Service-warranty companies - the hybrid of the insurance industry: companies that sell extended warranty service contracts can take advantage of a tax accounting method available to insurance companies, or use other methods, to account for premiums. This article analyzes the various tax accounting options available to a service-warranty company.

• Author: Bertolini, Michelle

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. 2004-34 (9) or (4) classifying the contract as an insurance product for Federal tax purposes and amortizing the income according to Sees. 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 frontloaded; 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 on p. 404. 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.

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...