Recent IRS rulings regarding extended warranty companies present a major opportunity for auto dealers. The IRS has ruled that an appropriately structured and operated warranty company will be treated as an insurance company for federal income tax purposes, even if it is not treated as an insurance company under state law. Because many states, including Georgia, generally do not treat warranty companies as insurance companies, the IRS’s position allows auto dealers to take advantage of certain favorable tax laws that apply to insurance companies without the expense of complying with state insurance regulations.
Auto dealerships often sell extended warranties using a “dealer-obligor” contract, under which the dealership itself is directly obligated to the customer for repairs to the covered vehicle. For tax purposes, a dealership that uses a dealer-obligor contract must report all of its income from the sale of warranties in the year of sale. Additionally, the dealership cannot deduct the costs of covered repairs until it actually incurs those costs, which usually does not happen until the final years of each warranty. The result is that the dealership must frontload its warranty income and backload its warranty deductions. This is horrible tax planning.
Because of recent IRS rulings, though, many dealerships that currently use a dealer-obligor contract may benefit from switching to a “dealer-agent” contract that is issued by an affiliated warranty company. A dealership that uses a dealer-agent contract acts as the agent of the warranty company, selling the warranties in exchange for a commission. The warranty company, not the dealership, is obligated to the customer on the contract. As discussed below, this has both tax and financial accounting benefits. Moreover, from the perspective of the customer, the dealer-agent and dealer-obligor contracts are virtually indistinguishable.
Tax Benefits: If properly structured and operated, the warranty company will be treated as an insurance company for federal (and generally state) income tax purposes. This means that the warranty company can reduce its premium income by an amount equal to eighty percent of its unearned premium at the end of each year. Since the warranty company will earn its “premium” on warranties by paying for covered repairs and since repairs occur over time and not necessarily in the first year of the warranty, in the early years of the warranties, this reduction for unearned premium often will offset a large portion of premium income. As a result, the reduction effectively allows the warranty company to recognize and pay tax on its premium income over the life of the warranties it issues. In other words, taxable income and deductible expenses match up more closely instead of creating front-loaded income and back-loaded deductions as in the dealer-obligor model.
To illustrate, assume that on January 1, 2007, Dealership remits $1,000 to its affiliate, Warranty Company, as premium from the sale of Warranty 1, a five-year warranty that names Warranty Company as the obligor. Additionally, assume for simplicity’s sake that Warranty Company will earn the premium on Warranty 1 pro rata over the warranty’s life. At the end of 2007, Warranty Company will have unearned premium of $800 attributable to Warranty 1, so for federal income tax purposes, it can reduce its 2007 premium income by eighty percent of $800, or $640. As a result, in 2007, Warranty Company’s recognized premium income from the sale of Warranty 1 will be $360, not $1,000. Further, Warranty Company will recognize premium income of $160 from the sale of Warranty 1 in each of the next four years. Thus, the reduction for unearned premium effectively allows Warranty Company to recognize income from Warranty 1 over the warranty’s life.
In the illustration, if Dealership, not Warranty Company, had been obligated on Warranty 1, Dealership would have been required to include the full $1,000 in taxable income in year 1. Thus, by using Warranty Company to issue the warranties that Dealership sells, the owners of Dealership can defer a substantial portion of the tax on warranty income. If Dealership sells a large number of warranties, this temporary deferral may result in substantial investment income that Dealership and its owners would otherwise forgo.
The IRS has sanctioned the use of warranty companies as described above subject to a few constraints, the most important of which are as follows. First, the warranty company needs to be an entity separate from the dealerships that sell its warranties, and at least half of the warranty company’s business must be the issuance of warranties. Second, the warranty company must be taxed as a C corporation. Under current law, this generally means that the warranty company’s operating distributions will be subject to federal income tax at a rate of fifteen percent.
If a warranty company satisfies the IRS’s criteria, it will be taxed as an insurance company even if it is not licensed to sell insurance under state law. This is important because many states generally do not require a warranty company to obtain an insurance license. In Georgia, for example, a warranty company generally is not subject to insurance regulation as long as it insures its obligations under its warranties with a commercial insurer. A warranty company can satisfy this requirement by acquiring an insurance policy under which the insurer will fulfill the warranty company’s warranty obligations in the event that the warranty company defaults, e.g., because it is bankrupt.
Aside from the tax benefits it confers, use of a warranty company and of a dealer-agent contract can also enhance the value of an auto dealership. Since the dealership is not obligated on a dealer-agent contract, its assets are not subject to the liabilities created by selling warranties. Instead, the dealer-agent contract isolates these liabilities in the warranty company. This can have an immediate positive impact on a dealership’s financial statements.
In sum, the IRS’s recent rulings on warranty companies present a major opportunity for auto dealers. An auto dealer can obtain the benefits of insurance company taxation without significantly altering the warranties it sells and without subjecting itself to state insurance regulation. Additionally, use of a dealer-agent contract isolates warranty liabilities in the warranty company, thereby enhancing the value of the dealership.
Gary Lucas is an associate in the firm’s taxation group. His practice focuses on federal and state taxation. Mr. Lucas received his bachelor's degree, summa cum laude, from Marshall University, his law degree, magna cum laude, from Tulane University and his LLM degree in taxation from the University of Florida - Levin College of Law.
Cassady V. “Cass” Brewer is a partner in the firm’s tax, real estate capital markets, exempt organizations, and wealth planning practice groups. Mr. Brewer focuses his practice in the areas of income tax planning, business formations, mergers and acquisitions, partnerships and limited liability companies, tax controversy, tax-exempt investments in real estate, and wealth transfer and protection. Cass received his bachelor's degree from Vanderbilt University and his law degree, with high honors from the University of Arkansas.