By Dave DeCredico, Senior Vice President, Business Performance, APCO Holdings/ EasyCare
Historically, dealer participation programs (DPPs), or “reinsurance” programs as they are generically referred to, executed with appropriate substance, sustain favorable tax treatment both at a company and a shareholder level. With the 2020 tax filing season underway, now is the perfect time to think about and plan for looming tax policy changes that may impact your current reinsurance structure in the coming years.
Regardless of whether you are currently participating in a CFC, NCFC, DOWC, or even a Retro program, it’s vitally important at this time to talk proactively with your reinsurance advisor about your current situation, what opportunities can be realized now, and how such changes may impact the future of your strategy.
Anticipated Tax Policy Change
During the election, President Biden identified several tax policy changes that were aimed at what he referred to as “closing the wealth gap.” While many of these proposals target an unwind of Trump-era tax cuts, the proposals may go a step further with regard to potential increases in preferential dividends tax rates and long-term capital gains tax rates. Specifically, if the Biden administration’s proposed tax plan passes both Houses of Congress, a possible result is that we will see higher effective tax rates on dividends and long-term capital gains, marginal ordinary income tax rate increases for top-earning individuals, and an increase in the corporate tax rate. In some way, shape, or form, dealer participation strategies are going to feel some of the pain associated with these increases.
Traditionally, tax law changes do not get through Congress easily as it regularly involves significant compromise measures; however, it is reasonable to wonder if the Democratic majority in both Houses will provide any sort of speed bump on the way to policy change. Fortunately, new tax law is generally introduced on a prospective basis, meaning that any changes that are legislated in 2021 won’t likely take effect until 2022. This gives reinsurance program participants time to consider tax planning strategies with regard to their reinsurance programs. As you put together your plan, here are some things to consider.
1) Should you take distributions from surplus amounts in 2021?
Realistically, we have to wait to see what the final policy changes look like before answering this question. However, on the surface, the base consideration is that if distributions from your reinsurance program may be taxed at a higher rate in 2022, then you would most likely benefit from taking a distribution from your program’s surplus before the close of 2021. Paying a 20% tax rate is better than 39.6%, right? But that may not be your only consideration. What may seem obvious isn’t always the best strategy for every dealer.
I’m frequently asked by dealers whether or not they should take distributions from their reinsurance positions My answer is always the same: “Your first consideration is whether you want or need the money.” Considering the tax ramifications of distribution, does immediate access to available amounts in your program allow for you to realize a personal dream or take advantage of a business opportunity that potentially outweighs the taxes?
Now layer on whether you were already planning to take a distribution sometime in 2022. If so, then it would most definitely seem like it would make sense to take it a few months early during what appears to be a tax-advantaged period. If the reason for distribution is not a clear case of want or need, I believe the next determination is strictly an investment decision. In weighing this decision, you should consider current vs future rates of taxes, expected investment returns if you leave the money in place vs. expected after-tax investment returns if you take a distribution, any restrictions that may occur that may limit your access to money in the future, and finally how the money will be taxed in the reinsurance structure going forward. When weighing all of these things together, you can make a sound decision.
2) Are you in the right structure going forward?
Until new legislation is ultimately passed, we won’t know for certain how tax laws will affect your reinsurance structure in 2022 and beyond. As mentioned above, while there is potential that new tax legislation will result in higher tax rates for dividends and capital gains on distributions to shareholders, it is also likely that new legislation has a direct impact on the taxation of the reinsurance structure itself. For instance, President Biden has discussed an increase in corporate income tax rates. At present, the corporate tax rate is a flat 21% rate. Under Biden’s proposals, corporate tax rates would rise to 28% or higher. An increase in these rates could have an impact on CFCs, which pay corporate income tax on investment income, and Dealer Owned Warranty Companies, whose favorable taxation as an insurance company defers corporate taxable income to later periods.
Keep in mind, the impact of tax law is only one of many factors that come into play when deciding which reinsurance structure is right for you. Other factors to consider are personal and business goals and objectives. Are you growing? Do you have plans to buy or sell dealerships? Where do you want your business to be in two, five, or ten years? While alone, tax changes may not be enough to spur you on to change the reinsurance structure that you are currently participating in, they should now at least be an important part of the discussion in evaluating or re-evaluating what reinsurance structure works best for you, based on your goals and objectives. I believe that a discussion regarding changing goals and objectives should be part of every substantive reinsurance discussion that you have.
3) How does the looming tax policy change instruct our approach to reinsurance moving forward?
I have long been an advocate that reinsurance strategy and F&I development strategies ought to be completely in lockstep. After all, the F&I development process is the fuel that ultimately powers your reinsurance profitability. In times like these, where most dealers will be looking at the availability of funds in their reinsurance programs, an important question that should be asked in hindsight, and addressed moving forward is “What could have been done to create a large pool of distributable surplus?” This is where your F&I development strategy fits in. As part of developing a symbiotic relationship between reinsurance and F&I, consider the following:
- Are you selling and reinsuring the right mix of products?
- Are you selling and reinsuring the right mix of terms and deductibles?
- Have you considered the impact of limited warranties on front gross and as an earnings tool in reinsurance?
- Do you have the ability to segregate products with longer terms into separate pools so as to not adversely slow the earnout of products with shorter terms?
These are just a few of the questions that you should be addressing at this time. While ultimately, you may not want to change the timeline you have set for distributing money out of your reinsurance program, doesn’t it make sense to figure out a strategy that helps you generate as much free surplus in your structure as quickly as possible? Even in a situation where you choose not to distribute funds, generally speaking, earning surplus faster may have the positive benefit of generating better investment yields as a result of employing a more aggressive investment strategy.
In conclusion, new tax legislation will almost certainly be passed this year that will potentially affect reinsurance profitability at a corporate and at a shareholder level in 2022 and beyond. You still have time to consider how changes will impact your position and to evaluate if you are best situated to achieve your goals and objectives going forward. Don’t wait until the last minute. Now is the time to talk to your reinsurance provider and CPA to discuss strategies to help you maximize your success going forward.
About the Author
Dave joined APCO as its Vice President for Reinsurance Programs in 2004 after a successful career in Public Accounting. In his current role he oversees program development for EasyCare’s Dealer Reinsurance programs, as well as business development activities for APCO, including relationships with OEM and other private labels. Dave is a licensed Certified Public Accountant (CPA).