Read the letter ruling: PLR 201314020 [PDF 65 KB]
*Private letter rulings are taxpayer-specific rulings furnished by the IRS National Office in response to requests made by taxpayers and/or IRS officials and can only be relied upon by the taxpayer to whom issued. It is important to note that, pursuant to section 6110(k)(3), such items cannot be used or cited as precedent. Nonetheless, such rulings can provide useful information about how the IRS may view certain issues.
In connection with an auto sales business, two corporations (both members of the taxpayer’s consolidated group) offer contracts that provide financial protection against economic loss for expenses related to vehicle repairs that are not covered by manufacturer’s warranties (“Contracts”).
- It is expected that the gross receipts derived from issuing the Contracts will represent a substantial majority of the two corporations’ total gross receipts.
- The two corporations will account for contract premiums received, related unearned premiums and loss reserves, and other items of income and deductions as insurance companies.
The Contracts provide protection to the vehicle purchaser or lessee for:
- Economic loss associated with the cost of repairs due to a mechanical breakdown over a contractually defined period
- A portion of the replacement vehicle rental expense in certain cases and towing associated with a mechanical breakdown
The Contracts do not cover any preventative or routine maintenance, incidental or consequential damages, or new product warranties.
If a policyholder cancels a Contract prior to its expiration, the policyholder is entitled to a refund of the unearned premium.
The Contracts are sold to policyholders by unrelated retail automobile dealers. The dealer, on the sale of a Contract, collects a “Purchase Premium” (i.e., the amount the purchaser paid for the Contract). The dealer retains an “Agent’s Commission” and remits the remaining amount (the “Agent’s Cost”) to the two corporations.
The corporations comply with state law requirements for surety bonds (or contractual liability insurance policies).
The IRS ruled that for federal tax purposes, the Contracts are insurance contracts, not prepaid service contracts. Unlike prepaid service contracts, the Contracts are “aleatory contracts.” The Contracts further are not prepaid service contracts because the two corporations provide no repair services. Also, by accepting a large number of risks, the risk of loss is distributed under the Contracts so as to make the average loss more predictable.
The IRS stated that as long as at the end of each tax year more than 50% of the business of the two corporations is issuing the Contracts, the corporations will qualify as insurance companies for purposes of section 831.
For purposes of computing each corporation’s insurance company taxable income under section 832, the IRS stated that the gross premium written on a Contract is the Purchase Premium paid by the policyholder for the Contract.
To determine expenses incurred (for purposes of determining a nonlife insurance company’s underwriting income under section 832(b)(3)), the Agents’ Commissions are a deductible expense that are a form of policy acquisition expense. Each corporation may deduct its Agents’ Commissions paid during the tax year in accordance with section 832(b)(6).