Two Overlooked Tax Strategies That Could Save Business Owners Millions

In the early 2000s, Peter Thiel, co-founder of PayPal, made a brilliant financial move that would later be worth billions—literally. 

Thiel managed to place PayPal shares into his Roth IRA when the company was still in its infancy and valued at less than a penny per share. As PayPal’s success skyrocketed, so did the value of the shares in his Roth. Eventually, those shares grew to be worth more than $5 billion, all within the tax-free confines of a Roth IRA.

Pretty savvy, right?

Now, I’m not suggesting that you, a small business owner, can net billions of dollars in tax savings like Peter Thiel through unconventional strategies…

But I am suggesting that with proactive planning, there may be millions of dollars in tax savings and wealth accumulation available to you as a business owner. 

While Thiel’s strategy was specific to his circumstances, the underlying principle of leveraging smart financial moves for tax efficiency is something every business owner can benefit from.

The problem is that most small business owners simply lack the bandwidth for strategic financial planning. Lacking the resources of a large company, most small business owners are forced to wear multiple hats. They often juggle roles in marketing, finance, operations, and customer service, all while trying to drive growth and maintain a work-life balance. 

At the same time, their CPAs often don’t have a complete view of their financial picture and tend to be more reactive than proactive, which can lead to missed opportunities for strategic decisions. 

Despite these challenges, business owners have unique advantages that regular employees do not—especially when it comes to strategic tax and wealth planning. While employees may be limited in their options to reduce taxable income, business owners have access to numerous opportunities to significantly optimize their tax and overall financial situation. 

From retirement plans tailored for business owners to deductions and credits that can help minimize taxable income, the potential to create a more tax-efficient financial strategy is far greater. Leveraging these strategies can be a game-changer for those looking to maximize profits and plan for long-term success.

Common Financial Planning Strategies for Business Owners:

• Optimize retirement plans: Evaluate profit-sharing, SEP IRAs, cash balance plans, etc. for business fit and tax savings.
• Maximize after-tax wealth: Implement a strategic savings plan combined with Roth conversions based on annual income fluctuations.
• Plan for succession: Structure and fund buy-sell agreements.
• Payroll for kids: Pay children to fund Roth IRAs and grow wealth tax-free. 
• Corporate structure selection: Choose between LLC or S-Corp to optimize payroll tax savings.
• Tax reduction strategies: Utilize tax-loss harvesting and optimal asset location.
• Ensure estate liquidity: Use strategies like life insurance to cover taxes or buyouts, preventing heirs from needing to raise cash.
• Bunch income/deductions: Time income and deductions to maximize savings in high-income years.

While these are some of the more common tax strategies, they only scratch the surface. (And, if you looked down that list and realized that you weren’t implementing many of them, it’s time to talk to a financial planner focused on helping business owners.)

Now that I’ve gotten my shameless plug in, what I want to explore in this paper are two often-overlooked strategies that can potentially result in substantial tax savings and wealth accumulation—amounting to hundreds of thousands, if not millions, of dollars.

Strategy #1: Section 1202 Stock Exclusion (Qualified Small Business Stock)

Section 1202 of the Internal Revenue Code offers a major tax benefit for business owners who invest in or sell shares of Qualified Small Business Stock (QSBS). This provision was initially introduced to encourage investment in small businesses by allowing business owners and investors to exclude a significant portion (or even all) of their capital gains from the sale of these stocks, provided certain conditions are met. For business owners, this can be a powerful tool to defer or eliminate capital gains taxes upon the sale of their business.

What Is Section 1202 Stock Exclusion?

The Section 1202 exclusion allows investors or owners of QSBS to exclude up to 100% of capital gains from federal taxes when they sell their shares, subject to limits and conditions. This exclusion is particularly valuable for business owners who may sell their company or a portion of their ownership after meeting the requirements, allowing them to avoid capital gains taxes on the sale.

Key Requirements for QSBS (Qualified Small Business Stock)

1. Qualified Small Business:

   • The company must be a C-Corporation, not an S-Corp or LLC. (You can convert to a C-Corp if you are not one already.)

   • At the time the stock is issued, the company’s gross assets must not exceed $50 million. This includes all assets immediately before and after the issuance of stock.

   • The company must be an active business and not engaged in certain prohibited industries, like professional services (law, accounting, etc.), banking, farming, or hospitality. Typically, this works well for tech, manufacturing, and product-based businesses.

2. Holding Period:

   • The stockholder must hold the QSBS for at least 5 years before they are eligible for the exclusion on capital gains from the sale of the stock.

   • If the stock is sold before the 5-year period, the exclusion does not apply, although the seller may be able to roll over the gains into another QSBS investment and defer the tax.

3. Stock Acquisition:

   • The stock must be originally issued to the investor or owner. It cannot be acquired through secondary markets or transferred.

