Certain Federal Income Tax Considerations – Warranty Insurance Providers
Through the issuance of a number of Private Letter Rulings, the Internal Revenue Service has provided guidance with respect to the proper federal income tax treatment of warranty insurance providers. While such rulings are only applicable to the particular taxpayer to whom the ruling is issued, they can provide insight into the thinking of the IRS with respect to a particular issue and thus provide potentially useful guidance. The rulings in question conclude that contracts providing protection to the vehicle purchaser or lessee, covering the economic loss associated with the cost of repairs due to mechanical breakdown, are insurance contracts for federal income tax purposes. The rulings also provide that a company issuing these contracts (the obligor) is an insurance company for federal income tax purposes, provided that at the end of each taxable year, more than 50 percent of the business of the company is the issuing of such contracts.
While these rulings cannot be specifically relied upon by other taxpayers, based on the position of the IRS, warranty providers that meet the specified criteria should be regarded as insurance companies and file a Form 1120-PC to report their business operating results for federal income tax purposes.
Several of the ensuing tax implications of classification as an insurance company for federal income tax return purposes are:
- Acquisition costs related to the issuance of new contract (warranty) sales are deducted as incurred.
- Revenue from the sale of new contracts is deferred and recognized over the term of the contract.
- Twenty percent (20%) of the deferred revenue is subject to tax in the year issued (written).
- Loss reserves for known incurred and unknown incurred (incurred but not reported, or IBNR) can be established and deducted for federal income tax purposes when identified (subject to required discounting of reserves).
Illustration of a Typical Contract
The dealer selling the contract collects the contract price (gross premium) from the contract holder but forwards an amount to the company issuing the contract net of the commission retained by the dealer. The IRS has determined that the gross contract price under IRC Section 832 is the amount that a purchaser (consumer) pays for the contract (i.e., the gross premium) and that the issuer of the contract is entitled to a deduction under IRS Section 832(b)(6) for the commission retained by the person (i.e., dealer) who sold the contract. The significant impact of this ruling methodology on the calculation of taxable income is illustrated as follows:
The difference between the two approaches is a timing difference that will reverse over the life of the contract. The gross approach can produce an immediate tax loss if the contract period is multiple years and the commission expense is significant. Under such circumstances the insurance company may generate tax losses for several years, especially if contract revenue is increasing year over year as the business operations expand. Because the “gross” approach may be a favorable accounting method for tax purposes, warranty providers should review how they currently account for contracts where they receive contract revenue net of a dealer commission. Companies that are using the “net” approach may wish to consider changing their accounting method to a “gross” approach by filing a Form 3115 for a change in accounting method. The use of the “gross” approach would require the warranty provider to collect data for the dealer contract sales price. Any contemplated change in accounting method should be accompanied by a detailed analysis of the anticipated tax impact to the change.