smith Family Irrevocable Trust, a Delaware Trust.  Joe will also extend an ownership interest to his two long term partners. The shares will not be subject to the claims of Joe’s personal creditors. Furthermore, the value of the shares will not be part of Joe’s taxable estate for federal estate tax purposes.

Activa Captive Management establishes the captive and administers the captive’s administrative operations. Activa performs a feasibility study analyzing Acme’s current coverage to determine risks that are either self-insured or under-insured. Acme’s feasibility study identified the risks below and designed coverage for the company’s identified risks. The outline below details the coverage and premiums.

Acme Risk Assessment and Coverage Proposal

The description of new coverage is as follows.

a. State or Federal Legislative Changes..

b. Directors and Officers Liability Insurance.

c. Inability of Insured Employee to Work.

d. Business Litigation Matters

e Detrimental Code.

f. Data Breach Liability..

g. Changes in U.S. Tax Law.

h. Loss of a Significant Investor

Acme structures the captive insurer into three different SBUs. One SBU is designed to provide reinsurance for a Fronting Company insuring some higher risk exposures. A second SBU will be owned by the Smith Family Trust and lastly, a third SBU will be owned by the Joe’s partners – the Acme COO, and General Counsel. Acme will receive a full tax deduction for its annual premium payments to the captive of $3.3 million to each of the SBU’s.

Acme will allocate 70 percent of each premium payment as a capital contribution to each trust to a Delaware LLC. The captive will own all of the preferred interests which have a preferred return equal to at least the long term applicable federal rate. The common interests in the LLC may be owned by family members or a family trust.

The preferred equity holder (the captive) holds voting control, preferred liquidation rights and a preferred cumulative return. The common equity holder is entitled to any excess return above the preferred return. The LLC is effectively treated as a private bond for insurance regulatory purpose.

The LLC structure allows the Joe and his partners to legal method for overcoming the conservative insurance regulations regarding permissible investments within the insurer. The firm may allocate 70 percent of each premium payment as a capital contribution to the LLC. The LLC may reinvest these funds back into the private equity  funds of the firm.

Summary

The captive strategy delivers a combination of significant tax benefits. The investment management firm is able to underwrite insurance risks that are not available in the commercial insurance marketplace. Furthermore, the premiums are fully deductible for income tax purposes. The captive will be not be taxed on premium income and only investment income in the event of a Section 831(b) election.

The captive’s surplus may be reinvested in the private equity firm’s funds at a lower tax rate than the principals of the investment management firm’s tax brackets. The captive and its assets will not be subject to the claims of the investment manager for asset protection purposes.

The captive and all of its future growth can be arranged so that it will not be part of the principal’s taxable estate. Dividends can be paid as qualified dividends at a preferential rate.  Additionally, the dividends received deduction might be useful in tax planning if Joe’s family investment company is taxed as a regular deduction.

The captive might pay dividends to the Family Investment Company which owns the shares of the captive. The Family Investment Company itself might be owned within an irrevocable family trust.

The captive can ultimately be sold or liquidated at long term capital gains rates. The captive itself can be owned outside of the taxable estate. Premium payments to the captive are not treated as taxable gifts.

The captive insurance company is the best integrated risk management and tax planning structure for private equity and venture capital firms as the tax treatment is set to undergo major changes. The captive covers important risks to the investment management firm while serving as a deferred compensation vehicle that is far superior to any qualified retirement plan. As the sand shifts in the tax landscape, give captive insurance a very close look in your planning considerations.