The Advantageous Tax Structure of an ARC

A Less Taxing Conversation

Hello everyone! Robby from The Dealer Reinsurance Specialist podcast here. Today’s episode will explain how an Affiliated Reinsurance Company (ARC) is taxed. What’s the saying? Nothing is certain except death and taxes. Both are true, but dealer reinsurance and its advantageous tax structure turns one of them into a less taxing conversation…and I mean that literally.  

When the tax reform act of 1986 passed, it read into tax code 501, governed under 501(c)(15), that small property and casualty insurance companies were exempt from paying income taxes on underwriting profit if they collected under 1.2 million per year in premiums - This threshold has since been adjusted to 2.3 million per year. 

This means that an insurance company, meeting the premium limitations of 2.3 million is subject to an alternative tax, based only on taxable investment income.  

On top of that, the investment income is taxed at a lower C Corp rate of 21%. This is due to insurance companies being classified as C Corps because they need to be able to retain earnings in order to pay future claims.

What does this mean to the dealer?  

An ARC, a qualified insurance company, that writes less than 2.3 million per year in premiums can chooseto pay taxes on the lesseramount between the underwriting and investment income. Since the investment income is substantially less, that amount is chosen and taxed at 21%. 501(c)(15) makes this choice possible. Tired of chanting death and taxes? Establish an ARC and the new mantra becomes choice and taxes.  

Make sense? Let’s review how this works for a single reinsurance service contract. 

Remember how an ARC earns a profit? Premiums minus claims equal underwriting profit…plus investment income. Let’s use the same figures from Episode 1: Turn a Dealership Expense into a Personal Asset for our example. If you haven’t listened to the first episode yet, do so as it could prove helpful here. Regardless, $800 in premiums minus $300 in claims equals a $500underwriting profit. 

But that’s not it because the ARC also earns investment income on the premiums. So, the $800 deposited into the ARC at a 4% return over 3 to 5 years would earn approximately $120 of investment income on this one contract. 

So, thanks to 501(c)(15), the ARC is allowed to choosewhether to be taxed on the $500 underwriting income OR the $120 investment income. That’s an easy choice, right? 

Okay, so let’s do the tax math on this single contract. $120 (investment income) x 21% (C Corp tax rate) = $25 Tax (per contract) 

Therefore, this single contract will earn $500 in underwriting income plus $120 in investment income for a total profit of $620. $25 (taxes) divided by $620 (total profit) makes the effective tax rate 4.03% per contract. Make sense? Excited yet? 

If the effective tax rate of a single contract doesn’t blow your mind, let’s examine the bigger picture – Taxation in regards to dealership (business) earnings versus ARC earnings. 

Let’s use $100,000 for this example. If a dealership earns $100,000 in the store, all of the $100,000 is taxable income. The normal tax rate is 38.6% max Federal plus 0-13% depending on the state. In California, where I currently reside, the state tax is 13%, which means the total tax rate is 51.6%. Ouch! That’s $51,600 in taxes. $100,000 x 51.6% = $51,600. 

That same $100,000 earned in an ARC would result in $90,000 of underwriting profit (not taxed) and $10,000 of investment income. What’s great about 501(c)(15)? It allows the ARC to chooseto be taxed on the $10,000 instead of the $90,000, which would result in $2,100 in taxes. $10,000 (investment income) x 21% (C-Corp rate) = $2,100 in taxes. 

There’s a $49,500 tax difference between earning $100,000 in a dealership versus earning $100,000 in an ARC. That’s what I meant previously by an advantageous tax structure. 

Now, your situation may be different, so the dealership total tax rate could be lower, but earning income within an ARC at 21% is still beneficial to earning income outside of the ARC at the 38.6% max federal rate.  

Basically, an ARC realizes two amazing tax benefits. 1) It’s taxed on investment income, not premium income and 2) it’s taxed at the C Corp rate of 21%, not Federal and state rates. Within the ARC, the Federal effective tax rate will be less than 5% and with NO state tax. There’s also a third amazing tax benefit, but it transpires when a dealer elects to take a dividend as they are taxed as long-term capital gains at 20% personal.  

Does all this makes sense? If not, reach out with your questions. I’d love to know if anyone finds this reinsurance taxation topic as exciting as I do. Kind of geeky, I suppose, but one of my favorite parts of the quarterly cession meetings is scrolling down the inception to date profit & loss statement and comparing the taxes paid versus the total income. It’s always pennies on the dollar because that 5% max federal effective tax rate equates to less than $50,000 in taxes on $1,000,000 in profit. That never gets old.   

Let’s recap:

• The tax reform act of 1986, governed under 501(c)(15), means that insurance companies collecting less than 2.3 million in premiums are exempt from paying income taxes on underwriting profit.   
• Writing less than 2.3 million allows the insurance company to choose the lesser amount between underwriting and investment income. 
• An ARC qualifies as an insurance company and benefits from these tax savings.
• Investment income is taxed at the C Corp rate of 21%, not normal (higher) tax rates.
• The resulting Federal effective tax rate will be less than 5%. 

Well, that’s it for today’s episode of The Dealer Reinsurance Specialist. Thanks for listening and please join us again next week for a brand-new topic. Please make sure to direct any questions or share any feedback to our website. We’d love to hear from you. Thank you…and enjoy the day!

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