Over the years, there has been uncertainty for entities that provide automobile service contracts as to their tax status for federal income tax purposes. Normally, these service contract providers do not meet the traditional definition of an insurance company from a regulatory standpoint, creating some uncertainty as to their proper tax status. Fortunately for business owners and tax practitioners alike, the Internal Revenue Service (IRS) has addressed this issue, providing us with tangible guidelines in the form of published rulings.
The analysis of whether an entity is an insurance company for federal income tax purposes is multi-faceted, but arguably begins with the following question: is the underlying contract an “insurance” contract for federal income tax purposes, as opposed to state regulatory purposes? Once this question is answered, there are other numerical and factual tests that must be considered in determining whether the entity is an insurance company for federal income tax purposes.
The IRS has issued a number of Private Letter Rulings (PLRs) which conclude that a contract providing protection to a vehicle purchaser or lessee, covering the economic loss associated with the cost of repairs due to mechanical breakdown, meets the definition of an insurance contract for federal income tax purposes. The IRS has also ruled 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 company’s business is the issuing of such contracts.
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