Independent Used Automobile Dealerships
The used car industry is composed of two major segments. The first segment is
made up of the new car dealers who accept trade-ins on the sale of new
automobiles and can also purchase used vehicles directly from customers, other car
dealers, or at wholesale auto auctions. The new car dealers then sell the used
vehicles either to retail customers, to used car dealers, directly to wholesalers
through auctions, or to other miscellaneous customers.
For more information on new car dealerships, see New Vehicle Dealership ATG,
Training Number 3147-120 (01-2005), Catalog Number 85870Y.
The second segment of the industry is made up of independent auto dealers. These
dealers are not affiliated with an automaker and, their principal business is the sale
of used vehicles. Since no trade franchise (that is, General Motors, Ford, etc.) is
necessary, the size of the used car dealership and the capital required to enter the
industry varies. However, every used car dealer must be licensed with the state in
which the dealership is physically located.
Most states have different laws that govern the ability of individuals or businesses to
sell used vehicles without a license. For example, one state permits an individual to
sell up to five vehicles per year without obtaining a license. Other states are more or
less restrictive. Independent auto dealers acquire vehicles from trade-ins on the
sale of used vehicles. Such dealers also purchase vehicles from individuals (private
purchase arrangements), other new and used vehicle dealers, and at wholesale or
retail auctions.
Impact of state regulation and state law
Every state regulates the operations of the independent dealer and requirements
vary from state to state. The specific requirements imposed on a dealer depend on
the particular state in which the dealer does business.
Common dealership activities regulated by states include:
- Transfers, assignments, and reassignments of titles
- Title transfer processes
- Collection and repossession rights and liabilities
- Consignment rules and procedures
- Payments of commissions for referring buyers
Additional information on state laws may be obtained from your state Motor Vehicle
One problem that the industry faces is competition from unlicensed dealers
(curbstoners) who buy, sell, and trade more used vehicles than a state allows
without a license. In almost every case, the curbstoner has no fixed place of
business and fails to adhere to most of the accepted industry practices or customs.
It is not known how much revenue the curbstoners generate, although industry
officials acknowledge that the amount is significant. Since curbstoners do business
illegally it is likely that their income from sales goes unreported.
State attempts to enforce licensing laws against curbstoners are hampered by a
lack of personnel and money. Furthermore, with no fixed place of business, a
curbstoner is often difficult to track. Signs of potential curbstoning include:
- Multiple auto listings in a paper with the same phone number
- Displays of multiple vehicles "for sale" in shopping centers or similar
parking lots all with the same phone number
The Federal Truth in Mileage Act requires odometer statements to be retained by
both the buying and selling dealers. Most states require that a licensed dealer
maintain certain records, which must be available for inspection by the appropriate
state licensing or regulatory agency. Information about the records a dealer is
required to maintain in a particular state can be obtained from the state agency
responsible for the regulation of independent dealers. (Normally this will be the state
Motor Vehicle Division or the state Department of Revenue.) Aside from these state
and federal requirements, other specific records that must be maintained will vary
from state to state.
The sophistication of the accounting and records system (including record retention)
will normally vary with the dealer's size and location. However, there are certain
common industry practices that provide documentation for a sales transaction.
These practices will vary from state to state, since each state has different record
retention requirements, but the basics will be the same. These industry practices
are discussed in the various sections on income recognition and inventory.
Currently, there is no overall computer accounting program specifically designed for
independent dealers, however, there are many programs that are used by dealers.
Car Jacket
The key record of a car sale is the car jacket, customer file, or deal jacket. A
separate file is normally maintained for each sale. Many dealers create a deal jacket
whenever a vehicle is purchased and assign a stock number to the vehicle. In that
case, the deal jacket may also be used to track the cost of the vehicle and the cost
of reconditioning the vehicle for sale. The file generally contains:
Cash Sale (No Trade-in)
1. Sales, Retail Buyer‘s order (including the VIN),
2. Buyer’s name, address and other information,
3. Sales Price,
4. Sales tax (depending on the state, sales tax may be on the gross sales
price or net sales price),
5. Documentary and Filing (Doc) fees,
6. State and Federal Disclosure statements, including Odometer readings,
7. Vehicle stock number,
8. Extended warranty or service contract information and information on any
insurance purchased,
9. Form 8300, if applicable.
Sales with Trade-ins
1. Same items as for a cash sale, and
2. Payoff on any outstanding loans, if applicable,
3. ACV of trade-in.
The customer file may be a separate manila folder, an envelope with the information
in it, or simply papers stapled together. All are acceptable methods of record
retention. A dealer will normally also maintain cash receipts records that will show
the cash received by the dealer on a daily basis. An analysis of the deposits will
indicate the sources of the dealer's revenues, which could include:
- Auto sales
- Collections on self-financed sales
- Commissions from service/warranty contracts sold
- Commissions from disability and life insurance contracts sold - ----
- Commissions from bank financing
- Customer paid service work
Aside from customer trade-ins, the most significant source of inventory for dealers is
an auction. Dealers use auctions both to buy and sell vehicles. Dealers use
wholesale auctions, where only dealers are permitted to buy or sell. Most dealer
transactions are handled by the wholesale auctions. Some states also permit retail
auctions, which are open to the general public, and may be used by the dealers as
Each auction company is run independently, maintains different records, and has its
own procedures. Some common rules and procedures used in the auction industry
�� Every dealer must register with the auction,
�� The dealer will provide the auction with the year, make, VIN, and
equipment of each vehicle offered for sale, either by phone or on site,
�� The auction will issue the selling dealer an auction check, thereby
assuming the risk of collection on the buyer's check,
�� The auction will handle the actual assignment of title to the buyer.
The seller may set the floor or lowest price that the vehicle may be sold for by the
Generally, each auction holds its general wholesale sale once a week. It is common
for dealers to attend more than one auction a week since each auction offers
different types of vehicles in varying price ranges for sale. Special manufacturer and
fleet auctions are held at various times throughout the year.
Dealers often attend several auctions a month, many of which are in another state.
By attending auctions outside of his or her area, a dealer is able to take advantage
of better market conditions for a specific type of vehicle. For example, a dealer in
Florida may want to purchase convertibles, which may have a high price in the
Florida market. However, a Wisconsin auction may offer convertibles for sale at
much lower prices due to the lack of demand there. The Florida dealer will travel to
Wisconsin, buy the convertibles, and profit from their sale to customers in Florida.
Thus a dealer from one part of the country can benefit from obtaining vehicles at an
auction in another part of the country.
While the overwhelming number of dealers may have a valid business reason for
attending out-of-state auctions, such practices are also a compliance concern. A
few dealers have been found attending out of state auctions to facilitate buying and
selling vehicles "off the books."
The starting point of an auction is the registration of the dealers participating in the
auction whether they are buying or selling. The auction generally requires that the
dealer be registered in advance. This usually involves obtaining a copy of the
dealer's license.
Once registered a dealer may participate in an auction. The selling dealer will
provide the auction with the appropriate information about the vehicles offered for
sale, as discussed previously. The vehicles will be assigned a number, which will be
displayed on the windshield, and offered for sale. Since the seller has the right to
set a floor price below which the vehicle may not be sold, not all vehicles offered for
sale at an auction are sold. However, on average roughly 50 percent of the vehicles
in a regular wholesale auction will be sold.
Once a buyer has successfully bid on a vehicle at auction, he or she is afforded an
opportunity to inspect the vehicle to be sure that all representations about the
vehicle made by the seller are correct. If there are no problems, the buyer then
proceeds to settlement, and gives the auction his or her check for the purchase
price. The auction fills in the title in the buyer's name and delivers the title to the
On the other side of the transaction, the seller will sign the title and deliver it to the
auction for completion. The seller will then receive an auction check, with the
restrictions noted below. Each party will also receive an invoice (Block Ticket) that
shows the vehicle sold, as well as the identities of the seller and buyer. The auction
invoice will also usually include an executed odometer statement.
The auction will not usually issue payment to a dealer without proof that a business
bank account exists. Additionally, the auction normally provides restrictive
endorsements on the check issued to the dealer to be certain that the proceeds are
deposited to that account. For example, an auction will not issue a check to an
individual, but will issue the check in the individual‘s business name. The check will
normally bear some restrictive endorsement on the back, such as, "For Deposit to
Account of Payee Only." Many auctions request a copy of a dealer's check to verify
with the bank that the dealer actually has an account there.
