The domestically dealer-owned warranty company (DOWC) is one of the many ways dealers have retained the underwriting profits from service warranty and ancillary products. Although the DOWC may seem like a new concept, the structure has been around since the 1970s.
Though in the marketplace for more than 40 years, the DOWC is not widely well understood, often leading to misrepresentation and inaccurate information.
The DOWC is the only domestic model to accomplish something similar to the controlled foreign corporation (CFC). Unlike the CFC, the DOWC does not require a third-party insurer and could possibly lead to lower overall fees per contract. In addition, from a domicile aspect, the only other domestic company that could write a service contract and still receive the beneficial tax treatment would be a full insurance company, which would require large amounts of capital and additional administrative and compliance burdens because of the insurance company status. The DOWC still receives the beneficial tax position but with lower administrative burdens because for state purposes it is considered a standard corporation.
The structural/financial aspects of the DOWC are similar in many aspects to a standard domestic corporation. The formation process for the DOWC contains three basic steps: locating an administration company for claims processing and assistance in formation, the actual incorporation of the entity, and gaining approval from the state or states in which the entity will operate to process service contracts.
Forming a DOWC
The first step in the process is locating an administrative company that can process and handle the claims administration, as well as the financial record keeping of the entity. Although the process of administering the service warranty contracts is rather straight forward, like processing claims, the more complex area is correctly accounting for the numerous contracts, as well as keeping track of the DOWC’s other expenses, investments, and statutory requirements. A dealer principal could act as their own administrator, but the process of tracking the policies and claims processing can be quite burdensome. A good administrative company should be able to assist the dealer principal in understanding the DOWC’s concept and offer timely financial reporting and quality claims processing to keep the ultimate consumer satisfied with the product. In addition, because there is no third-party insurer working as a middle-man, the overall fees are often lower than other participation programs. The DOWC may also offer extra flexibility when designing the service contract and the ability to pay claims without prior approval.
Once the administrative company is selected, the second step is for the dealer principal to incorporate. This entails the normal incorporation process — filing articles of incorporation with the state, creating bylaws, and issuing shares to the shareholders. In addition, the corporation should obtain a federal tax identification number and fulfill any state tax requirements. Unlike a CFC or NCFC, the shareholders and board of directors have direct control of the company. The actual state of incorporation is not important; most DOWCs are incorporated in the state where the entity will sell the policies. There is no tax advantage to selecting one state over another since the allocation of taxable income is based upon the location where the policies are sold, not the state of incorporation. After the incorporation, the DOWC can now open bank and brokerage accounts for investing the proceeds of the contracts.
After the entity is incorporated, a quality administrative company will seek approvals from the state or states where the DOWC will sell policies. The process can be as simple as filing some basic paperwork, but some state requests personal financial information for all the shareholders. In addition, the administrative company will obtain a contractual liability insurance policy (CLIP) for the DOWC, if required, which ensures the contracts sold will be valid even if the DOWC becomes insolvent. To date, no DOWC to my knowledge has ever become insolvent. Once the approval process is completed, the DOWC is now ready to be capitalized and sell policies.
At this point, the initial capitalization of the corporation is required. There are two capitalization thresholds, with the first normally created by the administrative company to make sure the DOWC is viable. This threshold initial capitalization averages around $50,000. The second threshold is the state capitalization requirement. A majority of the states do not have a base capitalization requirement, so the administrative company capitalization is the base; however, some states, such as Florida, require $500,000. In addition to the capitalization requirement, the administrative company will require a trust account of some type, this could consist of a two-signature brokerage account or the administrator requiring certain amount of deposits be held in trust for the administrator in case the DOWC becomes insolvent. Again, the choice of administrative companies is important because for the double signatory, the shareholder/directors still control the investments, whereas the deposit method normally limits the investment options.
Operationally, the DOWC acts as any other corporation — sales come in, expenses go out, and the net result is a profit or loss. However, the complexity comes during the financial accounting of service contract sales. The correct methods of accounting for such policies are based upon the National Association of Insurance Commissioners (NAIC) or generally accepted accounting procedures (GAAP). In both cases, the premium income is amortized over the life of the policy. In addition, any acquisition costs of the policy, commissions paid to the dealership, and administrative fees per policy are also amortized over the life of the policy, thus matching income with expenses. Investment income and operational expenses are earned or expensed in the period received. An important aspect here is the administrative company should be able to supply a balance sheet and income statement to the DOWC monthly so the dealer/shareholder can track the financial position of the company. A quality administrator should also be able to supply claims analysis, performance per dealership, in-house claims payments, and so on.
