We are just a few days away from the presidential election – as well as several state, county, and city races. As a dealer principal, you are likely watching the races for their impact on your strategic planning to ensure your financial positions are secure. While we do not have a crystal ball as to the outcome of the election, we do have some data points to assist with your strategic planning.
We all know that historically a typical Democratic policy reflects higher taxes on businesses, and a typical Republican policy touts lower taxes. While it is ineffective to apply this thinking across the board, the historical perspective can be useful in planning scenarios. Perhaps more importantly, there are some specific tax policies which could be in play depending on changes in congressional power.
Democratic Control and Taxes
If the Democratic candidate wins the presidential election and Democrats take a stronger position in Congress, there is a probability that corporate taxes will increase. More specifically, congressional Democrats may seek to remove the Bush-era qualified dividend tax break, affecting Controlled Foreign Corporation (CFC) and Non-Controlled Foreign Corporation (NCFC) reinsurance positions. To understand the implications of this, let’s consider the dividend breakdown. In terms of tax policy, there are two types of dividends: unqualified and qualified.
Unqualified dividends pay out at the standard income tax rate of between 30 and 35 percent of your total income. For example, when you liquify employee stock options, that money is now counted as income and taxed as income.
Qualified dividends pay a different tax structure, the same rate as long-term capital gains. For example, after one year of investing in a particular stock, you may liquify part or all of your investment. Holding the stock for more than one year qualifies you for the qualified dividend tax break, paying a tax rate of around 20 percent.
The general Democratic approach on tax policy is that all income should be taxed at the same rate, removing the unqualified dividend tax break.
So how does this affect your reinsurance? It all depends on whether you have a Controlled Foreign Corporation (CFC), Non-Controlled Foreign Corporation (NCFC) or Dealer-Owned Warranty Company (DOWC).
CFCs and NCFCs
Under CFC and NCFC reinsurance positions, if you withdraw money while still putting money into the position, you pay the standard tax rate. However, if you stop putting money into the position, you pay the qualified tax rate. For example, if you take money out of a position that has money flowing into it to invest in a new location to grow your business, you’ll pay a standard tax rate. However, if you’ve retired and separated your reinsurance position from your business (i.e. no money is flowing into your position), then you can take money out at the qualified tax rate. If the qualified tax rate is eliminated, you will pay the standard income tax rate regardless of when the money is taken out.
Dealer-Owned Warranty Companies (DOWCs)
Some dealers have adopted DOWC reinsurance positions, which seek to defer taxes rather than qualify for elimination under the qualified dividend designation. With this approach, itemized deductions or net operating losses (NOLs) are subtracted from the adjusted gross income. Then you pay the standard income tax rate on that reduced gross income number. For example, within your reinsurance position, the commission paid to the F&I manager for selling the F&I product that contributed to your reinsurance position is considered an NOL. Because they do not rely on the qualified dividend tax break, DOWCs are likely to have low volatility should there be a change in party leadership in Washington after the November election.
Republican Control and Taxes
If Republicans retain control of both the White House and the Senate, we should expect more of the same when it comes to dealership reinsurance positions. However, we should see more discussion around Social Security and Medicare. The funding for both these programs currently comes from taxes. The Republican stance on this issue is that the funding should be eliminated from taxes and found elsewhere, for example in the private sector. The road ahead to eliminate Social Security and Medicare taxes is even steeper than the road to eliminate the qualified dividend. Seeing movement on either the Republican or Democratic tax stances would require significant control of both the legislative and the executive branches of government.
In general, all reinsurance positions are invested using the following parameters:
- 85 percent fixed assets (non-risk assets such as Treasury bills) with a 1.5 – 2.5 percent return
- 15 percent equity which incurs a higher risk with higher return, currently ranging between nine and ten percent
With a potential change in administration party affiliation, your reinsurance investments can be affected the same as any other investment. If transitioning from a Republican to Democratic controlled government, historically interest rates increase. By contrast, a change from a Democratic to Republican controlled government, interest rates typically decrease.
However, the current economic crisis brought on by the pandemic has prompted the Federal Reserve to lower the interest rate to historically low levels. This factor should be incorporated into your strategic planning.
Regardless of the outcome of the election this November, it is important to fully explore your various tax and reinsurance scenarios to make the most of what could be a challenging year. We encourage dealer principals to always consult an experienced tax advisor to assess the volume of business and goals for the future to determine the optimal tax rate.