Since the auctions guarantee that vehicle titles are lien-free, the auctions handle all
title issues to ensure that the transfer is made correctly. Some common title
problems include incorrect VIN, unsatisfied liens, incorrect title assignments, and an
incomplete chain of title. The auctions have a great deal of experience with
interstate transactions and generally have a very good working relationship with the
various states Motor Vehicle Divisions.
Titling Issues and Processes
Titling procedures are determined by state law; thus there are 50 different sets of
rules that apply. The state Division of Motor Vehicles, or similar agency, regulates
the issuance and transfer of a vehicle‘s title and maintains a record of the owner.
This information is available, although its usefulness in tracking an unreported sale
or sales will depend on the database used by that particular state. In most states
dealer-to-dealer transfers of title are accomplished through dealer reassignments.
These reassignments are not usually recorded unless the state issued the original
title or is recording the title once the vehicle is ultimately sold to a retail customer.
All of these issues are compounded by the tremendous amount of interstate sales
that occur. Although the use of state title transfers does have drawbacks and cannot
be used to reconstruct or determine all of a dealer's sales, it remains a useful tool in
checking the accuracy of reported sales. Despite no uniformity in titling rules or
procedures, some very basic elements exist in all states:
�� Every vehicle must have a title,
�� There must be a written record of the sales transaction given to a
�� A title must contain certain specific information, although the
contents will vary from state to state,
�� A valid title must be produced in connection with a sale, but some
exceptions exist for old vehicles in some states,
�� Only dealers can reassign title, individuals cannot reassign titles.
Generally, title to vehicles purchased at an auction is reassigned directly from the
seller to the buyer, although some states require the auction to note on the
reassignment of title that the transaction is an auction sale. Some dealers may also
purchase vehicles purchased in Canada. Canadian titling laws are much different
from those in the United States, and advice on procedures should be sought from
an international examiner, who can put you in contact with the Revenue Service
Representative for Canada. Do the same with any dealer transactions in Mexico.
In most states, dealers need not take actual title to a vehicle, but can reassign the
title. This may be done on the title, or on a separate sheet attached to the title. The
significance of reassignment is that the dealer will not have to register the title with
the Motor Vehicle Division until the vehicle is sold "at retail" to a non-dealer
customer. This can make tracking the sale of a vehicle very difficult.
Example of titling
A dealer in Virginia takes a vehicle with a Maryland title in trade on a sale.
The dealer then sells the trade-in at a North Carolina auction, where the title
is reassigned to the North Carolina dealer who acquires the vehicle. That
dealer then sells the vehicle to a Florida dealer with a reassignment of title.
The Florida dealer then sells the vehicle to a New York dealer, again
reassigning the title. Finally, the New York dealer sells the vehicle to a
California dealer, by yet another title reassignment. The California dealer
then sells the vehicle to a California resident. The State of California will
issue the new title to the retail purchaser. California may notify Maryland, the
state with record of the original title, of the new title. Maryland would then
cancel the original title. The notice may show all of the reassignments.
However, no title record of the vehicle's sales will appear in any of the
intervening states. The Virginia, North Carolina, Florida and New York Motor
Vehicle Divisions will not record the vehicle being sold in their state.
However, each dealer should have a deal jacket for the transaction involving
the vehicle.
The initial interview is crucial in all examinations. When examining an independent used
vehicle dealer, as with all other examinations, the standard interview questions are
required. There are a number of specific industry-related questions that should also be
included as part of the interview process.
1. The examiner may want to ask the owner if he keeps a personal record or list of
his or her profits on each vehicle or deal.
2. What types of sales transactions did you have for the year under examination?
3. Any sales at auctions? If yes, which?
4. Any sales to wholesalers? If yes, which?
5. Any sales to other dealers? If yes, which?
6. Any consignment sales? If yes, volume?
7. Any scrap sales? If yes, describe.
8. Any in-house dealer financing sales?
9. Any third-party financing sales?
10. Did you have any other types of sales transactions?
11. Did you have any sales that resulted in a loss on the sale? If yes, describe the
nature of these sales.
12. Interest income on dealer-financed sales?
13. Commissions or referral fees on third-party financing?
�� What third party financiers did you use?
�� What was the fee/commission arrangement?
�� Commissions or referral fees on vehicle insurance placement?
�� Which insurance companies were used?
�� What was the fee/commission arrangement?
a. Commissions or referral fees on warranty/repair placement
b. What other commission/referral fee arrangements do you have
income from?
14. How Sales Are Recorded
�� When selling a vehicle, how do you report the sale?
�� Gross sales price per Sales Contract?
�� Net cash received upon sale after discount and/or trade-in?
�� Through the use of a sales contract made in the year under examination,
show me how you recorded the sale.
�� Are sales taxes reported in the gross sales price?
�� Are licensing fees or titling fees included in the sales price? (Note; if
answer is no, look for them as expense items, if so, make the appropriate
15. Do you sell warranty or service contracts?
a. How do you record the income from them on the books?
b. How do you record the expense items on the books?
c. Note: Be attentive to proper timing of Income/expenses.
16. Do you finance sales?
. How do you record the income from the financing on the books?
a. Note: Be attentive to proper timing of income.
17. Do you sell finance contracts?
. How does this transaction work?
a. Who do you sell finance contracts to?
b. Have the taxpayer walk you through a specific example.
c. Do you own or are you a shareholder of the finance company?
d. If the owner of the vehicle dealer is also an owner of the finance
company, see Related Finance Companies under Accounting Methods,
for additional information.
e. Do you have a dealer reserve account at any financial institution?
18. What other goods or services do you provide in your business? How are these
transactions reported on the books?
�� Vehicle repairs?
�� Portering/detailing services?
�� Vehicle mats, etc.?
19. Pricing Policies and Discounts
0. When setting an asking price for a vehicle, what information sources do
you consult, for example, Blue Book?
1. When valuing a trade-in vehicle, what method do you use, that is, resale
value to a customer, wholesale value to another dealer, or some other
method such as personal judgment. Please explain the method by giving
an example?
2. How do you arrive at the amount of discount you recognize on a sale?
3. Please provide an example.
20. When overvaluing a trade-in how do you record it on the books? How do your
record this paper loss?
21. When recording a sale of a trade-in on the books, how are the ACV and the
discount recorded on the books?
Inventory Items
1. When setting an inventory value for a vehicle, what information sources do you
consult, that is, Blue Book?
a. Do you ever change this value?
b. How is this change in value recorded on the books?
c. What factors are considered when changing the inventory value?
d. Do you always use one official valuation guide or do you consult more
than one? Please explain. (Methods of fixing values differ among
valuation guides. See Treas. Reg. section 1.446-1(a) (2)
e. For any vehicle that is valued below cost, how does the asking price at
any point in time differ from the value recorded on the books at year-end?
Please explain. (The propriety of a write-down may be determined by
actual sales price. See Treas. Reg. section 1.471-4(b)
2. If a vehicle is portered or repairs are made to it for resale, how do you record
these costs?
a. Current expense?
b. Added to the value of the vehicle?
3. When junking a vehicle for scrap, how do you account for it?
�� What value is used for vehicles in ending inventory?
�� Does this value differs from the one originally recorded at the time of
�� In determining the yearly LIFO index, what is the vehicle in ending
inventory compared to in the ending inventory of the preceding year (that
is, the taxpayer's own cost for the same type of vehicle or a
"reconstructed" cost from an official valuation guide for the same type of
vehicle at the beginning of the year)?
�� Explain how these vehicles are comparable.
1. Have you ever taken items other than vehicles in trade? Please explain.
a. How was this accounted for on the books?
2. Explain the titling regulations that you are responsible for as a licensed vehicle dealer.
3. Provide your log/record of titles for all vehicles sold for the year.
4. Do you acquire vehicles at auctions?
a. If yes, which auctions?
b. Which, if any, are out of state?
5. Do you acquire vehicles from wholesalers?
a. If yes and a few are used, which wholesalers are used?
b. If yes, and many are used, who are the primary wholesalers?
c. What out of town wholesalers do you use?
6. What other non trade-in sources of vehicles do you utilize?
a. What business names do they operate under?
b. Are any of these businesses out of state?
c. If yes, which ones are out of state?
7. How can I identify how a vehicle was acquired for resale?
8. How do you gauge the used vehicle market at any given time?
9. How does this affect your pricing and valuation practices?
10. If you use a vehicle for business, what records do you keep?
Accounting methods
Used car dealerships normally maintain an inventory, which is a material income
producing item. Material income producing items are required to be accounted for
under an accrual method of accounting. Nationwide, many used car dealerships
have been found to be using an improper accounting method, either the cash
method or the installment method.
