on the Federal Income Taxation of Dealer Owned Warranty Companies (“DOWCs”) under the Internal Revenue Code and Regulations
Question 1: How is an insurance company taxed for federal income tax purposes, and at what tax rate?
If a DOWC meets the definition of an insurance company (as discussed below), it will be treated as a “per se” corporation for federal income tax purposes. Treas. Reg. Section 301.7701-2(b)(4). As a C corporation, its taxable income (as calculated in the case of a non-life insurance company pursuant to the rules of part II of subchapter L of the Internal Revenue Code [“IRC”]) is taxed annually at regular corporate income tax rates pursuant to IRC Section 831(a). Under current law, the corporate tax rate (as amended by the Tax Cuts and Jobs Act in 2017 and set forth in IRC Section 11(b)) remains at 21%.
On May 28, 2021, the Treasury Department released the Biden Administration’s Fiscal Year 2022 Revenue Proposals (the “Greenbook”). One of the proposals in the Greenbook would, if enacted, raise tax rates on domestic corporations from 21% to 28% and impose a 15% minimum tax on corporations that have worldwide book income in excess of $2 billion. These Greenbook proposals (if enacted) would be effective for tax years beginning after 2021. At the present time, it is uncertain whether the Greenbook proposals will become law.
Question 2: What is the definition of an insurance company for federal income tax purposes?
IRC Section 831(c) provides that for purposes of IRC Section 831, “the term ‘insurance company’ has the meaning given to such term by [IRC] section 816(a).” IRC Section 816(a) provides that the term “insurance company” means “any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” Therefore, a dealer-owned warranty company will be taxed as an “insurance company” if more than half of its business involves the issuance (or reinsurance) of “insurance contracts.” While the IRC does not define the term “insurance contract,” case law and rulings provide that “insurance” requires that there is both risk shifting and risk distribution and that the contracts meet the generally accepted definition of an insurance contract, whereby insurance risk is transferred to the insurance company. This definition is separate and apart from any applicable regulatory framework.
Question 3: How does an insurance company calculate its annual taxable income?
IRC Section 832(a) defines the term “taxable income” of a non-life insurance company as the “gross income” as defined in IRC Section 832(b)(1) less the “deductions” allowed by IRC Section 832(c). “Gross income” is defined in IRC Section 832(b)(1) as including the combined gross amount earned during the taxable year from “investment income” and from “underwriting income,” computed on the basis of the “underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners,” as well as gain during the year from the sale or other disposition of property, and other items of “gross income” applicable to non-insurance companies and set forth in “subchapter B” of the IRC.
IRC Section 832(b)(2) defines “investment income” as “the gross amount of income earned during the taxable year from interest, dividends, and rents, computed as follows: To all interest, dividends, and rents received during the taxable year, add interest, dividends, and rents due and accrued at the end of the taxable year, and deduct all interest, dividends, and rents due and accrued at the end of the preceding taxable year.”
IRC Section 832(b)(3) defines “underwriting income” as “the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred.”
IRC Section 832(c) provides that an insurance company is entitled to deduct various items in determining taxable income, including losses incurred, ordinary and necessary business expenses, interest, etc., that are generally deductible for corporations. In the case of an insurance company, this includes commissions that are paid on the sale of an insurance contract.
Question 4: How are “premiums earned on insurance contracts during the taxable year” determined?
IRC Section 832(b)(4) defines the term “premiums earned on insurance contracts during the taxable year” as an amount computed as follows:
(A) From the amount of gross premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance.
(B) To the result so obtained, add 80 percent of the unearned premiums on outstanding business at the end of the preceding taxable year and deduct 80 percent of the unearned premiums on outstanding business at the end of the taxable year.
As a result, the benefit for a DOWC qualifying as an insurance company is the ability to deduct 80% of the change in the unearned premium reserve each year from the amount of gross premiums written in determining taxable income. Only 20% of that UPR is treated as taxable income. Since the insurance company is allowed to deduct various expenses (including commissions), this generally results in the insurance company generating net operating losses for federal income tax purposes.
Question 5: What is the treatment of net operating losses of an insurance company taxed under IRC Section 831(a)?
Under current law specific to non-life insurance companies, as set forth in IRC Section 172(b)(1)(C), a net operating loss (“NOL”) carryover as defined under IRC Section 172(a), is available to be carried back for two years and carried forward for 20 years. The special rule that was included in the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which had extended the carryback period for all corporate net operating losses generated in 2018, 2019, and 2020 to five years, no longer applies to losses generated in 2021 and beyond.
