By Don Ray, Portfolio
When buying one or more car dealerships, there are numerous areas the buying dealer must consider. F&I is a very important area of consideration. All auto dealers selling F&I products should make sure that they participate in the underwriting profit of each product he or she sells. Underwriting profit is defined as the difference between the premiums earned, minus claims and administrative costs. Someone is earning this underwriting profit and it should always be the dealer.
Without a doubt, the dealer should always participate in this underwriting profit. The question is not whether to participate, but how. Well that depends…on the specific dealer structure including size, ownership structure, managers, family and more. For most dealerships, the preferred structure is the use of an Affiliated Reinsurance Company (ARC). A properly structured ARC gets preferential treatment under IRC 831(b) of the US tax code. This treatment allows the ARC to NEVER pay corporate income tax on its underwriting profits. It only pays corporate income tax on its investment income.
And dividends are “qualified dividends,” making them subject to the same federal income tax rate as long term capital gains. There are limited times when the use of a retrospective (deferred) commission structure known as a Retro could be used, as well as times when a true offshore company (NCFC) makes sense as well. Even in times that a Retro (always taxed as ordinary income to the recipient) or NCFC (complex tax rules govern, but non-liquidating dividends are NOT “qualified”) is used, they should generally be used in conjunction with an ARC structure to ensure maximum dealer profitability.
For example, in January 2017, Moe and Larry buy a group of 25 auto dealerships with Curly LP (a private equity firm adverse to offshore ownership). Five years of production would generate approximately $50m of earnings. Their structure could look like this:
Using a hybrid structure will also necessitate a strategy to determine what products will be placed in what structure. Will they be ceded pro rata? Or not. If not, what criteria should be evaluated to determine the ceding strategy? These considerations require thoughtful input from skilled and trusted advisors, including your broker in the buy/sell.
This is simply an example of a how various structures can be used in combination to maximize the after tax earnings of a complicated ownership group. In all structures and especially complex ones, both the tax consequences AND the administrative policies of the provider are very important to maximizing after tax profits and cash flow. When evaluating administration policies of the product provider, irrespective of the use of an ARC, NCFC or Retro, dealers should consider:
- Does the dealer get 100% of the underwriting profits?
- Does the dealer have control over who manages the cash investments?
- Who determines what financial institution holds the cash?
- Properly structured, is the dealer allowed to borrow against UNEARNED reserves in addition to earned reserves?
- Is there a “tie-back” to the selling dealership for the performance of covered repairs? In other words, is the dealer able to “recycle” his/her own money when paying claims from his/her reinsurance company?
- How often are dealership remittances ceded (deposited) into reinsurance company bank account?
- Is the reinsurance of ALL F&I products allowed?
- Is there an additional fee charged for each consumer claim?
- Is there any type of termination penalty for any reason to the dealer including the freezing of funds?
Having the skills, policies and the passion to manage complex structures like this differentiates providers. When buying a dealership or just considering your opportunities, make sure to do your homework. Not all provider policies are the same.
Don E. Ray works at Portfolio…THE Reinsurance Company for Auto Dealers. He can be reached at 917-359-5128 or dray.portfolioco@gmail.com