�� IRC section 448 places limits on the use of the cash method of
�� IRC section 453(b) (2) (A) and (B) disallow the use of installment method
on any dealer disposition and disposition of personal property that would
have to be included in inventory if the property were on hand at the close
of the taxable year.
Smith v. Commissioner, T. C. Memo. 1983-472. The court ruled that where the
purchase and sale of automobiles was the principal income-producing factor in a
used car dealer‘s business, requiring the use of an inventory, the dealer was
required to use the accrual method of accounting.
Income reporting
There are certain issues in dealer income recognition that agents should consider
during an audit. These include:
�� Not recording a trade-in on a sale, then selling the trade-in for cash. One way
to avoid reporting all sales is by cash sales in which a trade-in is sold directly
to a third party. The dealer takes a car in as a trade from customer A.
Customer A signs the title, but the dealer does not put the car in inventory or
show it on the dealsheet as a trade-in. The dealer then sells the car to
customer B for cash and signs the title over to the customer. The dealer
keeps the cash and the title shows a direct sale from customer A to customer
B. There is no indication that the dealer was ever involved in the trade.
Indications that this may be occurring include unidentified cash deposits,
reconditioning costs incurred about the same time as the sale of the trade-in,
but not allocated to vehicles, substantial sales discounts, or sales contracts
that show a trade-in allowance with no corresponding stock number
assignment. However, substantial discounts are frequently given by dealers
to get rid of overage vehicles, where a cash (no financing) sale occurs or in
similar situations.
�� Reporting net sales based on financing obtained, omitting cash received.
Comparing the sales contracts with the financing files should disclose this
problem. Also, the state sales tax can be used to determine the sales price,
which should include any cash paid.
�� Not reporting the sale of all cars purchased. Comparing the purchase of
vehicles acquired by trade and at auctions to a subsequent sale of that
vehicle can provide information on accuracy of sales figures. Also, a review
of claimed travel expenses can lead to information about auctions attended
where possible purchases occurred or sales were made. However, dealers
may attend auctions where they make no purchases or sales.
�� Purchasing a group of cars, allocating the entire purchase price to only some
of the units; then selling one or more units off the books. A review of the
purchase documents may provide evidence of the number of cars
purchased. Furthermore, an analysis of the cost assigned to the inventoried
cars acquired in the package should be made for reasonableness. However,
it is common for the buyer to assign a different value to each car in the group
than the seller has assigned. The buyer is not privy to the seller's allocations,
and generally bases his or her allocation on the relative value of each vehicle
in the group.
�� Purchases from other dealers are generally similar to purchases from
auctions. However, there may be no written record of the transaction, and the
transfer of title probably will be by a reassignment of title to the purchasing
dealer. Frequently, the dealer may make a package purchase. This is a
purchase of several cars for a lump sum. The purchasing dealer should
record the cost of the cars based on the ACV of each car to the total
purchase price. The ACV of cars sold in a package can vary greatly since it
is common to put one or two cars that are difficult to sell in a package, with
the expectation that the purchaser will want the other cars in the package
enough to accept the entire package. As with cars purchased at auctions, the
cost of the car will be increased by any reconditioning costs incurred in
preparing the car for sale.
�� As mentioned above, dealers may purchase — “clunker“cars as part of a
package deal. The dealer may know this at the time of purchase, in which
case a low market value will be placed on the inventory value of the vehicle.
At other times, a dealer will not realize it bought a "clunker" until
reconditioning has begun. At this point in time, the dealer has two likely
- Sell the car from his or her lot, or
- Sell the car at an auction.
Either way, the likely result will be a loss on the sale of the vehicle and no
further transactions with the other dealer.
�� Other methods dealers may use to avoid reporting all income is to purchase
four cars from another dealer or at auction. The purchase document will
show four cars purchased. The dealer then books three cars into inventory
and sells the fourth car without reporting the sale on his or her books. If such
activities are suspected, check with the auction house as a third-party
�� The independent used car dealer may take almost anything as a trade-in.
Boats, trailers, snowmobiles, campers, etc. may be accepted as a trade-in.
These traded items may or may not end up on the lot for sale. The owner of
the dealership may be getting personal use of these items and sell them on
the side as personal property instead of inventory.
�� Vehicles taken in as trades may not be issued a separate stock number. It is
a common industry practice for the new trade-in to be assigned a stock
number that is based on the original stock number. For instance, a car with
stock number 122 is sold and a 1988 Plymouth is taken in as a trade; the
Plymouth will be assigned stock number 122A.
�� In some parts of the country, used car dealers have been found to be
members of bartering clubs. For example, in Wisconsin, a dealer may
receive "points" from a bartering club based on the value of a car, which can
be exchanged for services or goods such as mechanical or body work on
cars purchased for resale. Such activities are frequently not included as
�� Many dealers engaged in "Buy Here/Pay Here“operations might repossess
the same vehicle several times before it is ultimately sold. The dealer reports
the gain on the first repossession, but not on the subsequent repossessions.
�� Some state Departments of Transportation/Motor Vehicle require all car
dealers to maintain a record book of all used cars purchased and sold. The
details of this requirement are discussed in the section on inventory
valuation. Use of this log will not only help in determining inventory and cost
of goods sold, but also in verifying all items are included in gross receipts. In
some states, such as Virginia, the number of dealer plates issued by the
state is based on gross receipts. Some other states issue plates based on
the number of salesmen or units sold. Wisconsin and other states will allow a
dealer to have any number of dealer plates, as long as the dealer pays the
fees for them. If your state is one in which the number of plates a dealer has
is dependent on gross receipts, that number can give the examiner an idea
of the accuracy of the amount on the return.
Automobile Sales
Used vehicle sales, obviously, are the principal source of income of a dealer. The
sales of autos will generally be made to three broad groups. First, the bulk of the
income will be from the sale of a single vehicle to an individual buyer. The dealer
may also have income from direct sales to other dealers or wholesalers and from
the sale of vehicles at wholesale or retail auctions.
Generally, sales proceeds from an auction will be paid to the dealer by check
marked "deposit only" or "deposit only to the account of payee." Payments from
sales to other dealers can be in cash, by check or from the proceeds of loans made
by a third party. If more than $10,000 is received in cash, the dealer will be required
to file Form 8300, Report of Cash Payments over $10,000 Received in a Trade or
The ultimate determination of the sales price will depend on a number of factors.
The initial "sales price" (asking or list price) established by the dealer is rarely the
final sales price. The difference is a discount allowed to the buyer.
However, that discount will not be determined the same way for each buyer
because different needs and desires motivate each buyer. Thus, some buyers want
a large discount and accept the dealer's valuation of the trade-in; others want a
large trade-in allowance (which in effect reduces the discount the dealer is willing to
give) and still others only worry about the monthly payment. Since the dealer is
interested in the bottom line profit on the sale of the vehicle, the sales price on
substantially similar vehicles may differ greatly. For example, an individual who is
willing to accept the ACV for his or her trade-in may have a lower sales price (or
greater discount) than an individual who insists on a trade allowance greater than
the trade-in's ACV, as illustrated by the following.
Example of an automobile sale
A dealer wants a gross profit of $500 each on two identical vehicles each with a
cost basis of $3,000. The asking price of each vehicle is $3,900 before any
discounts. Customer #1 has negotiated final sales price of $3,500, with a $2,000
cash payment and a trade-in allowance of $1,500 which is the ACV of the vehicle
traded in. The sales contract may show the net price of $3,500 ($2,000 + $1,500) or
the gross price of $3,900, less a discount of $400. Customer #2 has a trade-in with
an ACV of $1,500, but refuses to accept anything less than $1,750 for his trade-in.
For the second customer, on the identical vehicle, the final net sales price will be
$3,750 ($2,000 + $1,750) to take into account the $250 over-allowance. In each of
these cases, the gross profit is $500; however, the sales price and trade allowances
are different. Furthermore, in each case, the cost of the trade-in for inventory
purposes will be $1,500. The proper accounting entry to record a sale with a tradein
is as follows using the gross sales price (using the example above):
Cash 2,000 2,000
Discount 400 150
Overallowance 250
Purchases or Inventory 1,500 1,500
Sales 3,900 3,900
Notice that the only difference between these two transactions is that for Customer
#1, the dealer combined the overallowance and discount into one account, rather
than maintain separate accounts for each type of discount.
