The Risks & Benefits of Mazimizing Profits in the F&I Department Using PORCs

Dealers selling service contracts and other financial products to customers can use Producer Owned Reinsurance Companies, or simply, “PORCs,” to tap additional profits from the F&I Department. The potential profits from using a PORC stem from the Dealer’s participation in insurance and investment income earned by the PORC. In addition, a PORC can potentially confer tax advantages to the owner, who should also be aware that these advantages are drawing heightened IRS interest.

IRS has a bias against PORCs, because they have the potential to be construed as abusive tax shelters. IRS put PORCs on its radar when it issued Notice #2002-70, and despite some of the cautionary language that follows, it is important to note that this IRS Notice does not have any judicial or legal authority. PORC is an unfortunate acronym, but it does help to remind everyone of the old saw that “pigs make money, but hogs will get slaughtered.” Whether you currently own one, or are contemplating setting one up, it’s important to know the difference between your farm animals. In other words, a lack of knowledge on how your PORC operates can put your tax haven in the tax penalty box.

IRS has charted a course that will likely include investigative efforts to learn of noncompliant PORCs. The difficulty with any discussion about PORCS is that they are structured in a myriad of ways, challenging even a basic understanding of the risks and benefits. The most common setup includes a cast of four parties to many reinsurance arrangements:

• The Dealer Owner (“Dealer O”)
• The Dealership (“Dealership A”)
• The Insurance Company (“InsurCo”) that is independent and unrelated
• The Producer Owned Reinsurance Company (“PORC”)

A simple example of how a PORC might operate is as follows:

Dealership A sells a vehicle service contract to a customer and remits the insurance premium to InsurCo (also known as a “direct writer” licensed to sell insurance). In the normal course of things, Dealership A retains a portion of the premium as commission income. Next, Dealer O sets up and owns a PORC, a separate legal entity created to reinsure the policies written by InsurCo, which pays claims from amounts it receives from Dealership A. InsurCo also remits a portion of the premium to the PORC, which will reinsure the risk assumed by InsurCo (reinsurance is simply something insurance companies do to spread the risk around). Any reinsurance premiums held by the PORC can earn investment income. Generally, the accumulated funds held inside the PORC, comprised of both underwriting profits and investment income, are allowed to grow with little or no income tax. Dividends of the PORC are later taxed to Dealer O at favorable tax rates.

PORCs are commonly created offshore because the regulatory environment for selling insurance products is less onerous. For example, the Turks and Caicos Islands are home to many PORCs, offering easy entry and requiring minimal capitalization. If the PORC is structured properly, it may qualify as a tax-exempt, non-life insurance company, provided that premiums written are less than $350,000 per year (Note: If premiums range between $350,000 and $1,200,000 per year, tax is levied on investment income of the PORC).

The radar blips at IRS blink brighter and faster if any of the following occurs:

1. Diversion of commission income earned by Dealer A to the PORC.
   This is also referred to as an “over-remit” condition. For example: Dealership A is living dangerously if it instructs InsurCo to reduce its normal $500 commission to $250 with the proviso that the other $250 be remitted to the PORC, owned separately by Dealer O. Why would Dealership A do this? Dealership A effectively moved $250 out of taxable income at the corporate level. Even in the unlikely event that Dealership A is directing this kind of diversion (imagine the reaction of the F&I Manager), it’s a safe bet IRS will nonetheless scrutinize the possibility. To avoid giving IRS ammunition here, premiums between Dealership A and InsurCo need to be established at reasonable, fair-market levels.
   
   
2. Is the PORC an insurance company?
   IRS will likely call into question the validity of the PORC as an insurance company if investment income is out of proportion to income earned from insurance premiums, a condition that will torpedo all related tax benefits. As a general rule, at least 50% of the PORC’s business activity should be comprised of writing insurance instead of an entity that disproportionately reports investment income. If you’re currently participating in a PORC, you should verify, at a minimum, that investment income of the PORC does not exceed income from insurance premiums.
3. Tax shelter or legitimate business activity?
   IRS may challenge the economic substance of the PORC, causing Dealership A to recognize more of the insurance amount collected from the customer. However, it can be argued that Dealer O has legitimate reasons for owning a PORC because Dealer O has a vested interest in the quality of the service contracts it sells. Dealers are all too familiar with independent insurers that went bankrupt (e.g. National Warranty, etc.), leaving the Dealer to pick up the cost of repairs –not from a legal obligation but out of concern for its reputation and CSI scores. It is in the Dealer’s best interest to take a proactive stance and reinsure against this risk.

   
   

   
   

   Also, if there are favorable loss ratios with claims, the PORC can realize underwriting profits formerly realized exclusively by InsurCo. In a competitive environment, Dealers will seek out alternative options that offer additional profits.

4. Watch out for loans between the PORC and the shareholder..
   Cash transfers, particularly loans, between the PORC and Dealer O are subject to additional scrutiny by IRS. In a precedent-setting case, IRS prevailed against former Dealer, William T. Wright, wherein the reinsurance company arrangement was ruled a sham transaction. IRS won because funds held by the reinsurance company were used by Mr. Wright indiscriminately and for personal purposes. IRS won and the income of the reinsurance company was taxed to the shareholder at ordinary rates. Because shareholder loans are such a magnet for IRS interest, Dealers have been advised by some to avoid such loans altogether.

If shareholder loans exist, extra care should be taken to ensure that:

• the loan is properly documented
• the loan is interest-bearing at adequate rates
• the loan is being repaid according to the terms of the note, and
• the loan amount should not adversely affect the capitalization of the PORC

To improve the chances your current or planned PORC is deemed compliant by IRS, all participants in PORCS should be knowledgeable on how it operates and ask questions of the promoter to learn of any conditions noted above that can jeopardize the reinsurance arrangement. If IRS finds that the PORC is operating outside of what is acceptable, taxes, interest, and penalties await the unsuspecting. Despite the current visibility of PORCS at IRS, they can be an effective way to maximize your return from the sale of F&I products when the rules are followed.