Notice 2016-66 comes with onerous disclosure requirements and penalties for noncompliance. Dealer-affiliated reinsurance companies have more questions than answers.
Many dealers have set up producer-owned (PORC) or producer-affiliated (PARC) reinsurance companies to provide their buyers customized, credible, and convenient insurance against financial loss incurred when a vehicle is totaled before it is paid off. These reinsurance companies have come under IRS scrutiny because they can be used as a mechanism for transferring ownership (and its related income and assets) to a dealer’s heirs without triggering estate taxes. New laws are taking effect that allow for such companies to contribute more in premiums each year; however, such increased limits come with additional rules regarding diversification of insureds and ownership of the reinsurance company.
Further compounding the problem, the IRS issued Notice 2016-66 in November 2016, which has put troubling disclosure requirements on reinsurance companies, dealers, shareholders, and possibly others. It includes hefty nondisclosure fines — and leaves dealers with a lot of unanswered questions.
To understand the problems that arise from Notice 2016-66, some background is helpful.
Reinsurance company tax benefits draw IRS attention
Dealers that wish to generate underwriting profits and transfer various warranty risks to customers rely on finance and insurance (F&I) products, small insurance companies, and reinsurance program strategies.
These risk-transfer transactions require a dealer to set up a reinsurance company (PORC or PARC) that receives premiums to insure against mechanical or other losses on vehicles purchased from them. Products include collateral protection insurance (CPI) and guaranteed asset protection (GAP) to safeguard customers from the risk of financial loss when there is a difference between the outstanding loan amount and the actual cash value of a vehicle that is declared a total loss.
PARCs are formed by dealers to insure the risk of administrators or other third-party insurance companies (direct underwriters). In other words, a dealership will sell a product (such as a service contract) to a customer that is insured with a direct underwriter, which will in turn reinsure its risk with the customer to the PARC established by the dealer.
The customer then has a contract with the direct underwriter, who has a contract with the dealer’s affiliated reinsurance company. The dealer does this as a service to customers. Of course, the dealer may benefit from the underwriting profit generated when premium income exceeds the ultimate claims experience.
Generally, these PARCs are set up in foreign domiciles. While it sounds exotic and seems complex, this practice is to avoid the economically prohibitive capital requirements and equally onerous regulations that have historically accompanied formation in the United States. There is no tax benefit in the foreign company formation; in fact, virtually all of these foreign-domiciled, small reinsurance companies elect under IRC Section 953(d) to be taxed as a U.S. taxpayer.
Reinsurance companies also file IRC Section 831(b) elections with their initial income tax returns to be treated as small property and casualty insurance companies. This allows these companies not to pay income tax on underwriting profits. However, income tax is paid on investment earnings net of related expenses.
This tax treatment is provided to encourage small insurance companies to retain their risk and use the related premiums to pay claims without being burdened by the complexity of regulations and tax rules applicable to large insurance companies. Ultimately, owners of these types of entities pay income tax on underwriting profits earned inside the reinsurance companies when such funds are distributed to them as stockholders.
The favorable tax benefit, derived by excluding underwriting profit from taxation, is what has attracted the attention of the IRS, motivating it to determine whether potential abuses exist. The IRS also seems concerned about the owners’ ability to use reinsurance companies to shift value between family members.
Diversification tests used to prevent abuse — but leave unanswered questions
The PATH Act (Protecting Americans from Tax Hikes Act), passed in December 2015, made a couple of changes with regard to small insurance companies. First, it increased the annual premium limit from $1.2 million to $2.2 million per year (adjusted annually for inflation). Second, it implemented two diversification tests that can restrict the use of these companies and disallow their treatment as insurance companies eligible for the favorable tax treatment under IRC Section 831(b).
The first “risk diversification test” provides that net premiums, or gross written premiums (if greater), from one insured cannot exceed 20 percent of total premiums for the year. If they do, then the company can still be treated as a small property and casualty insurance company, provided it meets the second hurdle: the “relatedness test.”
The 20 percent test is not clearly defined, nor has it been clearly determined what types of policies are considered insured risks by “one insured.” Some products such as warranties, guaranteed auto protection (GAP), and collateral protection policies appear to insure customer risk; however the IRS has occasionally created questions in this area.
The PATH Act allows for companies to be 831(b) entities, even if they fail the 20 percent test, so long as the dealership (insured) and insurance or reinsurance company are virtually identically owned. It appears, then, that Congress’s objective is to make sure these reinsurance companies aren’t structured in such a way that the transfer of ownership, income, and assets to the dealer’s children does not evade estate taxes.
It’s been some time since the PATH Act was passed, but taxpayers and their advisors still don’t have answers to their questions about compliance with these tests and regulations. The IRS has not indicated that it will provide clarifying information anytime soon.
Notice 2016-66 requirements are burdensome and vague
On top of the diversification tests and regulations included in the PATH Act, Notice 2016-66 requires that taxpayers and their preparers include certain disclosures related to various insurance transactions. These disclosures are to be included in the returns of the reinsurance companies, dealerships, shareholders, and potentially other parties. Many of you have likely already complied with these filings (many of which were due on May 1, 2017); however, unless further guidance is received, such reporting will also be required for 2017 returns.
IRS Notice 2016-66 outlines the insurance situations it is seeking information on, which it has identified as “transactions of interest,” and which aren’t typical for most dealership reinsurance companies. In general, the notice seeks information on captives that insure “business enterprise risks,” such as general liability, data breach, catastrophe, terrorism, and other risks inherent in the operation of any business. Risks that are reinsured by PARCs — mechanical breakdowns, vehicle collision, and total losses — arguably don’t fall into that category.
The notice vaguely outlines the risks it is interested in when identifying transactions for which disclosures are required. Unfortunately, it does not exclude reinsurance transactions for which a dealership assumes responsibility as the contractual obligor or acts as a dealer obligor (DO). DO products are not uncommon in dealer insurance transactions whereby a dealership insures a customer’s risk, which is then subsequently transferred to the PORC. Even though the actual risk is with the direct writer, it still appears to meet the notice’s requisites for reporting.
This notice has proven to be bewildering to dealerships, insurance administrators, shareholders, and tax advisors trying to respond and comply. The penalties for failure to file are significant at $50,000 per nondisclosure, per entity required to disclose, per year; one reinsurance company’s failure to disclose could cost the related companies $50,000 each. So, if five disclosures were required, potential penalties could be $250,000 per year. For this reason, many tax preparers and their clients see disclosure as their only option.
The trouble is that disclosure could possibly result in IRS scrutiny of the dealership or other disclosing parties as the IRS determines how it is going to use the information included in the admission. It is estimated that over 50,000 disclosures may have been filed already. How the IRS decides to use this information is anyone’s guess. It is likely more IRS activity or guidance will be forthcoming in the insurance area in the future.
Other insurance arrangements
Although neither Notice 2016-66 nor the Path Act affected some alternative dealership insurance structures, it seems logical if the IRS or Congress make changes in the micro captive area, they may look into other insurance structures. These might ultimately include non-controlled foreign corporations (NCFC), risk pooling structures, over-remit arrangements, or various F&I product offerings.
How we can help
Even with the uncertainty in this area, such structures do offer benefits that can provide profit for your dealership. Just because uncertainty exists does not mean such arrangements should be completely avoided. CLA’s dealership industry professionals can help you evaluate your company’s unique tax situation and determine how to advantageously interpret and apply these complex provisions.