Note that a dealer may also account for the sale as a net sale, in which case the
discount and overallowance would be netted against the sales price, and the net
figure recorded as the sales price.
Many dealers sell service or warranty contracts at or close to the time of the sale of
the vehicle. These service/warranty contracts are most often third-party obligor
contracts, with the dealer receiving a commission for the sale.
Some dealers have begun to establish separate related companies to sell these
contracts. There are several business reasons to establish a separate company to
sell the contracts. Liability can be isolated in a separate entity, ownership of the
separate entity can be spread among employees or family members, and any
problems associated with the sale of these contracts can be handled without
jeopardizing the vehicle sales business. There are no inherent prohibitions against
using a separate company for this business, and there are normally no additional
costs that are incurred above the normal costs of creating a new entity.
Most of a used car dealership's income is from the sale of cars. Not all car sales are
retail sales. Dealers may sell to other dealers, often in package deals. Dealers may
also sell vehicles at various auctions, both wholesale (dealers only) and retail
(public) auctions.
Not all dealerships have all of these secondary sources of income, but it is common
for a dealer to have one or more of them. Generally, secondary sources of income
are listed on the customer file.
Used car dealerships may also provide other income-producing services. These
services include body repair work and routine maintenance such as oil changes and
tune-ups. Leasing used cars on plans similar to those of new car dealership has
become another source of income for used car dealers in certain parts of the
Dealers may also buy vehicles that are later scrapped or junked. When this occurs,
it is common for parts from the junked car to be used to recondition other cars that
are eventually sold to customers. A dealer may also buy cars that are already scrap
cars (also called junked cars) for parts that are used to recondition cars for sale to
customers. The parts taken from a junked car may be used to recondition several
cars (for example, the carburetor used for one car, the alternator for another).
However, it would be unusual for the parts to be sold to third parties, since there is
no network for such parts. A proportionate cost of the parts used should be added
to the inventoried cost of the car sold. Once the usable parts have been removed,
the junked car is normally sold to a scrap or junkyard for a small fee. The income
received for the scrap or junk value of the car should be recorded on the dealer's
books, although the amount of such income is usually very small, normally under
$50 per car. Not many dealerships regularly purchase scrapped or junked cars due
to space limitations and the bad appearance that the cars make on the dealer‘s lot.
Dealers frequently attend auctions to purchase cars for inventory. Many auctions
give prizes with the purchase of certain cars, or hold drawings for prizes during the
auction. Frequently these prizes are of minimal value; however, large items such as
television sets and stereo equipment may occasionally be given away. Such prizes
are includible as income to the dealership. New car dealerships may also give
prizes to used car dealerships for purchasing certain types or quantities of cars
during a given period of time. These prizes are also gross income.
Fee Income
Auction fees are payments collected by a dealer for purchasing a particular vehicle
for a customer at auction. Some dealers will bring the customer to the auction,
although the dealer may have his or her buying card revoked by the auction if
caught doing this. Other dealers will take a description of the vehicle as an open
"buy order," then buy the particular type of vehicle when it goes through the auction.
Many states have licensing requirements that make it illegal for some of the dealers
to purchase a particular vehicle for a customer at auction. Dealerships caught in
such activities will not only lose auction privileges, but may also have their dealer
license revoked.
Typical auction fees are paid by the customer, not the auction, and range from $150
to $350, depending on the cost of the car, relationship with the customer, etc. The
dealer may be reluctant to admit this type of income as the activity is discouraged
by the auction.
The best way to check for auction fee income is to obtain a print out of the vehicles
purchased from auctions the dealer does business with and spot check the listings
for inclusion in income. Check unusual purchases. For instance, if a dealer primarily
sells domestic "sleds," a $20,000 Mercedes SL sports car purchased at auction
would be out of character. There may be various legitimate reasons for such a
purchase, such as a ready-made sale, or needing a leading car to put in a package
deal with less desirable cars currently in inventory. Bird Dog Fees are a form of
commission payment also known as finder or referral fees. These fees are
generated by:
1. Serving as a broker between two dealers/wholesalers, etc.
2. Finding a retail buyer for another dealer.
These fees are often paid in the form of a check written directly to the dealership or
in cash. Many dealerships will claim these fees as an expense, but very few
dealerships claims the income. One examination uncovered $32,000 in broker fees
for sales between dealers, none of which was reported as income.
Rebate Income
Dealerships may offer life insurance and disability insurance to buyers at the time of
sale. The insurance policies are generally purchased from unrelated insurance
companies, with the dealer receiving a commission from the sale of the insurance.
There is very little self-insuring through related insurance companies in the industry,
due to the complexity of meeting the definition of an insurance company, and
complying with the multitude of regulations set up by state insurance
Referral fees from an insurance agent or agency are typically paid to the individual
who made the referral rather than the dealership. The commission may be in cash,
bartered insurance coverage, trips, etc. Such income can be found by reviewing
either the deal files of the year under exam, or current deal files. Look for a
particular agent writing most of the coverage.
Credit life and disability insurance (CLI) is usually offered in conjunction with
financing and provides that if the insured event happens (that is, the buyer dies or
becomes disabled), the buyer's note will be paid off by the insurance company. The
commissions may range from 30 to 50 percent. If offered, CLI should be a large
source of income.
Although most states allow car dealerships to sell CLI and earn commission income
on each policy sold by the dealer, some states specifically prohibit car dealerships
and their employees from receiving any portion of the insurance premium
attributable to the retail sale of a motor vehicle.
Therefore, in states such as Michigan, it is a common practice for an automobile
dealer to establish a "dealer-related" insurance agency with a family member of the
owner as an officer or owner of the dealer-related agency. Michigan law is violated if
it can be shown that the dealer controls or manages the insurance company.
Auto dealerships in Michigan and states with similar laws may not deduct under IRC
section 162(a) the commissions paid to the Finance and Insurance manager for the
sale of CLI. These expenses do not relate to the dealership business, but rather to
the "dealer-related" insurance agency. Michigan law further prohibits the dealer
related insurance agency from reimbursing the dealership for the dealer's actual
costs incurred in connection with the sale of CLI.
If you are unsure of the laws regulating the sale of insurance by auto dealerships in
your state, contact the state Attorney General's Office, Department of Motor
Vehicles, Department of Commerce, Financial Institutions Bureau, Insurance
Bureau, or related state agencies for information.
Financing rebates may take several forms. There may be a reserve account set
aside by the finance company for recourse paper or aggregate loan performance.
As the loan portfolio ages, some of the reserve may be refunded to the dealer.
Some smaller finance sources may make kickbacks to the dealer for sending the
finance company business.
In Commissioner v. Hansen, 360 U.S. 446 (1959), the Supreme Court held that
when an accrual basis car dealer sells installment paper to a finance company, it
must report as income not only the amount of cash received from the finance
company but also the amount held in reserve by the finance company that records
the reserve as a liability to the dealer because the dealer has a fixed right to receive
the reserve even though not until a later year.
To find if income from finance rebates exists, look at the dealer agreement with the
finance company, loan proceeds and recorded income. The dealership should be
asked to provide account statements to determine the transactions in the reserve
account. A listing of contracts financed, the amount financed and the withheld
amount should also be reviewed. Review the title work or lien, checking for common
finances sources. If the dealer records deposit sources, you may be able to spot
check the deposit slips.
Some dealers sell a lot of "sleds," which often have had some body or paint work.
Also some dealers specialize in insurance rebuilds. It has been a common practice
for body shops to inflate the costs of repairs and rebate the difference to the owner
in cash.
Warranty Contracts
Used car dealers sell two basic types of extended service contracts. The first type,
which is known as third-party or Administrator-obligor contract, is between the
customer and an unrelated underwriter. The dealer is merely an agent for the
underwriter and keeps as profit the difference between the sales price of the
contract and the "cost" paid to the underwriter.
The second type is a contract between the customer and the dealer (known as a —
Dealer-obligor contract). In the case of a dealer-obligor contract the dealer may buy
insurance covering his or her risk or be "self-insured." If the dealer buys insurance,
the income and expenses should be reported according to Rev. Proc. 92-97, 1992-2
C.B. 510 and Rev. Proc. 92-98, 1992-2 C.B. 512. If the dealer is "self-insured," the
sales price of the contract should be reported as income in the year the contract is
sold and expenses deducted in accordance with provisions of IRC section 461(h).
