Service-Warranty Companies—the Hybrid of the Insurance Industry

Executive Summary 

• Premiums from a service-warranty contract can be taken into account in four different ways: full inclusion; service-warranty accounting; advance payments; or as an insurance company.
• Under the first three methods, the warranty provider is not
  subject to mandatory C corporation status; however, the insurance company route offers the greatest deferral of income taxes if the policies are of a sufficient duration.
• There are advantages and disadvantages to each method; tax advisers should review how each would affect a client’s particular situation. 

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The joy of new toys: flat-panel high-definition televisions, laptop computers, digital cameras and more. These toys are so loved—and their repairs so dreaded—that consumers often buy extended warranties or replacement plans for such products. Circuit City reported that 3.8% of its domestic sales in 2006 were attributable to extended warranty programs it sold on behalf of unrelated third parties who are the primary obligors.1 That equals $417 million in commissions by one retailer, an amount that exceeded its operating income. The extended warranty industry was reported to be $15 billion in 2005 and growing.2 Yet extended warranties are really service contracts that are, in essence, repair insurance. The companies that sell these contracts can take advantage of a tax accounting method that is available to insurance companies. This article presents the unique tax accounting options available to a service-warranty company.

Background

Service-warranty companies first became popular in the 1970s, when manufacturers shortened the warranty period on new automobiles.3 Third parties began to offer extended warranties. Manufacturers, third parties and even standard insurance companies have since jumped into the market to offer extended warranties on everything from large-ticket items (such as homes and automobiles) to inexpensive electronics (like coffeemakers). As the industry grew, accounting issues gained attention, such as how the premium income should be taxed. The answer depends on whether the extended warranty is an insurance product or a service contract.

The service-warranty industry generally developed outside of the regulated insurance company framework. Some courts held that a service warranty is merely a contract and is not subject to regulation as an insurance product by the National Association of Insurance Commissioners or the various state regulatory agencies.4 Other courts have held that warranty contracts are insurance.5 Florida takes a unique hybrid approach, by requiring service-warranty companies to meet minimum capital requirements and report financial condition to the Insurance Commissioner.6 However, the requirements are less onerous than those placed on standard insurance companies. In most states, service-warranty companies are merely required to provide some minimum additional protection related to the actual contracts, such as contractual liability insurance. This guarantees that if the company goes bankrupt or cannot fulfill the contract, a third-party insurer will continue the coverage for the consumer.7

Earned and Unearned Premiums—Income Recognition

A warranty company is generally not an insurance company under state law; thus, it may choose its accounting method for Federal and state income tax purposes. There are four ways that premium income from a service-warranty contract can be taken into income: (1) on receipt, (2) using the accounting method specified in Rev. Proc. 97-38,8 (3) using the advance-payment method under Rev. Proc. 2004-349 or (4) classifying the contract as an insurance product for Federal tax purposes and amortizing the income according to Secs. 831 and 832.

Full-Inclusion Method

The simplest (but most costly) way to recognize premium income is on receipt. The receipts or full-inclusion method requires all taxes to be front-loaded; income is recognized on receipt, but reinsurance expense is amortized over the term of the contract.10

Example 1: A company sells a four-year contract for $2,000, pays $1,000 for reinsurance, incurs $100 of other expenses in each contract year and is subject to a 35% Federal tax rate. The cashflow over the term of the contract is illustrated in Panel 2 of Exhibit 1 (below). The company earns an after-tax rate of return of 7%11 on its investments and is able to use all losses against other income, as illustrated in the calculation of tax benefit (or cost) in Panel 1 of Exhibit 1. 

The contract will generate an NPV cashflow of $356.59 after taxes. Generally, a taxpayer is not required to reinsure its risk if it uses the full-inclusion method. However, it is prudent business practice to carry reinsurance and, for purposes of comparing the accounting methods, the same set of facts is used for all examples throughout the article.

