Lary Williams, Crowe Chlzek: "I am not sure that a lot of dealers' accounting firms are aware of what's going on."
Among the goals of the Pension Funding Equity Act of 2004 is cracking down on questionable tax shelters. Revised rules governing small tax-favored insurance companies are part of the law, which President Bush signed this spring.
Dealers with reinsurance companies have been on the hot seat for two years. The IRS required some of them to report ownership in these companies on 2002 tax returns.
Last December the IRS began investigating reinsurance companies set up by a leading credit insurance writer, American Bankers Group Inc. of Miami. The insurer does business with car dealers.
A tax expert warns that the new law will virtually eliminate the tax-exempt status of small reinsurance companies. Larry Williams, an executive with the dealer accounting firm Crowe Chizek in a suburb of Nashville, Tenn., told Staff Reporter Donna Harris that the IRS is taking an especially hard look at offshore reinsurance companies.
What percentage of your clients owns reinsurance companies?
I would say 80 percent have reinsurance companies of some sort. More than half of them are offshore companies.
Is the IRS auditing dealers with reinsurance companies?
None of my clients are under audit, but the IRS has made it pretty clear they are going to go after small tax-exempt organizations. The IRS has an initiative to study and audit the tax-exempt companies (with $350,000 or less in annual premium revenues) and companies with premiums of $1.2 million or less in which premium or underwriting income is tax-exempt and they are taxed only on investment income.
In 2002, the IRS issued a ruling saying that if the company was offshore and was a small tax-favored insurance company, (ownership) needed to be disclosed on the dealer's tax return (as a potential tax shelter).
What types of abuse is the IRS looking for?
The IRS is looking for dealers who put part of the commissions from extended service contracts in the reinsurance company. They want arm's-length premiums. They are asking what a third party would charge for an extended service contract; what are the expected claims; what is a reasonable commission for the dealer; and what is a reasonable profit for the insurance company.
The IRS wants to know if the dealer is putting part of the commissions into the reinsurance company and calling them premiums to get the tax advantage.
Sometimes regional IRS offices are more aggressive about enforcing certain tax laws. Is that the case here?
I haven't seen any part of the country get more scrutiny than others.
What are some of the key restrictions in the law that passed this year?
Before, tax-exempt companies had to have no more than $350,000 in premium revenue, and it didn't matter how much investment income they had. Some companies (not car dealers) would shelter huge investment portfolios. Now the companies can have up to $600,000 in revenues and at least 50 percent must be from insurance premiums.
That sounds as if it will be easier to qualify for tax-exempt status.
It is more difficult. The new law requires dealers (and other businesses with reinsurance companies) to apply a "group" test. They have to group all revenues of companies with common ownership (including revenues of the car dealership) together to determine if the reinsurance company is tax-exempt.
An affiliated company is one with more than 50 percent common ownership. This makes it difficult for dealer-owned reinsurance companies to qualify unless the companies have different ownership structures. Dealers might try to use different ownership, but they will lose some control. In my opinion, the tax-exempt status is not useful anymore.
What if the companies are owned by different family members?
The law has some family attribution rules, meaning the (law) considers you to own what your children own. Dealers might be able to compensate their executives by giving them ownership in the insurance company as a way to get around the restrictions on tax-exempt companies.
You have said dealers should set up their reinsurance companies in the United States because foreign corporations will get more scrutiny.
If you have an offshore reinsurance company, to get the tax benefit (for small companies) you have to make an election to be taxed as if you are a U.S. corporation. You have to file an election statement with the IRS in Plantation, Fla., and you will automatically be on the IRS radar screen.
Why has the federal government come down so hard on these reinsurance companies?
A lot has to do with the publicity. The New York Times and Forbes have written about businesses abusing the rules on small tax-favored companies - mostly about companies other than auto dealerships.
As an example, an investment firm in New York that was capitalized with $20 million - but only wrote $14,000 in premiums - grew to $100 million and did not pay any taxes. Under the older rules they qualified as a small insurance company. They put huge investment portfolios in the company and sheltered the gains. That was the abuse that got the attention of Congress.
Are dealers prepared for the extra scrutiny?
No. I think they are starting to hear about it and get concerned, but it is such a specialized area that I am not sure that a lot of dealers' accounting firms are aware of what's going on. Or they may have a general sense but do not keep up with the details unless they specialize in this area.