All eyes on the Green Book

President Biden’s tax plan, known as the Green Book, details some major changes for the wealthy, especially those earning more than $400,000. Currently there are significant infrastructure proposals on Capitol Hill, and someone will have to pay for them.

It is well known that captives can be efficient tools for businesses to finance their risk as well as add profit to their bottom line. The consideration of captives has grown as businesses evaluate their avenues for retaining risk versus offloading it to a commercial carrier. In many instances, commercial coverage is just not available.

A major component of risk financing is the tax effect. Given the results of the recent election, it is important to consider the possible implications of the proposed tax plans to be introduced by the Biden administration. There are of course many unknowns, but here are a few components of the plan and their impact.

It is likely that the Biden plan will have a positive impact on the tax effects of proper risk financing utilising a captive insurance strategy, but a larger exit tax if not properly planned.

The Green Book would increase the top individual income tax rate to 39.6 percent (from 35 percent) for taxable income over $509,300 for married individuals filing a joint return; $452,700 for unmarried individuals (other than surviving spouses); $481,000 for head of household filers; and $254,650 for married individuals filing a separate return.

This is an increase in maximum rate of 4.6 percent for married filers. It goes up even more for pass-through entities (see Net investment income tax).

It is likely that Biden will be increasing the long-term capital gains and qualified dividend rate substantially. Currently the maximum capital gain/qualified dividend rate is 20 percent plus a net investment income tax of 3.8 percent for a total of 23.8 percent. For individuals with incomes of over $1 million there would be no advantageous tax rate for long-term capital gains (typically long-term capital gains and qualified dividends are treated the same, but in the proposed plan this is an unknown).

Under the Biden plan, net long-term gains (and presumably dividends) collected by those with incomes above $1 million would be taxed at the same 39.6 percent maximum rate that is proposed for ordinary income and net short-term capital gains, plus the net investment income tax of 3.8 percent for a total of 43.4 percent.

The wind-down of a captive or a dividend paid out of a captive is typically either a long-term capital gain or a qualified dividend. Foreign captives which have not made the 953(d) election do not get the qualified dividend rate, and there are myriad other issues. The plan for declaring and paying dividends to owners in years during which the owner has an income lower than the threshold amount can therefore yield substantial savings.

This planning component will need to be evaluated every year. The major impact is in the wind-down phase. As important as exit planning is in the captive formation stage, it will be important to engage the captive’s tax advisors in the feasibility phase.

Pass-through earnings are taxed at the owner’s ordinary rate. Let’s assume the owner’s ordinary rate will be the maximum rate of 39.6 percent being proposed. There will be an increased rate of 3.8 percent of net investment income tax (NIIT) on top of the 39.6 for a total of 43.4 percent. Obviously, given the increased rate and the ability of captive premiums to be deducted in most cases, the tax effect is 8.4 percent greater, which will increase the total return on investment for forming a captive.

The global intangible low-taxed income (GILTI) regime currently applies a 10.5 percent minimum tax to 10-percent US corporate shareholders of controlled foreign corporations (CFCs) based on the CFC’s “active” income above a threshold equal to 10 percent of the CFC’s tax basis in certain depreciable tangible property—this basis is known as qualified business asset investment (QBAI).

Biden’s plan will remove the 10 percent QBAI exemption and apply a 21 percent GILTI tax, which more than doubles the rate. This may lead to more offshore captives making a 953(d) election or re-domiciling onshore.

In 2018, the corporate tax rate changed from a graduated rate with a maximum of 35 percent to a flat rate of 21 percent as a result of the 2017 Tax Cuts and Jobs Act. The Green Book plan would increase the corporate tax rate to 28 percent.

The impact on captives would be an increase in taxes paid on the same amount of income. This seems straightforward, but it also impacts on deferred tax calculations. It will have a positive impact on the surplus/net worth of captives that have a deferred tax asset at the time of the tax rate adjustment, or a negative impact on the surplus/net worth of captives that have a deferred tax liability at the time of the adjustment.

For captives, the impact is significant. Insurance companies have advantageous tax rules such as the ability to deduct reserves prior to the actual loss being paid, which is not allowed in typical non-financial institution business enterprises. For example, assume a construction company had a workers’ compensation claim which is likely to be paid over five years, an insurance company/captive can deduct the full amount of the reserve (subject to loss discounting) in the year of the loss.

However, if the construction company did not have a captive, they would only be able to deduct the loss as it was paid. There is a major acceleration of a tax deduction by having a captive, which is more advantageous at a higher corporate income tax rate.

For captives who make an 831(b) election, the Biden tax plan will be even more advantageous. The 831(b) election is for captives with premiums of $2.4 million or less, indexed for inflation. An insurance company electing 831(b) is taxed on its net investment income at the corporate rate, but not on underwriting gains.