EXHIBIT 1: FULL-INCLUSION METHOD

Panel 1: Income tax calculation

	Year 1	Year 2	Year 3	Year 4
Premium income	$2,000.00
Reinsurance	(250.00)	$(250.00)	$(250.00)	$(250.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Taxable income	$1,650.00	$(350.00)	(350.00)	(350.00)
Tax benefit (cost) at 35%	$(577.50)	$122.50	$122.50	$122.50

Panel 2: NPV Cashflow

	Year 1	Year 2	Year 3	Year 4
Premium income	$2,000.00
Reinsurance expense	(1000.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Cashflow before taxes	$900.00	$(100.00)	$(100.00)	$(100.00)
Tax benefit (cost) at 35%	$(577.50)	122.50	122.50	122.50
Net cash after taxes	$322.50	$22.50	$22.50	$22.50
NPV of cashflow	$356.59

Service-Warranty Income Method

To alleviate cashflow problems caused by taxing premium income in the first year under the complete-inclusion method, Rev. Proc. 97-38 provides a “service-warranty income method” for warranty contracts on durable consumer goods issued by the retailer, manufacturer or wholesaler of the product covered by the contract.12 This accounting method allows taxpayers to recognize as gross income, generally over the period of the service-warranty contract, a series of equal payments, the present value of which equals the portion of the advance payment qualifying for deferral. The basic requirements to use this method are:

1. The service arrangement is for a fixed term;
2. The cost of the warranty is separately stated within the sales contract;
3. The warranty contract begins in the year payment is received or on expiration of a fixed-term manufacturer’s warranty beginning in the tax year the advance payment is received;
4. The taxpayer purchases a policy that constitutes insurance for Federal income tax purposes from an unrelated party to insure the obligation; and
5. Payment to the unrelated third-party insurer is made within 60 days of receipt of the payment from the purchaser of the warranty.

This method requires the taxpayer to reinsure the risk of performance and to pay promptly for such reinsurance.

Under the service-warranty income method, a taxpayer includes the qualified advance-payment amount, increased by an imputed-income amount, in gross income on a level basis over the shorter of the contract’s term or six years. The “qualified advance payment amount” is the portion of an advance payment received by a taxpayer under a multi-year service-warranty contract paid by that taxpayer to an unrelated third party within 60 days after receipt for reinsurance. The imputed income is determined by a table in the Appendix to Rev. Proc 97-38 and depends on the term of the contract and the applicable Federal rate (AFR).

Example 2: In Exhibit 2 (below), the facts in Example 1 are accounted for under the service-warranty income method. Based on the mandatory table in Rev. Proc. 97-38, a four-year policy and a 5% AFR,13 the qualified advance payment is amortized at 26.86% per year. This adds up to more than 100% of the amount received attributable to the reinsurance.

Under the assumptions presented, the service-warranty method results in an increase in NPV of $8.67 over the full-inclusion method. The reason for the shift is that the better matching of income and expense more than offsets the cost of recognizing $2,074.40 income, an amount greater than the $2,000 received from the customer. The benefit of using the service-warranty method would increase as a company’s after-tax rate of return increases relative to the AFR.

EXHIBIT 2: SERVICE-WARRANTY INCOME METHOD

Panel 1: Income tax calculation

	Year 1	Year 2	Year 3	Year 4
Premium income not deferred	$1,000.00
Premium income deferred	268.60	$268.60	$268.60	$268.60
Reinsurance expense	(250.00)	(250.00)	(250.00)	(250.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Taxable income	$918.60	$(81.40)	$(81.40)	$(81.40)
Tax rate (35%)	$(321.51)	$28.49	$28.49	$28.49

Panel 2: NPV cashflow

	Year 1	Year 2	Year 3	Year 4
Premium receipt	$2,000.00
Reinsurance expenditure	(1,000.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Cashflow before taxes	$900.00	$(100.00)	$(100.00)	$(100.00)
Tax rate (35%)	$(321.51)	28.49	28.49	28.49
Net cash after taxes	$578.49	$(71.51)	$(71.51)	$(71.51)
NPV of cashflow	$356.26

Advance-Payment Method

Accrual-basis taxpayers can defer income from certain payments received in one year for services to be performed in the next succeeding tax year.14 Rev. Proc. 2004-34 allows a taxpayer to recognize revenue from extended warranties ancillary to certain goods, services and intellectual property over a two-year period, using straight-line basis or calculating the first-year inclusion on a statistical basis, if adequate data is available.

Example 3: Exhibit 3 (below) shows the NPV generated by the facts in Example 1 using the advance-payment accounting method. The income attributable to the second through fourth years is deferred until the second year.

The NPV of cashflows using the advance-payment method is $32.09 more than when using the full-inclusion method. The increase in cashflows could be even greater if a statistical method were used to calculate the first year’s income inclusion.

