Nobody likes paying taxes. Forming a reinsurance company can help reduce your liability, among many other benefits. Two of the most tax-advantaged structures are controlled foreign corporations (better known as CFCs) and dealer-owned warranty companies (a.k.a. DWCs or DOWCs). To properly plan for the future, you need to look at both. Let’s compare and hopefully provide some clarity in your search for the best fit.
1. Assess Your F&I Production
If you are writing less than $2.3 million in annual net premium, the CFC structure allows you to cede all the F&I products your dealership sells. Should you exceed that threshold, you would form additional CFCs with slightly differing ownership; as countless dealers have discovered, reinsurance companies can be critical to succession planning and talent retention.
A DWC has no such limitations since it does not ask for special insurance company tax benefits in the first few years of its operation. If your annual net premiums exceed $2.3 million and you have no family members or business partners to share ownership with, you need to look closely at the DWC structure.
2. Determine Your Upfront Costs
Most providers charge around $5,000 to $6,000 to form a CFC. With proper underwriting and claims management, the contract reserves can handle the policy risk, so there are no precapitalization requirements.
DWCs do require upfront capitalization — as much as $50,000, depending on the provider. This is an investment in your own company, but it’s a lot to spend before you’ve even written your first contract.
3. Consider Your Tax Status
One heavily promoted advantage of DWCs is their IRS classification. The federal government considers them U.S. corporations filing taxes as an insurance company. Unfortunately, at the state level, they are regular domestically domiciled corporations, taxed on ordinary income.
CFCs are foreign domiciled corporations. They are treated as U.S. taxpayers under IRS Section 953(d) and pay taxes only on investment income. They are not domiciled in any state. And contrary to what you may have been told, your reserves are held in U.S. banks or brokerage accounts, not offshore.
4. Ensure Future Access to Capital
Whatever the structure, you need loan flexibility. Ask if you can borrow from unearned premiums in addition to the surplus and whether any conditions apply.
5. Keep the Profits
The DWC structure may allow you to defer taxes for as long as five or six years. Your claims reserve amount is determined by the amount your customers pay — without deducting dealership profit or provider fees — making retail cost the starting point for calculating earned premium. These expenses easily outweigh the early earnings so no profit is generated and no tax liability incurred.
Eventually, the tax bill is going to come. You would have to start paying corporate taxes or, more likely, cease writing new business into your DWC, take an 831(b) election to be taxed only on investment income, then run the company off.
That minimizes your IRS bill. But it’s not recognized as an insurance company locally, so the concern over state tax issues remains. You would still need someplace else to put your business. The CFC structure takes the 831(b) election in its first year and is only ever taxed on investment income.
6. Get Expert Advice
Don’t leave your CPA, attorney and wealth managers out of the selection process. They are responsible for your financial well being. And if they are members of the American Institute of CPAs or the National Association of Dealer Counsel, they may know more about reinsurance than you realize.
If any reinsurance provider refuses to meet with your advisors, the structure you choose could be the least of your worries.