Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

administered by the fronting company and/or the automobile dealer. The fronting company
retains a fee for its services.
For each extended service contract sold by the automobile dealer, the dealer remits to the fronting
company a "premium" from which the fronting company derives the fees for its services. The
balance is remitted to the related reinsurance company. The fronting company administers the
extended service contracts and charges the reinsurance company for the cost of all approved
repairs. The reinsurance company’s tax return is filed under the insurance company provisions of
the Internal Revenue Code.
When an automobile dealer is the party obligated to pay for repairs under an extended service
contract, the risk of loss rests on the automobile dealer. If the dealer purchases insurance
coverage from the fronting company who then reinsures most, if not all, of the risk with the
related reinsurance company, the risk of loss then rests with the reinsurance company. However,
the risk remains the burden of the person who owns or controls both the automobile dealer and
the reinsurance company.
There is no economic shifting or distributing of risks of loss with respect to the risks carried or
retained by the reinsurance company. The economic consequence of the reinsurance arrangement
is that those who bear the ultimate burden of loss are the same persons who suffer the losses.
The Service and the courts have long held that amounts set aside by a taxpayer as a reserve for
self-insurance, though equal to commercial insurance premiums, are not deductible for Federal
income tax purposes as "ordinary and necessary expenses paid or incurred during the taxable
year." See Rev. Rul. 60-275, Rev. Rul. 57-485, 1957-2 C.B. 117, and Pan American Hide Co. v.
Commissioner, 1 B.T.A. 1249 (1925). Even where a self-insurance fund is administered by an
independent agent, such fact does not make payments to such fund deductible. See Spring
Canyon Coal Company v. Commissioner, 43 F. 2d 78 (10th Cir. 1930), cert. denied, 284 U.S.
654 (1930).
Rev. Rul. 77-316, 1977-2 C.B. 53 held that insurance arrangements between related corporations
are not true insurance but "self-insurance." While there were a number of corporations that
participated in the arrangement with one captive insurance company, there was no risk shifting
since the corporations were one economic family.
Similarly, where the captive insurance company was under-capitalized and the losses were
indemnified by the captive’s parent, there was no risk shifting and the insurance premiums were
disallowed. See Malone & Hyde, Inc., et al. v. Commissioner, 76 AFTR2d 95-5250, (6th Cir.
1995).
In situations where the owner of the dealership also owns the reinsurance company and personally
uses the funds of the reinsurance company, the income of the reinsurance company is taxed to the
owner. See William T. Wright et al. v. Commissioner, T.C. Memo. 1993-328.
13-3