Tax Benefits of Section 1202

The tax benefits of the Section 1202 exclusion are significant, particularly when the maximum exclusion applies:

1. Exclusion Amount:

   • 100% Exclusion: For QSBS acquired after September 27, 2010, up to 100% of the capital gains on the sale of QSBS can be excluded from federal taxes.

   • 50% or 75% Exclusion: For QSBS acquired before 2010, the exclusion percentage varies (50% or 75%), depending on the acquisition date.

2. Cap on Exclusion:

   • The total exclusion is limited to the greater of:

     • $10 million in gains, or

     • 10 times the stockholder’s adjusted basis in the stock. This means if the business owner sells their company for a significant profit, they can exclude either up to $10 million in gains or 10 times their basis in the stock, whichever is larger.

3. Alternative Minimum Tax (AMT):

   • Gains that are excluded under Section 1202 are not subject to the Alternative Minimum Tax (AMT), which is another key benefit of this provision.

Who Benefits from Section 1202?

• Entrepreneurs and business owners with C-Corporations that plan to grow their business and eventually sell it.
• Investors in small businesses who are willing to take on some risk but want the potential reward of tax-free capital gains after a 5-year holding period.
• Startups and early-stage businesses looking to attract investors. Offering QSBS can be an enticing benefit to potential investors because of the potential for significant tax savings upon exit.

Real-World Example

Let’s say a tech startup founder incorporates the business as a C-Corporation in 2015 when the company’s value is $2 million. Over the next six years, the company grows rapidly and is sold to a larger firm for $20 million in 2021. Because the founder held the stock for more than 5 years and the company qualifies under Section 1202, the founder can exclude up to $10 million of the capital gains from federal taxes, effectively reducing their tax burden by millions.

Without Section 1202, the founder would likely face capital gains taxes of 20-23.8% (including the Net Investment Income Tax) on the $20 million, resulting in a tax bill of roughly $4-5 million. With the exclusion, they can save much or all of that amount, depending on their gain.

When Should Business Owners Consider Section 1202?

Business owners should consider this strategy if:

• They expect the business to appreciate significantly over time and plan to sell or exit in the future.
• They are comfortable with the C-Corporation structure and its requirements.
• They are willing to hold the stock for the required 5 years to qualify for the exclusion.
• They want to offer an attractive incentive to outside investors by issuing QSBS.

Planning Opportunities

1. Pre-sale Restructuring: If a business is not currently a C-Corp but plans to sell in the future, it may consider restructuring to take advantage of Section 1202 benefits. However, timing is important since the clock for the 5-year holding period starts at the issuance of QSBS stock.

2. Maximizing the Exclusion: A business owner can structure the sale to maximize the Section 1202 exclusion. For example, by transferring QSBS to family members, each person can utilize their own $10 million exclusion, potentially shielding more of the sale from capital gains taxes.

Potential Challenges and Downsides

1. C-Corporation Requirement: The business must be structured as a C-Corporation, which has some downsides, including double taxation (once at the corporate level and again at the individual level). While there are methods for dealing with this, such as paying the owners a higher salary and bonus, it has to be within reason. 

2. 5-Year Holding Period: For business owners and investors looking for short-term liquidity, the 5-year holding period may be too long. It requires a long-term commitment and stability in the business.

3. State Taxes: While Section 1202 provides federal tax benefits, not all states conform to this provision. In states that don’t recognize the QSBS exclusion, business owners may still be subject to state capital gains taxes on the sale of their stock.

Strategy #2: A Captive Insurance Company

A captive insurance company is a strategy that allows a business owner to set up their own insurance company to insure against specific risks within their business. While it might sound complex, this strategy can provide significant financial and operational benefits, especially for high-revenue businesses or those in industries with unique or hard-to-insure risks. Let’s break it down:

What is a Captive Insurance Company?

A captive insurance company is an insurance company that is owned and controlled by the business (or the owner of the business) it insures. Essentially, instead of purchasing insurance from a third-party provider, the business forms its own insurance company to cover certain risks. The premiums paid to the captive are tax-deductible as business expenses.

There are two primary types:

1. Single-parent captives: Owned and controlled by one business.

2. Group captives: Owned by multiple businesses that pool risks together.

How It Works

1. Formation: The business owner sets up a captive insurance company, often in a jurisdiction with favorable regulatory and tax treatment (like Bermuda, Cayman Islands, or even certain U.S. states like Delaware or Vermont). The company is structured to meet legal requirements as a legitimate insurance entity.

2. Premiums: The business then pays insurance premiums to the captive, just as they would to a third-party insurance company. These premiums are tax-deductible for the business.

3. Reserves & Risk Management: The captive holds the premiums in reserves, which are used to pay out any claims the business might have. If claims are lower than expected or don’t materialize, the captive accumulates surplus reserves, which can be invested or distributed back to the business.

