Authored by Joseph Vermeulen
For auto dealerships that include a vehicle service contract (VSC) as an additional offering with the purchase or lease of a vehicle, it is possible for the VSC to be considered insurance, and for the Company to be considered an insurance company, if certain qualifications are met.
In a recently issued Private Letter Ruling (PLR), the IRS determined that vehicle service contracts sold by car dealers to their customers, from which one of their wholly owned subsidiaries provides financial protection loss for repair costs but does not provide the actual repair services, are insurance contacts.
You should note that a PLR is only binding on the taxpayer that requested it. However, it does provide guidance on the IRS’s view of the issue. The facts the ruling is based on are highly important and if your structure or fact pattern is different, the IRS may reach other conclusions.
A Parent Company and select subsidiaries are in the business of manufacturing and importing motor vehicles for sale and lease in the U.S. Under the old business model, a subsidiary of Parent Company sold vehicle service contracts to its customers. Subsidiary received a fee for each contract sold, but did not assume any risk of loss.
The vehicle service contracts are designed to help cover the costs of certain repair costs either by reducing the upfront cost or reimbursing the customer. They do not cover routine preventive maintenance, incidental or consequential damages such as property damage, personal injury, inconvenience or loss of vehicle use. If a customer cancels a contract prior to the end date, the customer receives a pro-rata refund of the purchase price.
Under a new business arrangement, Subsidiary created a subsidiary, Obligor 1. Obligor 1 then created two more subsidiaries, Obligor 2 and Reinsurer. Depending on what state the contract was sold, Obligor 1 or Obligor 2 (Obligors) would be responsible for the VSC. Also depending on what state the VSC is sold, some or all of the risk will be ceded to Reinsurer under a reinsurance agreement, or first to an unrelated insurance company, which will then retrocede the risk to Reinsurer. To the extent permitted, Reinsurer will indemnify Obligors for portions of contract losses and expenses, but Obligors will remain responsible for all VSC benefits.
Each Obligor is responsible for accounting for their respective share of premiums, unearned premiums, loss reserves and other items of income and deductions in accordance with IRC section 832.
The Internal Revenue Code defines the term “insurance company” as any company with more than half of the business during the taxable year from issuing insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.
The Internal Revenue Code does not specifically define insurance. The Supreme Court of the United States has stated that in order for a transaction to qualify as insurance, “the amounts must be received as a result of a transaction which involved an actual ‘insurance risk’ at the time the transaction was executed. Historically and commonly insurance involves risk-shifting and risk-distributing.” Additional case law describes insurance as “involving a contract whereby, for an adequate consideration, one party undertakes to indemnify another against loss arising from certain specified contingencies or perils.”
Risk shifting occurs when a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer. Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as a premium and set aside for the payment of such claim.
To determine whether an arrangement constitutes insurance in its commonly accepted sense, the following factors must be considered:
- Is the insurer organized, operated and regulated as an insurance company?
- Is the insurer adequately capitalized?
- Are the insurance policies valid and binding?
- Are the premiums reasonable in relation to the risk of loss?
- Are premiums duly paid and loss claims duly satisfied?
Based on the information provided and submitted in the Private Letter Ruling, the IRS held that:
- The vehicle service contracts issued by each Obligor will constitute insurance contracts for federal income tax purposes; and
- Provided that at the end of each taxable year, more than half of each Obligor’s business is issuing the VSCs, each Obligor will qualify as an insurance company for that taxable year for purposes of section 831.
The IRS concluded that the VSCs are not prepaid service contracts as they do not cover regular routine preventative maintenance nor do the Obligors provide repair services. Each Obligor is responsible to indemnify customers for economic loss not covered by the manufacturers or other warranty.
Also, the VSCs will cover a significant number of new and used vehicles as each Obligor will issue VSCs to a substantial number of individual consumers. Therefore, the risks will be distributed across a large number of insureds. Further, by accepting a large number of risks, the average risk of loss is more predictable for each Obligor.
In addition to having insurance risk, risk shifting and risk distribution, the arrangement constitutes insurance in its commonly accepted sense.
For more information on how vehicle service contracts may constitute insurance, or how this may apply to your dealership, please contact a Baker Tilly advisor.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.