By Mercedes Hendricks, CPA & Partner, Dannah Capital Partners
There is no doubt the automotive retail industry is in a dynamic buy-sell environment. Dealership valuations are about as high as they have ever been and new players are entering the market every day. The prospect of a dealer being able to successfully pass the business on to the next generation has brought new challenges for succession and estate planning.
How is the next generation going to be able to pay such high dealership prices? It’s time to think outside of the box. What about employing a captive insurance company as a strategy for funding sales to family members?
To understand this, we must first be clear as to what a captive insurance company is and how we are using it in this context. It is a licensed and regulated insurance company owned by its insureds.
It is not a reinsurance company that most dealerships have set up for the purpose of extended warranties and other F&I products. It is an insurance company such as property and casualty, that a dealer can own for the purpose of insuring his or her own businesses, rather than paying a third party insurance company.
The captive insurance company writes insurance policies to the dealerships, the dealerships pay insurance premiums into the captive (owned by the dealer), and the captive pays claims of the dealerships when submitted.
Under current IRS regulations, qualified captive insurance companies can receive up to $1.2 million per year in insurance premiums that are not subject to income tax¹. The premiums accumulate inside of the captive insurance company for the purpose of paying claims as they come due. The captive operates just like any other insurance company, and like all other insurance companies, they can be very profitable.
There is flexibility in how a captive insurance company can be structured and owned. If the goal of the dealer is to sell the business to his or her children, a captive insurance company to be owned by the children (or any other family member, as long as they are over 18 years of age) can be created.
Over a period of time, premiums are paid into the captive by the dealerships, losses are paid out as claims arise, and surplus is accumulated. Subject to regulations that differ from domicile to domicile, this surplus can be invested and also distributed back out to the owners.
Assume such a company is created. How can that help fund a sale of the dealership to a family member?
The dealer and his children enter into a buy-sell agreement, locking in the valuation of the dealerships. This can be especially effective for appreciating assets (such as dealership stock) as it freezes the value at current prices. To fund the purchase, the children enter into a note agreement with the dealer to pay for the dealership stock over time. To pay down the note agreement, the children can withdraw the accumulated surplus from the captive insurance company² when allowed by regulations set by the domicile.
This is one illustration on how a captive insurance company can be used to achieve long term goals of a dealership owner. The flexibility of the use of captive insurance companies makes them very attractive in any long term planning.
¹Proper formation and management of captive insurance companies is crucial. If you are thinking about a captive insurance company for your business, it is important that you consult with your legal and tax professionals.
²Withdrawals from the captive insurance company are taxed at capital gains tax rates.
Dannah Capital Partners is a business consulting firm specializing in risk management and asset protection services, working with dealers from coast to coast. Ms. Hendricks can be reached at 954-654-0892 or firstname.lastname@example.org.