4. Claims & Payouts: If an insured event occurs (e.g., business interruption, litigation, data breach, etc.), the captive pays out the claim, just like a traditional insurance company would.

Key Benefits

1. Tax Efficiency:

   • Deductible Premiums: Premiums paid to the captive are considered a legitimate business expense and are tax-deductible.

   • Deferred Taxation: If claims are lower than expected, the reserves accumulated within the captive are typically taxed at a lower rate than if those funds were simply held by the business.

2. Risk Management & Control:

   • Customized Coverage: A captive allows the business owner to tailor insurance coverage specifically to their business's needs, including covering risks that may be difficult or expensive to insure through the traditional insurance market.

   • Improved Claims Processing: The captive can manage and process claims in a more business-friendly manner, allowing more flexibility compared to traditional insurers.

3. Cost Savings:

   • Lower Premiums Over Time: While there are startup costs to form a captive, over time, businesses can reduce overall insurance costs by avoiding the overhead and profit margins charged by commercial insurance companies.

   • Recapturing Premiums: Since the business controls the captive, any unused premium funds can be reinvested or returned to the business.

4. Investment Income:

   • The captive can invest the premiums it holds in reserves, allowing for the potential of significant investment returns over time, which further strengthens the captive's financial position.

5. Asset Protection:

   • Captive reserves can be protected from creditors in case of bankruptcy or litigation, offering an additional layer of asset protection for the business owner.

Potential Downsides

1. Startup and Maintenance Costs: Setting up a captive can be expensive due to legal, regulatory, and administrative costs. Annual operating costs can also be significant, requiring actuarial reviews, audits, and compliance with insurance regulations.

2. Regulatory Scrutiny: Captives must be set up and run as legitimate insurance companies. The IRS closely monitors captives to ensure they aren’t being used purely as tax shelters. Failure to meet regulatory requirements can lead to penalties or disqualification of tax deductions.

3. Underwriting Risk: If claims are significantly higher than expected, the captive could face financial difficulties, just like any other insurance company. Proper actuarial management is crucial to avoid underestimating risks.

4. Complexity: Running a captive requires specialized knowledge in insurance, risk management, and compliance. Most business owners will need to work with legal, actuarial, and financial experts to operate the captive effectively.

Who Benefits Most from a Captive?

Captive insurance companies are typically most beneficial for:

• High-revenue businesses: Companies with significant profits that want to minimize tax burdens.
• Businesses with unique risks: Companies in industries where traditional insurance is costly, limited, or unavailable (e.g., construction, energy, healthcare, transportation).
• Companies with predictable risks: Businesses that can accurately predict their risk exposure and manage claims effectively over time.

Example of How It Can Work

Let’s say a business owner, who runs a manufacturing company, forms a captive to cover potential risks like product liability and environmental hazards. The business pays $500,000 in premiums to the captive annually. The captive insures the business, and over five years, it has only $250,000 in claims.

• The business deducts $500,000 in premiums each year as a business expense.
• The captive holds $2.5 million in reserves, of which $2.25 million remains after paying out claims. This amount can be invested to generate additional returns or distributed back to the business.

Additionally, should a major risk materialize, the business is protected by its captive rather than relying on costly traditional insurance.

When is it a Good Fit?

A captive insurance company makes sense when:

• The business generates enough revenue to justify the upfront costs.
• There are significant risks that can be self-insured but benefit from a formal structure.
• The owner seeks additional tax efficiency and long-term wealth accumulation through surplus premiums.

By incorporating captive insurance into a business owner’s financial strategy, you can create long-term value, reduce taxes, and provide flexibility in risk management.

Once excess reserves from a captive insurance company are distributed back to the business, there are a few key considerations regarding how these funds are treated, both from a tax and operational standpoint. Here's how the process typically works and what happens next:

Tax Implications of Distributing Excess Reserves

When the captive insurance company has excess reserves and decides to distribute them back to the business owner or the business, this is usually treated as a return of capital or dividends, depending on the structure and the jurisdiction of the captive. The way these funds are treated can have different tax implications:

• Return of Capital: If the distribution is considered a return of capital, it may not be taxed immediately because it's viewed as a repayment of the premiums that were initially contributed to the captive. However, if the return of capital exceeds the initial capital contributed, it could be treated as taxable income to the business or business owner.
• Dividends: If the excess reserves are distributed as dividends, they are typically treated as taxable income for the business owner or shareholders. In this case, the owner would pay taxes on the dividends received, either at the individual dividend tax rate or corporate tax rate, depending on who receives the distribution.
• Capital Gains: In some cases, if the captive’s shares or interest have appreciated, distributing reserves might trigger capital gains taxation, especially if the captive is structured to distribute equity or assets.