EXHIBIT 3: ADVANCE-PAYMENT METHOD

Panel 1: Income tax calculation

	Year 1	Year 2	Year 3	Year 4
Premium income	$500.00	$1,500.00
Reinsurance	(250.00)	(250.00)	$(250.00)	$(250.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Taxable income	$150.00	$1,150.00	$(350.00)	$(350.00)
Tax rate (35%)	$(52.50)	$(402.50)	$122.50	$122.50

Panel 2: NPV cashflow

	Year 1	Year 2	Year 3	Year 4
Premium receipt	$2,000.00
Reinsurance expense	(1,000.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Cashflow before taxes	$900.00	$(100.00)	$(100.00)	$(100.00)
Tax rate (35%)	$(52.50)	(402.50)	122.50	122.50
Net cash after taxes	$847.50	$(502.50)	$22.50	$22.50
NPV of cashflow	$388.68

Insurance Company Alternative

The fourth possible accounting method for extended warranties is achieved outside the normal tax regime, by classifying the entity as an insurance company for Federal income tax purposes. Insurance companies, other than life and mutual, are taxed in accordance with Secs. 831 and 832. An insurance company is defined by Sec. 816(a) as “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.” Although warranty contracts are generally not insurance policies under state law, they could be considered insurance policies for Federal tax purposes.

Insurance defined: The Federal tax definition of insurance is based in case law. In LeGierse,15 the Supreme Court defined insurance as a contract that shifts and distributes risk. In determining whether risk has been shifted, the courts look to the insured’s assets. In Humana Inc., 16 the parent did not shift risk when purchasing insurance from its subsidiary, a captive insurance company, because the captive’s stock was an asset of the parent. The court found, however, that risk-shifting and distribution did occur between the captive and Humana’s other subsidiaries, because the sister companies did not have an ownership stake in the captive.

In United Parcel Service of America, Inc., 17 United Parcel Service (UPS) kept its Bermuda insurance company off its balance sheet by distributing the Bermuda company stock to UPS shareholders. It then added a third-party insurer to the arrangement. UPS sold excess-value coverage to shipping customers on behalf of the unrelated third-party insurer. UPS, which took special measures to safeguard valuable shipments, collected the premiums and processed claims. The excess of premiums over claims was sent to the third-party insurer, who collected a commission and then reinsured the entire risk with the Bermuda company owned by UPS shareholders. The premiums paid to the third-party insurer were well above industry norms, even though it had virtually no risk of loss because of the Bermuda reinsurance contract. Yet the court held that UPS’s arrangement to provide excess-loss coverage and lower its liability exposure had sufficient economic substance to merit respect. The court noted that reinsurance did not completely foreclose the risk of loss to the third-party insurer; the contract, like all agreements, was susceptible to default.18

Rulings: Classification of contracts as insurance for Federal tax purposes is paramount to qualifying under Secs. 831 and 832. Numerous warranty companies have sought letter rulings for assurance that a particular contract meets the Federal definition of insurance.19 The following discussion de-scribes the principal similarities across these rulings.

First, a warranty company can be a subsidiary of a manufacturer, retailer or wholesaler,20 an entity related to a retailer or wholesaler,21 or an independent third-party provider.22 In all cases, the company issued contracts that ran parallel to the manufacturer’s warranty, in a transaction separate from the purchase of the product. There was also a separate charge for the extended coverage. The company issued multiple contracts to end consumers to distribute the risk across the group. The contracts were normally for durable goods ranging from home electronics to automobiles.

In the rulings, the IRS reviews whether the contracts meet the definitional standards for insurance set by case law. Under Regs. Sec. 1.801-3(a)(1), the Service further defines an insurance company as an entity whose predominate business is issuing insurance. Finally, it looks at the company’s name, state charter and the applicability of state insurance laws to the business. However, the latter is not as important as the former; the character of the business is more important than its structure. In all the cases in which an entity has requested a letter ruling to interpret the contract or to confirm that it is in fact an insurance company, the IRS has ruled favorably.

Premiums and reserves: The major differences between a regular corporation and an insurance company are the use of reserves and the deferral of unearned premiums. A warranty company generally reserves for losses rather than purchasing reinsurance, and recognizes premium income as specified in Sec. 832(b)(4). Total premiums earned on insurance contracts during the tax year are determined by beginning with the insurance company’s gross premiums written on contracts during that year, adjusted for certain other items. This amount is increased by 80% of the unearned premiums on insurance contracts at the end of the preceding tax year, and is decreased by 80% of the unearned premiums on insurance contracts at the end of the current tax year. Regs. Sec. 1.832-4(a)(9) requires the company to recognize premium income pro rata, unless the risk of loss varies significantly. In that case, the company may recognize premium income based on its claims ratio to total premiums outstanding. In either case, the premium is spread over the life of the policy.