Dealer-obligor warranties are more profitable. The warranty accounts need to be
carefully examined for proper reporting of income and expenses.
Some states allow dealers to sell vehicles on consignment. In these cases an
individual may contract with the dealer to sell the vehicle. The individual receives a
stated price upon the actual sale of the vehicle. The dealer receives either a flat fee
or any excess of the sales price over the stated floor price agreed to with the owner.
There are two different practices for recording the cost aspects of the consigned
In the first and preferred method, when the consignment agreement is entered into,
a stock number is assigned to the vehicle. Costs incurred in prepping and repairing
the consigned vehicle is posted to its assigned stock number. The stock numbers
assigned to consigned vehicles may have a different numbering system or some
other designation that quickly identifies the vehicle as a consigned vehicle. At the
time of sale, the consigned vehicle is then assigned another stock number to reflect
the stated price to be paid the owner, and the reconditioning costs are transferred to
the new stock number. Under the second method, a stock number is not assigned
until the sale of the consigned vehicle actually occurs. In either method, incidental
and reconditioning costs incurred by the dealer are deducted from the stated price
paid to the owner. Many dealers also treat consignment sales from other dealers
differently than consignment sales from the general public. Consignment sales from
the general public are more detailed in the dealer‘s books because of titling
Dealer Financing
Dealers commonly receive commissions on sales of financial products. Some
dealers make arrangements with finance companies to provide financing for their
customers. The finance company frequently pays the dealer a commission or
"finder's fee" based on the amount of the loan, or a set fee per loan.
Dealers may also have gross income from a rate spread on a loan. A dealer may
have made arrangements with a finance company to write loans at a set interest
rate, 8 percent, for example. When a car buyer purchases an auto from the
dealership, the dealership may write the loan for a higher interest rate, 10 percent,
for example. The excess interest generated by the higher rate would be paid to the
dealership by the finance company and would be includible income. The rate
spread in this example is 2 percent, the difference between the rate the finance
company charges the dealer and the rate the dealer charges the car buyer.
A dealer financing his or her own sales (Buy Here/Pay Here Lot) generally collects
on the buyers note in one of two ways. First, he or she will get monthly or weekly
payments over the term of the note. The portion of the monthly or weekly payment
reflecting interest is income to the dealer. The principal portion of the payment will
reduce the receivable since the sales income has already been recognized at the
time of sale.
Alternatively a dealer may sell a note or a number of notes (bulk sale) to a third
party at a discounted amount. The discounts are often significant, usually exceeding
20 percent of the principal, and in some cases approaching 50 percent. The dealer
may continue to have secondary liability for the note (a recourse note).
The discount is deducted at the time that the note is sold since the dealer is not
entitled to any more collections on the note, and the usual accounting entry on a
$5,000 note sold for 20 percent discount is:
Cash 4,000
Discount on Note 1,000
Notes Receivable 5,000
A detailed discussion of the sales and discounting of note receivable can be found
in the Related Finance Company section.
A dealer who finances a car sale customarily keeps a financing file. Since both the
state and federal government under various statutes regulate the financing
transaction, a dealer must maintain a paper trail of the transaction. A financing file
usually contains the following documents:
�� Promissory Note.
�� Security Agreement.
�� Disclosure Notices required by law (if not contained in the Note or
Security Agreement).
�� Credit Application and Credit Report.
�� Vehicle Title. (Some states send the title to the owner, and provide a
notation of lien on the title.) In those states, the dealer will not have
physical possession of the title).
Sales taxes, registration and licensing fees
Sales taxes and registration/license fees are collected by the dealer and paid to the
state. In most states, used car dealers are required to charge sales tax on all retail
sales. Many municipalities have their own retail sales taxes, which the dealers are
also required to collect. In several states, autos with a lien will be charged an
additional fee to register the lien. The lien fee is normally passed on to the
customer. New license plates may or may not be required when the vehicle is sold,
depending on state law. If license plates are necessary, many states require the
dealer to collect the fee from the buyer and submit the additional amount to the
state. The dealer may also have income from sales to other dealers or wholesalers
and from the sale of vehicles at wholesale or retail auctions. Sales to other dealers
are not subject to sales tax in many states. Check state and local laws to determine
whether sales taxes are applied to wholesale auto transactions. Some dealers
include these fees in gross receipts and deduct the amounts paid to the state as an
expense. Other dealers will not include these amounts in income or expenses.
Repossessed vehicles
Repossessions are common in the used car industry. When repossession occurs,
the industry practice is to bring the car back into inventory at the vehicle's ACV,
determined by the N.A.D.A. blue book or other Department of Transportation
approved valuation guide. Likewise, the defaulting buyer receives a credit against
the balance due for the ACV of the car. Alternatively, the dealer may obtain bids
from other dealers or simply sell the car at an auction. In those cases, the buyer is
credited with the net sales price of the car. State law often controls what the dealer
can do with repossession, how the repossessed car should be valued, and what
sales procedures must be used to sell a repossessed car. Accordingly, where the
dealer has substantial repossessions, state law on repossessions should be
reviewed. Repossession costs increase the basis of the car. These costs can
include attorney‘s fees, repossessor fees, repair costs and re-title fees. Small
dealers may have better experience with repossessions than the larger dealers
because they see it as a moneymaker, or they require a larger percentage of the
purchase price as a down payment. A deficiency can arise when the ACV is less
than the amount owed, just as a gain can arise when the ACV is greater than the
amount owed. For example, a car repossessed has an ACV of $1,800. The amount
owed the dealer at the time of the default on the loan is $3,000. A $1,200 deficiency
exists. Using the same ACV of $1,800 and the amount owed to the dealer at the
time of the default on the loan of $1,500, the repossession would result in a $300
The dealer will try to collect the deficiency from the defaulting buyer; although state
law will dictate what collection procedures may be used. The dealer will also resell
the car, either in a private sale or at public auction. If the sales price is less than the
ACV credited to the borrower, the dealer may attempt to collect the difference from
the buyer. Likewise, if the sales price exceeds the ACV credited to the buyer, the
deficiency is reduced by the excess of sales price over ACV. If the repossessed car
is sold with an overage (sales price exceeds the amount owed the dealer), the
overage is repaid to the owner of the vehicle. Such requirements vary from state to
state and may be shown on the contract. Many dealers will create a new stock
number for the repossession, while others will reassign (restock) the old number.
When a sale of personal property is reported under a deferred payment plan, the
gain on a subsequent repossession is equal to the Fair Market Value (FMV) less the
seller's basis in the instrument obligation and less any repossession costs. The
basis of repossession is the FMV on the day of repossession. The basis of the
obligation is figured on its full face value or its fair market value at the time of the
original sale, whichever was used to figure the gain or loss at the time of sale. From
this amount, subtract all payments of principal received on the obligation. If only part
of the obligation is discharged by the repossession, figure the basis in that part.
The fair market value is the price at which a willing buyer would purchase a vehicle
from a willing seller with neither party being under any constraints to complete the
transaction. The FMV can be different than the Actual Cash Value, which is based
on adjusted wholesale values.
Purchases from Other Dealers
Purchases from other dealers are generally similar to purchases from auctions.
However, there may be no written record of the transaction, and the transfer of title
probably will be by a reassignment of title to the purchasing dealer. Frequently, the
dealer may make a package purchase. This is a purchase of several cars for a lump
sum. The purchasing dealer should record the cost of the cars based on the Actual
Cash Value (ACV) of each car to the total purchase price. The ACV of cars sold in a
package can vary greatly since it is common to put one or two cars that are difficult
to sell in a package, with the expectation that the purchaser will want the other cars
enough to accept the entire package. As with cars purchased at auctions, the cost
of the car will be increased by any reconditioning costs incurred in preparing the car
for sale.
Cost of Labor
Labor costs involved in reconditioning and delivery of autos are required to be
included in cost of goods sold. The costs attributable to vehicles in ending inventory
should be included as part of the inventory value. Labor costs may be incorrectly
included in "outside services" or other such accounts.
Other Costs
Other costs may include reconditioning, parts, delivery, detailing, outside services,
repairs, and subcontracting. This is another area in which capital or personal items
may be hidden.
Reconditioning Expenses
A dealer will generally have substantial reconditioning expenses. These are the
costs that must be incurred to get the traded car ready for sale. The total dollars
spent on reconditioning cars may be one of a dealer's largest expenses, depending
on the condition of vehicles normally purchased. The cost of reconditioning each car
should be added to the inventory cost of the car.
