Tag Archives: capital gains

An Avalanche of M&A?

A financial adviser friend likes to say that “taxes are on sale” at the moment. He’s focusing on the possibility of higher income-tax rates for his well-to-do clients and for the corporations whose shares are in their portfolios, and trying to get clients to reduce or liquidate certain holdings before the increases hit. But this idea of taxes on sale should have effects that ripple far beyond my friend’s client base, possibly including a spate of consolidation in the insurance industry.

That’s the thesis that was advanced last week by Stephen Schwarzman, CEO of Blackstone Group, the private equity firm that as of March 31 had a staggering $650 billion of assets under management.

He says corporate leaders worry about a Biden administration proposal to tax capital gains as ordinary income for those earning more than $1 million a year, rather than let them apply the much lower rate that has long been used for profits on sales of stock, real estate and many other assets. The change would mean a tax rate of 39.6% on capital gains for those high earners, rather than 20%.

While any tax increases look to be at least months away, Schwarzman said high earners are starting to look now at selling assets and booking profits, to be safe.

Although he didn’t single out insurance, I suspect his thinking applies, in particular, to many owners of insurance brokerages and agencies. We could see an acceleration of the consolidation that has been occurring in the distribution channel. Private equity has already been buying up brokerages and agencies, and having eager sellers should only increase the pace.

The continuing digitization of insurance sales, accelerated by the pandemic, may also encourage owners to continue selling. Digitizing takes capital that some don’t have, so, knowing they face a steady loss of competitiveness, owners might explore selling now. Even if they have the capital, owners have to decide whether they want to manage a significant transition — moving business online and incorporating digital technology into a host of internal processes while also figuring out how to reopen offices following the pandemic. Many may decide that they’d just as soon let some bigger entity handle the shift. For anyone contemplating an exit, now would seem to be a good time.

Beyond the effect on agencies and brokerages, the possibility of a higher tax rate on capital gains could encourage insurtechs and even some larger, established companies to consider putting themselves on the market now if they had already been considering an exit. The same for the possible increase in the corporate tax rate in the U.S. from 21% to 28% (or whatever the final proposal turns out to be): Potential sellers might hope to get a higher valuation based on the loftier net income that lower taxes allow.

It’s not clear how great the effect of the possible tax changes would be for insurtechs and larger companies. Lots of other factors come into play, the larger a company is, and tax increases aren’t anywhere near a done deal. But the prospect of higher taxes might tip the scales for some.

In theory, consolidation will address one of my bugaboos — the wild inefficiency of so many insurance processes — through economies of scale and greater investment in digitization.

I realize that the adage says: “In theory, there is no difference between theory and practice. In practice, there is.”

And, in fact, a lot of the increase in scale among agents and brokers seems to have been used to press carriers for higher commissions, rather than to drive efficiency.

But I don’t give up easily. I’m holding out for scale that drives digitization and that drives costs down while simplifying life for customers.



Section 831(b) Captive Insurance Companies And The Tax Preparer Penalty

An Actual Scenario: A CPA was preparing the tax return of a longtime client who had purchased three captive insurance companies from a well-known provider of such entities, and had paid $3.3 million in insurance premiums to these companies. The client wished to show that payment as a tax deductible item. The client had $28 million in revenue and paid $92,000 annually for their usual third-party insurance program. The insurance premiums paid to these new captives were for “coverages” that supplemented their existing insurance. What could the CPA do with this request?

Background: Owners of profitable businesses are attracted to the tax and financial planning benefits of forming and owning a captive insurance company that qualifies for the tax benefits of section 831(b) of the Internal Revenue Code (the “Code”).

The Code section provides that if an insurance company has no more than $1.2 million in annual premium income, it can elect to exempt that income from taxation. And under a series of judicial decisions and Revenue Rulings, the insured company may be able to fully deduct the premium paid, even if the same person (or persons) owns both the insured and the insurance company.

This concept can be financially powerful, resulting in an immediate reduction in the owner's tax bill, yet virtually all of the funds remain tax free inside a related company. The profits of that company can either be accessed later at capital gains rates or passed to heirs outside of the estate tax regime.

The Problem: The deductibility of the premium is not automatic. The hurdles for properly deducting premiums paid to one's own insurance company are both numerous and, to some extent, subjective. The new insurance company must demonstrate sufficient “risk distribution,” the amounts charged by the insurance company as premium for the coverages offered must be “reasonable,” and the client must demonstrate an adequate “business purpose” for entering into the transaction, to name just a few of the important hurdles involved. These are each very important requirements that a tax preparer is unlikely to be able to judge with any degree of comfort.

Tax preparers who face the request to sign a return that reflects the deduction of such premiums must be careful not to run afoul of the Return Preparer Penalties of section 6694 of the Code. In addition, the client could face an accuracy-related penalty under section 6662 of the Code equal to 20 percent of the underpaid tax should the deduction ultimately be disallowed.

The standard for avoiding the Return Preparer Penalty is that the preparer held a reasonable belief that the position (the deductibility of the insurance premium) would have a greater than 50 percent likelihood of being sustained on its merits.

One of the factors included in the Regulations covering Section 6662 to determine whether a tax return has been negligently prepared is “failure to reasonably ascertain the correctness of an item that to a reasonably prudent person would appear 'too good to be true' under the circumstances.”

In this case, it appeared that a sudden increase in insurance expense from $92,000 to over $3 million might make the deduction of that expense “too good to be true.” But how could the preparer “reasonably ascertain” the likelihood of this deduction being upheld in audit?

The third party that the client relied on for advice in this transaction was the captive insurance company provider that sold them the program in the first place. But that party obviously believed that their program was fully compliant and therefore could not deliver a truly objective response to the CPA's concerns.

The client's attorney was not versed in captive insurance companies and could not be helpful without an expensive journey up the learning curve.

Turning to another captive insurance provider for an analysis of the client's situation was an obvious option. But each provider has their own competing program and clearly has an incentive to undermine the competition and encourage the client to switch providers. Certainly this may not always be the case, but it is wise to question the objectivity of the person doing the analysis if that person is a competitor.

The Solution: In this case, the CPA needed two sources of help. First, she needed to find an expert in captive insurance who did not also offer his own competing program. Second, she had to find an independent actuary who was familiar with captive insurance programs and who would be willing to opine as to the “reasonableness” of the premiums being charged by the captives.

Finding these independent advisors required networking with other CPA firms, searching the web for relevant articles and identifying their authors, and locating captive insurance sites and blogs.

The Result: The independent advisor created a report that the CPA could rely on, stating that while the structure of the captive insurance program would likely be compliant, the amounts of the premiums being charged did not appear reasonable, given both the nature of the client's business and relevant premium rates in the third-party market. The CPA then advised the client to hire an independent actuary to perform a rate review. The actuary ultimately opined that the client could reasonably support premiums of about half of the amount originally considered.

The client got a large tax deduction and the preparer had in file objective third-party support for the position ultimately taken on the tax return. While this support does not guarantee a favorable result in the event of audit, it should be very valuable evidence in any such audit and should satisfy the requirements for avoiding the Return Preparer Penalty.