A warranty company that qualifies as an insurance company generally sells the contract through an agent, to whom a commission is paid. The agent who sells the policy to the ultimate consumer can be either an unrelated or a related party.

Example 4: In Exhibit 4 (below) the facts in Example 1 are modified to eliminate the reinsurance. Instead, the assumed cash outflows related to the premium income are due to a 20% commission and a 30% claims rate over the policy’s term.23 The company still incurs $100 of other expenses annually. (These numbers are arbitrary, but correspond with the above examples; if claims were higher, the reinsurance required in the previous examples would be priced higher to cover the additional claims expense. In all cases, the total outlay is $1,400.) The calculation of premiums earned (as specified by Sec. 832(b)(4)) is shown in Panel 3 of Exhibit 4.

Based on the above analysis, the NPV of the cashflows of the hypothetical policy using insurance company accounting is $470.70, higher than the other three methods. If the contract sales were through a related party, the $400 commissions would be earned in the related group, thus raising the NPV of the arrangement. In the current example, the taxpayer retains the warranty contract risk premium (i.e., premium income less claims paid). In addition, the timing of the deductions works in the company’s favor, because all acquisition costs are deductible in the current period, under Sec. 832(b)(3). Insurance companies do have additional adjustments; however, adjustments other than those attributable to unearned premiums illustrated above are minimal.

EXHIBIT 4: INSURANCE COMPANY ACCOUNTING METHOD

Panel 1: Income tax calculation

	Year 1	Year 2	Year 3	Year 4
Premium income (see panel 2)	$800.00	$400.00	$400.00	$400.00
Commissions	(400.00)
Claims	(150.00)	(150.00)	(150.00)	(150.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Taxable income	$150.00	$150.00	$150.00	$150.00
Tax rate (35%)	$52.50	$52.50	$52.50	$52.50

Panel 2: Premiums-earned calculation

	Year 1	Year 2	Year 3	Year 4
80% unearned premium (start of year)	–	$1,200.00	$800.00	$400.00
Premiums collected	$2,000.00
80% unearned premiums (end of year)*	(1,200.00)	(800.00)	(400.00)	–
Premium income for tax	$800.00	400.00	400.00	400.00

* The unearned premium is computed as follows: $2,000 premium less $500 earned in the first year, leaving $1,500 in unearned premiums at the end of year 1.

Panel 3: NPV cashflow

	Year 1	Year 2	Year 3	Year 4
Premium income	$2,000
Commissions	(400.00)
Claims	(150.00)	$(150.00)	$(150.00)	$(150.00)
Other expenses	(100.00)	(100.00)	(100.00)	(100.00)
Taxable income	$1,350.00	$(250.00)	$(250.00)	$(250.00)
Tax rate (35%)	(52.50)	(52.50)	(52.50)	(52.50)
Net cash after taxes	$1,297.50	$(302.50)	$(302.50)	$(302.50)
NPV of cashflow	$470.70

Advantages and Disadvantages

As can be seen through the examples, the insurance company route appears to offer the best return. However, other factors also play into whether one method is preferable in a given situation. Under the first three methods (i.e., the full-inclusion, service-warranty accounting and advance-payment methods), the entity is not subject to the mandatory C corporation status of an insurance company. Thus, the warranty provider could be an S corporation, a limited liability company (LLC) or a partnership. However, the advantage of a single level of tax must be weighed against the disadvantages of the other methods. Under the full-inclusion and advance-payment methods, income recognition is accelerated. Under the service-warranty income method, an S corporation, a partnership or an LLC may defer some income, but must also include imputed income that is not considered as basis for future tax-free distributions.24

In the case of an insurance company, there are also advantages and disadvantages. The main advantage is that the company gains the benefit of retaining insurance profits, rather than ceding those to a reinsurer. Retaining insurance risk would, of course, be detrimental if claims were higher than expected. However, the extended warranty business is, in general, very profitable. The ability to be taxed under the insurance company regime increases returns for insurance companies (as illustrated above); at the same time, a second level of tax will apply to distributions.

Finally, insurance companies could potentially have costs not reflected in the example. Because the company is now an insurance company, it must maintain records for each policy sold and administer any claims, which might be too great a burden or will require a third-party administrator. However, the overall cost of recordkeeping would be the same as for the reinsurer under the first three methods, as the reinsurer would factor the recordkeeping costs into the reinsurance premium. Further, the company may have certain state requirements.25 A company should assess its ability to handle these additional responsibilities efficiently before it decides to pursue the insurance company route.