Remanufactured Cores
If your dealer is engaged in servicing vehicles for repairs and/or warranty work and
even reconditioning, he or she may purchase remanufactured parts (for example,
carburetor, alternator). Generally, the price of the remanufactured part includes a
charge for the "core." This is an amount that will be refunded to the dealer once the
old part is returned. If the dealer has any cores on hand at year-end, they should be
inventoried. For example, a part may cost $100 divided into two costs: $70 for the
cost of rebuilding the part and a $30 core charge. The $70 may be an inventoriable
cost if part of reconditioning a vehicle or a current expense for repairs or warranty
work. The $30 is inventoriable separately with other parts until the core is returned
for credit. Although it is improper, the dealer may expense the entire $100 when the
part is purchased and include the $30 core charge as income only when the core is
Inventory Valuation
Inventory valuation is a complex issue for a used car dealer. A dealer generally
buys used cars from new car dealers, other used car dealers, wholesalers, or at
auctions. In addition, a dealer also acquires cars when he or she sells a car and
takes a trade-in. The cost of the vehicles will be increased by the costs incurred to
prepare the car for resale. However, the method of determining the initial cost of an
inventoried car will vary, depending on the source of the purchase.
Accounting records
The industry custom is to maintain a file of cars in inventory by stock numbers. A
stock number should be assigned as each car is purchased. A list of the stock
numbers on hand is maintained. The stock number of the car will be recorded in the
customer file at the time of sale. The dealer will note other dispositions of the cars,
for scrap, at auction, etc. Special issues arise for consigned cars, as discussed
later. Many smaller dealers do not assign stock numbers to their inventory, since
the amount of inventory on hand at any given time is small.
Most dealers turn inventory quickly, selling acquired cars to retail customers, other
dealers, wholesalers, or at auctions. Cars are sold at auction if the car is not sold off
the lot in a very short period of time (90 to 120 days). It is also common for dealers
to use the periodic inventory method, whereby inventory is taken at the end of the
year. This is particularly true where lower priced cars are involved. It is also an
industry custom to use the lower of cost or market method of inventory valuation.
This usually results in some adjustment at year-end being made to the inventory.
This adjustment may increase or decrease the cost of goods sold, depending on the
inventory level.
Accounts receivable
While new car dealerships have very detailed receivables and separate schedules
for each type, the independent used car dealership may have no detailed receivable
information. Many used car dealer returns show no account receivable. They will
not accept any terms other than cash on delivery of the vehicle. Others may allow
selected buyers to pay a portion of the purchase on delivery and accept payments
for the rest. The full amount may not be shown in gross receipts when the sale is
made. Frequently, the sales are recorded as the payments are received. The
balance due may be kept in a separate book, index cards, or recorded on the dealsheets.
IRC section 453 does not permit the deferral of income from an installment
sale for a dealership that regularly sells or otherwise disposes of personal property.
The absence of accounts receivable or an unusually low amount may indicate that
the dealership has discounted its receivables. See the Related Finance Companies
section for information concerning discounting of accounts receivable.
• Are all sales reported?
• Are all sales reported in the proper tax year?
Audit Techniques
1. Sample deal sheets, checking for terms of the sale.
2. Review sales recorded in the opening days of the next tax year to
determine whether sales are includible in the year under examination.
3. Determine whether the full amount of the sales price involving payment
plans was recorded as income at the time of the sale.
Some of the most complex inventory issues arise in the valuation of trade-ins.
These complexities arise because the amount allowed as the trade-in does not
usually equal the ACV, which is the initial inventory cost to the dealer. Various
factors make the determination of value very difficult.
Cost Basis of a Trade-in
The starting point for determining the cost of a car taken in trade is the Actual Cash
Value (ACV). It is a common industry practice to determine the ACV by the following
�� Refer to a valuation guideline. While the Kelley Blue Book and N.A.D.A.
Used Car Guide are two of the more common valuation guidelines, any
guideline approved by the Department of Transportation is acceptable,
including Auction guidelines. However, these books serve only as the
starting point, as a guideline for the value of the car. Even the valuation
guidelines point out that adjustments must be made for the actual
condition of the car, since the guideline assumes an average condition.
Many dealers may not follow proper tax procedures through the use of a
published guideline, instead basing their determination on the actual
market conditions existing at that time in their location.
�� The dealer will then adjust the value to take into account specific features
of the car that add to or subtract from the guideline value. Some of these
factors include:
- Actual wear and tear on the car,
- Mileage,
- Accessories,
- Any hidden damage such as frame damage,
- The cost of complying with Environmental Protection Agency (EPA)
- Whether the car has been in an accident.
�� The dealer will also consider another intangible factor, the market
conditions. This is a factor to carefully examine because it deviates from
valuations provided in the published guidelines. For example, a
convertible offered as a trade in November may have less value than one
offered as a trade in April or July, since the opportunity to quickly resell
the convertible depends on the season. (Clearly it is harder to sell a
convertible when snow is falling than it is on a warm spring or summer
day). There are three problems with this type of write-down:
a. The actual cash value of the convertible will not change dramatically
between November and December.
b. The car can be sold in a warmer climate for what it is worth, or more,
because of greater demand for convertibles in warmer climates.
c. Tax law will not allow a write down of a vehicle when the facts show it
will be worth substantially more only 4 or 5 months later.
d. Other conditions such as the overall market for the particular car being
offered for sale, safety recalls, or changes in the automobile industry can
all impact the value of a car.
�� The value of the car is then adjusted for reconditioning costs and other
expected expenditures that the dealer will have to make to get the car
ready for resale. Some common expenditures include:
- Cleaning the car
- Mechanical repairs
- Body damage repairs
- Interior and upholstery repairs
- Safety inspection
- Required state inspection
- Emissions control inspection
- Painting
- Tires
- Finder's Fees.
Trade-in Valuation
The valuation of a trade-in is an art, not a science. This outline of the valuation
process may or may not be followed by a particular dealer. Many dealers, for
example, rely more on experience and personal judgment than on a valuation
guide. Others may rely solely on their professional judgment of the value of the car
in that area at that time. However, every dealer values a car for the sole purpose of
making a profit on both the cars in inventory and the trade-in, when it is ultimately
sold. Revenue Ruling 67-107, 1967-1 C.B. 115, states that used cars taken in trade
as part payment on the sales of cars by a car dealer may be valued, for inventory
purposes, at valuations comparable to those listed in an official used car guide (as
the average wholesale prices for comparable cars). Prices, which vary materially
from the actual market prices during this period, will not be accepted as reflecting
Some Dealerships may undervalue their year-end inventory to overstate the cost of
goods sold by using unacceptable methods of valuation. For example, it is common
for dealers to use personal knowledge and year-end auction prices for similar cars
as the means of valuing inventory. The reason given for using auction value is that
this is the price one could get for their cars if forced to sell the inventory at auction
and close the business. However, this may not be the dealer's primary market and
would be an unacceptable valuation method.
Dealers may also try to use loan values to determine inventory value. The dealer
may state he could get better loans from the bank by using the loan value of the
cars as the inventory value. This too would be an unacceptable valuation method.
While the industry may recognize the use of experience and personal judgment to
value inventory, the Internal Revenue Service and the courts do not accept such
methods of valuation. Valuations must be comparable to those listed in an official
used car guide. Courts have ruled that an officially recognized valuation guide
would be accepted for tax purposes. See Brooks-Massey Dodge, Inc. v.
Commissioner, 60 T.C. 884 (1973) and Revenue Ruling 67-107, 1967-1 C.B. 115
under references in this section for more information concerning proper inventory
Once the ACV of the trade-in is determined, then the trade-in allowance that will
appear on the sales contract must be negotiated with the buyer. These negotiations
often result in an over-allowance, for various reasons. As indicated earlier, the sales
price is usually adjusted to take the over-allowance into account. Properly
determining the ACV of a trade-in is critical to the dealer's success since the profit
on sale of both the inventory and traded vehicles will ultimately be determined by
how accurate a value is placed on the trade-in.
A problem may arise when there is a loan outstanding on the trade-in. Some
transactions will be upside down, with the outstanding loan amount greater than the
ACV of the car. In those cases, the dealer will give the buyer a trade-in allowance
equal to the loan balance. The excess of the loan amount over the vehicle's ACV is
an over-allowance which, in the industry, is treated as a discount to the sales price.
The dealer will pay off the outstanding loan balance.
The smaller dealers may use single entry systems. Records may be a check
register or ledger sheet showing the purchases of inventory and other expenses
listed together.