Reinvesting Excess Reserves

Rather than distributing the reserves, some business owners choose to reinvest the excess funds back into the captive for future business use. The following options are common:

• Reinvestment in the Captive: The business can leave excess reserves within the captive to continue growing its financial strength. This allows for future claims to be paid out or for the business to take on more self-insured risks as it grows. Additionally, retained reserves can be invested by the captive in various investment vehicles (stocks, bonds, etc.) to generate returns, which further enhances the captive's financial capacity.
• Reinvestment in the Business: If the reserves are distributed to the business, these funds can be reinvested into the core business operations. This could be used for expansion, new equipment, hiring, R&D, or other capital-intensive projects that further the company’s growth.

Personal Wealth Strategies

If excess reserves are distributed to the business owner personally, there are several wealth-building options:

• Retirement Savings: The business owner can place these funds into personal retirement accounts like IRAs or Roth IRAs, depending on eligibility, to defer or grow wealth tax-free.
• Diversified Investments: Owners may also choose to diversify outside the business by investing in stocks, real estate, or other assets to reduce concentrated risk in the business and increase personal wealth.
• Estate Planning: The distributed reserves can be channeled into estate planning tools, such as trusts, to pass wealth to heirs with minimized tax consequences. This could be particularly useful for business owners looking to transfer wealth tax-efficiently.

Using Excess Reserves for Other Strategic Purposes

If distributed to the business, excess reserves can also be used in other strategic financial maneuvers:

• Debt Reduction: If the business has outstanding loans or debt, using the reserves to pay down debt can improve cash flow and reduce interest expenses, strengthening the company’s financial position.
• Liquidity for Buy-Sell Agreements: The reserves can also be used to fund buy-sell agreements or key person insurance policies, ensuring smooth ownership transitions or business continuity in the event of death or departure of key personnel.

Conclusion

While these two strategies—the Section 1202 Stock Exclusion and the Captive Insurance Company—offer substantial tax savings and wealth-building potential for business owners, they are just the tip of the iceberg. 

If they don’t fit your particular situation, rest assured there are countless other tax and wealth planning strategies available that can be tailored to your specific needs. From income-shifting tactics to advanced retirement planning options, working with a financial advisor who specializes in helping business owners can uncover opportunities you may not even be aware of.

If you’re ready to explore how you can optimize your financial situation and reduce your tax burden, don’t hesitate to reach out. Book a complimentary consultation today to discover how we can work together to create a strategic plan that aligns with your business and personal goals.

Steven Neeley, CFP® is a senior wealth advisor and founder of Fortress Capital Advisors LLC, a registered investment advisor offering advisory services in the State of Indiana and other jurisdictions where registered or exempted.  Tel: (317) 210-3727 Web: www.FortressCapAdv.com E-mail: SNeeley@FortressCapAdv.com

Disclaimer:
The information provided in this document is for general informational purposes only and does not constitute legal, tax, or financial advice. Every business and financial situation is unique, and specific advice should be tailored to your individual circumstances. You should consult with a licensed financial advisor, tax professional, or attorney before implementing any of the strategies mentioned. While we strive to ensure the accuracy of the information provided, we make no representations or warranties regarding its completeness or applicability. Tax laws and financial regulations are subject to change, and any outcomes mentioned are not guaranteed.

Sources:

1. Frost Brown Todd LLC. "Maximizing the Section 1202 Gain Exclusion Amount." Available at: https://frostbrowntodd.com/maximizing-the-section-1202-gain-exclusion-amount

2. Frost Brown Todd LLC. "A Section 1202 Walkthrough: The Qualified Small Business Stock Gain Exclusion." Available at: https://frostbrowntodd.com/a-section-1202-walkthrough-the-qualified-small-business-stock-gain-exclusion

3. Columbia Law Review. "The Qualified Small Business Stock Exclusion: How Startup Shareholders Get $10 Million or More Tax-Free." Available at: https://columbialawreview.org/content/the-qualified-small-business-stock-exclusion-how-startup-shareholders-get-10-million-or-more-tax-free

4. WTW (Willis Towers Watson). "Establishing a Captive: What You Need to Know from Application to Optimization." Available at: https://www.wtwco.com/en-us/insights/2023/09/establishing-a-captive-what-you-need-to-know-from-application-to-optimization

5. Captive.com. "Forming and Operating a Captive Insurance Company." Available at: https://www.captive.com/news/forming-and-operating-a-captive-insurance-company

6. Fox, Matthew. "Peter Thiel Has Amassed a $5 Billion Fortune in a Tax-Free Roth IRA Account." Business Insider, 24 June 2021. Available at: https://markets.businessinsider.com/news/stocks/peter-thiel-5-billion-fortune-tax-free-roth-ira-account-2021-6