Conclusion

Numerous accounting methods are available to service-warranty companies. No one method is a panacea for the industry. Each taxpayer should review how each method would affect its particular situation. The taxpayer should assess its risk tolerance, expected claims ratios, complexity of recordkeeping, terms of service contracts and expected profits, before selecting one method over another.

For more information about this article, contact Ms. Bertolini at bertolini@fau.edu.

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Notes

1 Circuit City, 2006 Annual Report.

2 Sykes, “Extend The Warranty Or Cut Your Losses?” Black Enterprise (November 2005), available at www.blackenterprise.com/
ArchiveOpen.asp?Source=ArchiveTab/2005/11/1105-29.htm.

3 Spahn, “Service Warranty Associations: Regulating Service Contracts as ‘Insurance’ Under Florida’s Chapter 634,” 25 Stetson L Rev. 597 (Spring 1996).

4 See, e.g., Griffin Systems v. Ohio Dep’t of Ins., 575 NE2d 803 (OH 1991), and Transportation Guarantee Co. v. Jellins, 174 P2d 625 (CA 1946); see also Samini, “Third-Party Extended Warranties and Service Contracts: Drawing the Line Between Insurance and Warranty Agreements,” 54 Ohio St. LJ 537 (Spring 1993).

5 See, e.g., Griffin Systems, Inc. v. Washburn, 505 NE2d 1121 (IL App. Ct. 1987); Jim Click Ford, Inc. v. City of Tucson, 739 P2d 1365 (AZ Ct. App. 1987).

6 Chapter 634 of the Florida Statutes is broken down into three separate sections: motor vehicle service agreement companies, home warranty associations and service-warranty associations. Only the first and last deal with the consumer-type warranty contracts this article discusses. The chapter gives the State Department of Insurance the right to oversee operations of the entities, and regulate and set certain reserve requirements and deposits.

7 See CA Civ. Code §1791 and CA Bus. & Prof. Code §9855; see also MN Stat. Section 59B.01. These are merely examples of two states’ definition and regulation of service-warranty contracts.

8 Rev. Proc. 97-38, 1997-2 CB 479.

9 Rev. Proc. 2004-34, IRB 2004-22, 991.

10 See Sec. 461(h)(1) and (4).

11 The 7% selected as the discount rate is merely for example purposes.
If the discount rate were smaller or larger, the fair market value of the cashflows would change appropriately. If operating losses could not be used until a later period, the contract’s net present value (NPV) would be less.

12 The service-warranty income method described in this procedure is the same method of accounting described in Rev. Proc. 92-98, 1992-2 CB 512.

13 The AFR is normally lower than a company’s after-tax rate of return. Thus, a 2% differential is included in the fact pattern. The difference is for example purposes only; the actual difference will depend on the company’s investment strategy and the AFR. If a company’s after-tax rate of return is at or below the AFR, the service-warranty method would generate a lower NPV than any of the other methods. Thus, any company considering this method must compare its return to the AFR.

14 See Rev. Proc. 71-21, 1971-2 CB 549, amended and superseded by Rev. Proc. 2004-34, note 9 supra.

15 Helvering v. LeGierse, 312 US 531 (1941).

16 Humana Inc., 881 F2d 247 (6th Cir. 1989).

17 United Parcel Service of America, Inc., 254 F3d 1014 (11th Cir. 2001).

18 See Rev. Proc. 71-21, note 14 supra.

19 See, e.g., IRS Letter Rulings 200042018 (10/23/00); 200140057 (10/9/01); 200147052 (11/26/01); 200403024 (1/16/04); 200525004 (6/24/05); 200416006 (4/16/04); 200138010 (9/24/01); 9225003 (2/28/92); 200119039 (5/14/01); 200416006 (4/16/04); and 200509005 (3/4/05).

20 IRS Letter Rulings 200042018, note 19 supra; 200140057, note 19 supra; 200147052, note 19 supra; 200403024, note 19 supra; and 200525004, note 19 supra.

21 IRS Letter Rulings 200416006, note 19 supra and 200138010, note 19 supra.

22 IRS Letter Rulings 9225003, note 19 supra; 200119039, note 19 supra; 200416006, note 19 supra; and 200509005, note 19 supra.

23 The 20% commission and 30% claims figures are merely for example purposes. The commission depends on the profitability of the warranty policy. The claims percentage varies depending on the product, life of the policy and actual claims filed.

24 See Rev. Proc. 97-38, note 8 supra.

25 See, e.g., FL Stat. Ch. 634, note 6 supra.