Some dealers will use a perpetual inventory method, whereby the inventory account
is updated with each sale and purchase. With this method, the dealer will know the
value of his or her inventory at any given time during the year. Adjustments to the
inventory account and cost of sales may be made throughout the year, or one
adjustment may be made at the end of the year. A majority of dealers will take a
periodic inventory, usually at the end of the year, and adjust the purchase, inventory
and cost of goods sold accounts at that time.
When dealer uses the periodic inventory method, a physical inventory is taken at
year-end. The dealer may write the inventory down at this time and make one entry
to record the inventory value less the write-down. In such instances, that will be the
only entry at year-end to establish inventory at the lower of cost or market. The
dealer should maintain a record of the write-down taken on each vehicle in
Year-end write-downs on used vehicles are allowable when certain requirements
are met. Revenue Ruling 67-107 allows a car dealer to value his or her used cars
for inventory purposes at valuations comparable to those listed in an official used
car guide adjusted to conform to the average wholesale price listed at that time.
(See also Brooks-Massey Dodge, Inc., 60 T.C. 884 (1973). Although this is a
practice recommended by the industry and used by nearly all car dealers, there are
some additional requirements.
Treas. Reg. section 1.446-1(a)(2) states in part that a method of accounting which
reflects the consistent application of generally accepted accounting principles in a
particular trade or business in accordance with accepted conditions or practices in
that trade or business will ordinarily be regarded as clearly reflecting income. Treas.
Reg. section 1.471-2(d) provides that the method must be applied with reasonable
consistency to the entire inventory of the taxpayer's trade or business. There is a
lack of consistency if more than one official valuation guide is used simultaneously.
IRC section 471 provides that inventories must conform as nearly as may be to the
best accounting practice in the trade or business and must clearly reflect income.
These regulations under IRC section 471 prescribe two instances where inventory
may be written down below cost to market. The first instance allows a taxpayer to
write down purchased goods to replacement cost (Treas. Reg. section 1.471-4(a)).
The second instance is contained in Treas. Reg. section 1.471-4(b) which states in
part that inventory may be valued at lower than replacement cost with correctness
determined by actual sales for a reasonable period before and after the date of
inventory. Prices, which vary materially from the actual market prices during this
period, will not be accepted as reflecting market. (See also Thor Power Tool Co. v.
Commissioner, 439 U.S. 522 (1979) and Pearl v. Commissioner, T.C. Memo 1977-
Commissions and fees
Many used car dealerships are operated solely by their owners, so the dealership
will not have commission expenses for payments to drivers. In cases where the
dealership employs salespeople, the salespeople likely will receive commissions,
which are considered wages and salaries for employment tax purposes from the
sales of vehicles. Contracts between employer and employee should specify how
commission wages are determined.
Dealerships may also pay commissions or finder's fees to other dealers or
individuals for locating a specific make or model the dealer needs on his or her lot.
Normally, these finder's fees are not considered wages since the amount is paid to
someone outside the dealer‘s business. These expenses should be included as part
of the inventory costs. A Form 1099 Miscellaneous must be issued if the amount
paid to an individual is over $600.
Dealers may incur charges referred to as "hiking" or "shuttling" for the transportation
of vehicles. Generally, these expenses are paid to individuals who are hired to drive
cars between dealers' lots and to or from auctions. These costs should be
inventoried under IRC section 263A if they are associated with moving or shipping
property acquired for resale.
They also may be subject to employment taxes, depending on the facts and
circumstances. In Leb's Enterprises, Inc., 85 AFTR2d Par. 2000-450, January 24,
2000, Car Shuttlers Drivers that transported vehicles from place to place were
employees of the company and the company was responsible for applicable
employment taxes.
Demonstration expense
Generally a used car dealer will not have any demo expense. It is likely that the
owner of the dealership will use vehicles on the lot for commuting and other
personal purposes. If this is the case, corporations should report income on Forms
W-2 for the personal use of the cars, and the sole proprietor should reduce
The taxpayer may argue that an owner's use of dealership vehicles is tax-free
because the owner qualifies as a full-time salesperson under Treas. Reg. section
1.132-5(o). This section defines who is a full-time salesperson, and what is qualified
automobile demonstration use. The taxpayer may also make other arguments to
justify using inventory for personal use, such as: he or she had the car repaired and
was test-driving the vehicle to make sure the repairs were properly made, or he or
she was driving the car around with a for sale sign as advertising. These arguments
will have to be addressed on an individual basis, taking into account the facts and
circumstances involved.
Industry Overview
The use of related finance companies (RFC) is a common practice in the used car
industry. Such companies serve many valid business purposes and were utilized
before any tax advantage scheme was offered. However, some RFC's are being
utilized by used and new car dealers to reduce or defer the reporting of income.
This section of the guide is to be used as an overview of RFC's. In it will be found
reasons for establishing RFC‘s, and issues faced in the examination of an RFC
There are three issues that exist in dealing with RFC‘s. The first involves the
economic reasons for the arrangement, the second involves the validity (form) of
the RFC itself, and the third and most critical issue involves the economic
substance of the discounting transactions.
Economic reasons
There are several reasons for creating and using an RFC. The following are some
of the major reasons that an RFC is created. Each of these reasons can provide a
significant and valid business and economic reason for creating a separate entity to
finance the dealer‘s receivables, even if no third-party receivables are acquired.
There are other equally valid and legitimate reasons for using an RFC.
1. Providing credit to enable the purchaser to buy a car.
Many if not most of the purchasers that utilize the services of an RFC do so
because of an inability to get credit elsewhere. In this way the RFC serves a
useful purpose in providing credit to individuals with little credit, no credit, or
bad credit. A properly operating RFC also focuses the collection function
outside of the dealership itself, which relieves the sales personnel from a
task that is time consuming. Payment schedules are on a weekly or monthly
2. Improving the collection of accounts receivable.
AN RFC can significantly enhance the collection of accounts receivable by
requiring the borrower/buyer to remit payments to a third party, even though
the third party is related to the dealer. It has been the industry's experience
that when payment is made directly to the dealer; bad experience with the
car often leads to a default on the note for the car. This, in turn, creates a
collection problem, and possibly a publicity problem for the dealership.
On the other hand, if an RFC is involved, experience shows that the
customer is less likely to default on the payment. Given the general
creditworthiness of the customers, this is a significant advantage. Some
dealers, through effective management and controls, have RFC discount
rates lower than what they can obtain from third parties and still make a profit
on their RFC financing operations.
3. Avoiding licensing and other regulatory requirements on the dealer entity.
Many states have licensing requirements for finance companies. Establishing
an RFC permits the dealer to isolate liability for violation of any requirements
in a separate entity, without jeopardizing the status of the dealership. In
addition, some states have capital requirements for finance companies that
may interfere with the normal operations of a dealership.
4. Preventing adverse publicity on repossessions and other collection actions
from affecting the dealership.
Repossession and collection problems are a daily fact of life for buy here/pay
here dealers. Creation of an RFC permits a new entity to undertake these
actions, thereby insulating the dealer from any adverse publicity. Even in
states where disclosure of the relationship is required, the resulting publicity
is usually less adverse when an RFC is used.
5. Insulating the dealership from the financial risk of default on the notes.
The industry deals with a customer base that generally has poor or nonexistent
credit. The default rate on buy here/pay here notes is substantially
higher than on general bank loans. This economic fact is recognized in both
the interest rates charged by the dealer or finance company and the reserves
that independent finance companies generally maintain. A separate RFC
removes the financial risk from the dealership entity.
6. Diversification of ownership.
Since the financing of used cars is not inherently a part of a dealership, an
RFC permits the dealer to provide ownership in that specific business by
both family and non-family members without diluting ownership in the
dealership. This allows the dealer to separate the two businesses and reward
certain employees or other individuals with an ownership interest in a
segment of the business. It also provides a more accurate accounting of the
financing activities when dealers report to banks and other financing entities.
A final advantage is that an RFC can be expanded, depending upon the dealer's
desire, to finance unrelated receivables as well as those of a particular dealership. It
should be pointed out that although this is possible, it rarely happens.
Validity or Form of RFC
The second issue that should be considered is how a valid RFC is structured and
operated. Since the purpose of the RFC is to isolate liability or segregate
transactions in a separate entity, the RFC should meet several criteria to be treated
as a separate, valid business. These criteria are:
1. The RFC should be a separate, legal entity.
2. The RFC should meet all licensing requirements of the jurisdictions in which
it operates.
