How the Indiana Service Contract Act Could Save Dealers on Taxes
Note: This article originally appeared in The Showroom.
The state of Indiana has adopted statutes that regulate the offering, selling, or issuing of service contracts in the state.1 These statutes provide the requirements for a service contract that is sold within the state, and they may provide dealers within the state an opportunity to save significant federal and state income taxes.
Generally, insurance products are subject to the regulatory oversight of the Indiana Department of Insurance. Many dealers have worried about whether a service contract was subject to such oversight. The Service Contract Act provides that contracts meeting the requirements of the act are not insurance and, except as provided in the Service Contract Act, not subject to regulation by the state of Indiana.
Prior to the enactment of the Service Contract Act, the insurance regulatory requirements such as the significant minimum capital requirements and licensure requirements would preclude many dealers from being able to have their own dealer-owned service contract company. The Service Contract Act gives dealers certainty from a regulatory standpoint with a greatly simplified regulatory regime.
Federal and State Income Tax Opportunity
Under federal income tax law, service contracts have generally been held to be insurance contracts despite the fact that they are not considered insurance contracts under Indiana regulatory law.2 This inconsistency is part of what may provide significant opportunities for Indiana dealers.
A small insurance company is generally an insurance company that has net written insurance premiums of $2.3 million (indexed for inflation) or less, that meets certain other requirements, and that has elected to be taxed as a small company. The fees collected for the sale of a service contract are considered insurance premiums for purposes of this test. For those companies that are eligible and have elected small company status, they are not subject to federal or state income tax on the company’s underwriting income. Underwriting income is the difference between the price the service contract company charges for the service contract and the claims paid (repairs) on the vehicle. All other income earned by the service contract company will be subject to tax.
To illustrate the effect, assume that a service contract company sells a service contract for $1,200. Also assume that the service contract company pays $200 to pay for a covered repair. The service contract company would have underwriting income of $1,000 ($1,200 premium minus $200 claim). Also assume that the service contract company earns $100 of interest income. Under the beneficial provisions for small insurance companies, the service contract company would not pay federal or state income taxes on “underwriting” income, but the company would be required to pay tax on the $100 of interest income. Assuming a combined federal and state income tax rate of 34%, the small insurance company provisions would reduce current income taxes on the underwriting income by $340.
Indiana Service Contract Act Requirements
There are numerous requirements of the Service Contract Act upon service contract providers. For example, there are uniform disclosures that are required of all service contracts that are sold in the state. In order to protect the purchaser of a service contract, the act requires that certain financial conditions are also met by the service contract provider. In particular, in order to sell a service contract in the state, the contract must meet one of two requirements: The service contract must either be backed by a regulated insurance company that is authorized to do business within the state of Indiana, or the service contract provider must maintain cash reserves equal to 40% of the retail purchase price of the contract, minus claims paid for all service contracts that are in force. These requirements are substantially less than the requirements for a regulated insurance company, but close attention must be paid to ensure that a service contract company meets the requirements of the act.
The Indiana Service Contract Act provides dealers with certainty regarding the regulatory requirements related to the sale of service contracts in the state. In addition, the Service Contract Act may provide dealers with the best of both worlds – a product that is not insurance under Indiana law but is considered insurance for federal income tax purposes, and one that, if properly structured, may provide a dealer with a significant income tax saving opportunity.
1 Indiana Code Sections 27-1-43.2 et seq. also known as the Service Contract Act.
2 See PLR 201773021.
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