In addition, for taxable years beginning after December 31, 2020, IRC Section 172(b)(2)(C) limits the net operating loss deduction of most corporations to 80% of taxable income (determined without regard to the NOL deduction); however, that rule does not apply to the carryover of nonlife insurance company losses. Instead, such losses are still available to offset 100% of taxable income of non-life insurance companies.
Question 6: What is the Section 831(b) election?
IRC Section 831(b) provides an alternative tax system that can be elected by insurance companies that meet certain qualifications. If an insurance company is able to make the Section 831(b) election, IRC Section 831(b)(1) provides that “[i]n lieu of the tax otherwise applicable under subsection (a), there is hereby imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable investment income of such company for such taxable year by the rates provided in section 11(b).” Accordingly, such a company is taxed at regular corporate tax rates (currently 21%) only on its investment income (its underwriting income is not taxed).
Question 7: What are the requirements to make the Section 831(b) Election?
IRC Section 831(b)(2) provides the requirements for an insurance company to qualify for the Section 831(b) alternative tax system. These requirements are:
- the net written premiums (or, if greater, direct written premiums) for the taxable year do not exceed a threshold amount set forth in IRC Section 831(b)(2)(A)(i), subject to allowable inflation adjustments by the IRS as set forth in IRC Section 831(b)(2)(E);
- the company must meet certain “diversification” requirements; and
- the company elects the application of this subsection for such taxable year.
For purposes of the first requirement set forth above, the threshold amount was originally set by statute at $2.2 million by the PATH Act in 2015 and has been adjusted for inflation at various times. In 2018, the threshold amount was adjusted to $2.3 million. It was subsequently adjusted upward in Rev. Proc. 2020-45, Section 3.36, to $2.4 million for taxable years beginning in 2021, and again in Rev. Proc. 2021-45, Section 3.36 to $2.45 million for taxable years beginning in 2022.
Any election made under IRC Section 831(b) shall apply to the taxable year for which made and for all subsequent taxable years for which the other two requirements (amount of premium and diversification) are met. Such an election, once made, may be revoked only with the consent of the Secretary.
It should be noted that in determining whether the insurance company meets the net written premiums test (i.e., that its premiums do not exceed the threshold amount), premiums written by all members of a modified “controlled group” must be included. See IRC Section 831(b)(2)(C).
Question 8: What happens if an insurance company that makes the IRC Section 831(b) insurance company fails to meet the requirements in a subsequent tax year?
As noted above in Question 7, one of the requirements to make the IRC Section 831(b) election is that the written premium cannot exceed the “threshold amount” which is currently set at $2.3 million. Therefore, it is possible that a company that had premium below that threshold amount in previous taxable years may become taxable as a regular insurance company under IRC Section 831(a) in a subsequent year. In fact, it is possible that an insurance company could fluctuate between taxation under IRC Section 831(b) and IRC Section 831(a) from year to year depending on the written premium for any taxable year. This treatment is mandated by the IRC and is not subject to approval by the IRS.
In fact, the language in IRC Section 831(b)(3) dealing with the treatment of net operating loss carryovers makes it clear that this fluctuation of tax treatment was anticipated by the drafters of the Code section. IRC Section 831(b)(3) provides ruling dealing with the carryover of net operating losses that were generated by a company that had been taxed under the general rules of IRC Section 831(a) prior to (or subsequent to) making the election under IRC Section 831(b). IRC Section 831(b)(3) provides that:
- For purposes of this part, a net operating loss (as defined in section 172) shall not be carried—
- (A) to or from any taxable year for which the insurance company is not subject to the tax imposed by subsection (a), or
- (B) to any taxable year if, between the taxable year from which such loss is being carried and such taxable year, there is an intervening taxable year for which the insurance company was not subject to the tax imposed by subsection (a).
Thus, if a company makes the Section 831(b) election, and has taxable years where it was taxable under Section 831(a) before making the 831(b) election, or alternatively, falls in and out of the 831(b) treatment due to failing to meet the premiums written threshold, IRC Section 831(b)(3) makes it clear that NOLs cannot be carried to any year where it is taxed under IRC Section 831(b), nor can any NOLs be carried forward or back from one 831(a) year to another if there is an 831(b) year in between such years.