From a commitment standpoint, a majority of the financial/day-to-day operational recording happens at the administrator level. The staffing required by the DOWC is minimal. The involvement might include keeping track of the local checkbook for incidental payments, such as tax preparation fees, printing, or other costs the dealer principal pays out of the DOWC. In addition, the DOWC can reimburse the dealership for any costs incurred by the dealership for the entity, but also for such things as labor, rent, or management fees.
A recap of the formational and operational aspects of the DOWC are as follows:
- The DOWC is a domestic corporation.
- The DOWC must be licensed in all states where the entity will sell policies.
- For financial accounting either NAIC or GAAP standards should be used.
- The DOWC should have a separate checking and brokerage/investment account.
- Dealer/shareholder involvement in operations are minimal.
- The DOWC should be able to invest in a variety of different investments.
- Administrative time at the entity level is minimal.
For state law purposes, the DOWC is considered a normal corporation. For federal tax purposes, the DOWC is considered an insurance company if the entity meets certain criteria. First, the DOWC must earn more than 50% of its gross proceeds from premiums related to federal tax defined insurance-based products. Although service contracts are not considered insurance for state law purposes, for federal tax purposes, the IRS has issued a number of private letter rulings stating the contracts meet the requirements to be considered insurance. Since the DOWC likely writes more than 50% of its business as service contracts, the entity is allowed the beneficial treatment of the Internal Revenue Code Sections 831 and 832. Unlike the CFC, the DOWC can write prepaid maintenance policies. These are not considered insurance, so the taxation is standard corporate taxation.
Since the service warranty contracts are considered insurance, they receive the beneficial tax treatment, while the gross premium is amortized into income over the life of the policy. The other beneficial aspect is all acquisition costs, commissions, and administrative fees are deductible in the year incurred. There is one adjustment required to get the real deferral. Because of the allowance of full deductibility of the acquisition costs, under I.R.C. §832(b)(4), 20% of the unearned premium reserve must be added into taxable income. The amortization of income and acceleration of the expenses for tax purposes allows for a deferral of taxable income. For financial accounting purposes, the DOWC is profitable in the first year of existence because of the matching of income and expenses.
The method of tax deferral used by the DOWC has been through IRS audit and allowed with no changes. The deferral period varies depending on product mix, but the average period is from seven to 10 years. In addition, any expenses, such as bonuses to F&I departments, rent of facilities, or management fees paid to outside parties, are deductible by the DOWC. Unlike the CFC, this is the shareholders’ company and can pay business-related expenses without seeking approval from the administrator.
The compliance requirements of the DOWC will be to file a federal form 1120PC – Property and Casualty Insurance Company return on an annual basis. Since the entity is domestic and operating in one or more states, the DOWC will also be required to file in any states where it sold policies or was registered. However, the same deferral period holds for state income tax purposes outside of some potential minimum payments that are minimal.
Because of the DOWC’s ability to qualify as an insurance company, the entity also has the right to make the I.R.C. §831(b) election if the criteria are met. Currently, the property and casualty insurance company must write less than $2.35 million in net written premium as of the date of this article. The benefit of this election is to allow the DOWC to be taxed on investment income only. The Internal Revenue Code does not require a specific timing of the election, as long as the entity meets the requirements of I.R.C. §831(b). In addition, the company can continue to operate even after the election is made, but it must remain below the $2.35 million annual threshold to benefit from the election. However, once the election is made, the company cannot cease being treated as a small insurance company without approval from the Commissioner of the IRS.
A recap of the taxation of DOWC is as follows:
Treated as anTreated as an insurance company for federal tax purposes.
- Allows pro-rata inclusion of premium income.
- Full expensing of acquisition costs in year incurred.
- 100% use of net operating loss carryforwards (unless I.R.C. 831(b) is elected).
- I.R.C. §831(b) election is available if the company meets the requirement.
- Qualified dividend treatment for distributions to shareholders.
Hopefully, this overview helps demystify the DOWC and some of the advantages that dealers can find when using this participation program. Though in the marketplace for more than 40 years, the DOWC is not widely well understood, often leading to misrepresentation and inaccurate information. What this overview fails to cover are other advantages, such as greater control of the F&I programs associated with DOWC and the ability of ownership groups to brand their F&I product offering. Also, as with any business relationship, partnering with an experienced provider is a key to success as not all DOWCs are created equal. If you are a dealer interested in exploring your options, make sure to clearly defined your financial objectives and make sure you work with a provider experienced with DOWCs.
Michelle Bertolini is both an attorney and certified public accountant. She began her tax career in the insurance industry more than 30 years ago working with the two largest insurance companies in the state of Georgia. In addition to her insurance experience, she worked at Crowe LLP, in their automotive division, and CohnReznick LLP in their high net worth and real estate divisions. In 2003, Michelle partnered with Diana Hermansen to create the CPA firm Bertolini & Hermansen, CPAs, P.A.