3. A major factor is that the RFC should be adequately capitalized in order to
pay for the contracts.
4. The RFC should have its own employees and compensate them directly.
�� However, the fact that the RFC and the dealership or other related
entities may elect to use a common paymaster does not indicate, that the
RFC does not have its own employees.
1. The RFC should obtain and maintain all appropriate local business and
similar licenses.
2. The RFC should have a separate telephone number.
3. The RFC should have a separate business address, which may be a post
office box. Even if a separate business address is maintained, it is common
for the RFC to have an office at the dealership.
4. The RFC should maintain a separate set of books and records.
5. The RFC should comply with all title, lien, and recordation rules in the
jurisdictions in which it operates.
6. The RFC should notify customers of the purchase of their notes.
7. The RFC and the dealership should have a purchase contract for the
receivables that both complies with the appropriate state law and provides
evidence of how the FMV of the receivables was determined.
8. The RFC should pay the dealer for the receivables at the time of purchase.
The RFC can generate the cash to make the payment from any combination
of capitalization of the RFC, bank or third-party borrowings, or borrowings
from related entities or shareholders. Borrowings from related entities or
shareholders can diminish the validity of this factor.
9. The RFC should be operated in a business-like manner.
�� While all of these attributes need not be present, to the extent that they
are absent, a question as to the substance of the RFC exists.
Economic substance of an RFC
The third and most important issue that should be addressed is the sale of
discounted receivables at fair market value (FMV). Sales of receivables must have
economic substance to qualify for tax purposes; valid business reasons alone will
not suffice.
The FMV of a receivable or group of receivables will depend on a number of factors,
Purchasing receivables are not an exact science, and many subjective factors enter
into the determination of value. The industry‘s position is that a deep discount is
warranted in nearly all transfers of receivables. The factors that directly influence
the amount of discount include:
• Absence of or poor credit history.
• History of payments on the note.
• Amount of time left on the note.
• The age of the vehicle.
Reviews of some third-party finance company documents indicate that these
companies can offer to acquire the receivables from dealers at up to a 50 percent
up-front discount. These discounts apply whether or not the finance company buys
in bulk or "cherry picks" the best accounts.
It is also important to note that these same third-party finance company documents
refer to back-end reserves. These back-end reserves can be released to the dealer
at the time the loan is paid off. The back-end reserves can restore the dealers profit
on the sale to 100 percent, less any transaction costs. RFC purchases at a deep
discount should be inspected for these back-end reserves.
A dealer can use an RFC to discount its receivables and have it accepted for tax
purposes. To summarize the above discussion, the following three factors need to
be addressed:
�� The discounting transactions must have economic substance. All of the
relevant facts and circumstances must be considered. Remember that the
primary reasons for selling receivables are to obtain cash (improve cash
flow) or to shift risk. If both of these are missing, it is a good indication
that the sales transaction lacks economic substance.
�� The form of the transactions and the form of the RFC must be perfected.
�� The receivables must be sold for fair market value. The seller and
purchaser must base the discount on some reasonable factors, not on an
arbitrary determination of the discount rate.
Among the issues that may arise are the following:
1. Whether there has been a change in method of accounting where
a related refinance company is used to defer income.
2. Whether a loss incurred by a car dealer from the purported sale of
notes receivable to a related finance company should be
disallowed because the related finance company existed only in
form and the transaction between the dealer and related finance
company lacks economic substance.
3. Whether IRC section 482 applies to the loss claimed by a dealer
from the sale of notes receivable to a related finance company
because the notes receivable were sold at less than the fair market
4. Whether Internal Revenue Code section 267 disallows a loss from
the sale of notes receivable by a car dealer to a related finance
5. Whether a dealer and related finance company are members of a
controlled group for the purposes of IRC section 267 and thereby
eligible for the special loss recognition rules of Treas. Reg. section
Issue Development
Issue development is the key to any substance versus form argument. This is
especially true when related companies are involved. Depending on the facts and
circumstances of each dealership, the RFC could be a valid business and should be
respected as a separate entity. Your issue will be resolved based on the particular
facts and circumstances of your taxpayer. Accordingly, the importance of fully
developing your RFC issue cannot be overstated.
Because of poor credit, many potential vehicle purchasers cannot obtain financing
directly from banks, credit unions or manufacturers‘finance companies. These
individuals are referred to as —non-prime or sub-prime consumers, depending on
their credit rating (non-prime having a higher credit rating than sub-prime). To tap
into this large market, many vehicle dealerships (particularly used car dealerships)
have established relationships with lenders who have dealers execute their own
retail installment agreements to these customers. These contracts are known in the
industry as non-prime or —sub-prime financing.
How a Non-Prime or Sub-Prime Plan Works
To facilitate cash flow and to avoid collection responsibilities, the dealerships often
transfer non-prime or sub-prime installment contracts to an unrelated finance
company shortly after the deals are consummated for an upfront cash advance and
the possibility of additional cash payments in the future. Dealerships may do
business with several finance companies, and may have paid a fee and entered into
a servicing agreement with each finance company prior to transacting business with
it. Servicing agreements vary among finance companies, and one finance company
may have a variety of programs, but the basic premise of most of these types of
programs is the same. Upon transfer of the installment contract, the finance
company pays the dealership an advance which may range from 50 to 75 percent of
the contract, depending on the credit rating of a particular customer or the
dealership‘s aggregate pool of contracts. The advance can be based on the face
amount of the contract without interest, or the total contract amount including
interest. After paying the advance, the finance company collects the installment
payments from the vehicle purchaser for a fixed percentage of each payment, often
20 percent. In addition, the finance company will be reimbursed for any out-ofpocket
collection cost incurred. Only after recovering the fixed percentage fee, out
of pocket collection costs, and the advance, will the finance company begin to pay
the dealership for the remainder of the contract, known as the BACK-END
To summarize, the finance companies apply the collections on the installment
contracts in the following order:
�� • To pay the fixed percentage collection fee
�� • To reimburse out-of-pocket collection costs (e.g. repossessions
related expenses)
�� • To repay the advance from the finance company to the dealerships,
�� • To remit any remaining funds to the dealer (back-end distribution)
Assuming a 20 percent fixed collection fee, and if the finance company has no outof-
pocket collection costs, the dealer has the potential through the advance plus
back-end distributions to receive 80 percent of the installment contract (either the
face amount of the contract or the face amount of the contract plus interest,
depending on the servicing agreement). However, because of the order in which the
collections are applied, dealers may not receive any back-end distributions because
the collections received may be subject to a high default rate and may never exceed
the sum of the 20 percent service fee, out-of-pocket costs, and the repayment of the
outstanding advances.
The chances of receiving back-end distributions are further reduced because the
finance companies aggregate the installment contracts rather than carry them
individually. For example, if a dealership transfers 20 non-prime or sub-prime
contracts, the advances from the finance company for all 20 contracts will be
aggregated, and only after collections are received that exceed the cumulative
advances on all 20 contracts will any back-end distribution be made. Thus, as long
as the finance company keeps issuing advances, the cumulative advance balance
increases and the collections received may never be enough to cover this ever
increasing advance balance.
To rectify this some finance companies offer pool capping. Under this arrangement,
the dealership may pay an additional fee to cap off one pool (or group) of contracts
and to create a new pool for additional contracts. Pool capping speeds up the time
in which the dealer is eligible to receive back-end distributions because it
segregates a group of contracts, and collections received on those particular
contracts are applied exclusively to those contracts. The collections on those
contracts are not used to repay advances on contracts in another pool. Once the
advances on the contracts in that specific pool are repaid and the 20 percent
collection fee and any out-of-pocket costs are covered, the dealership will begin to
receive back-end distributions on those contracts. The same process applies to all
pools of the dealer that have been capped. The terms of pool capping
arrangements must be carefully analyzed, however, since cross collateralization of
pools may occur (payments made on contracts in one pool may be applied to
another pool), diminishing the benefits of capping. Non-prime and sub-prime
arrangements are constantly changing, so it is difficult to provide a “one-size fits
all“description of these products. Agents should consider all the facts and
circumstances pertinent to a particular servicing agreement when examining these
What are the issues?
The discussions in this audit technique guide are directed toward dealership
reporting. No conclusions should be drawn from these discussions about the
treatment of these contracts by finance companies.
There are several dealership issues associated with the tax reporting of non-prime
and sub-prime contracts, including the following:
• Is the transfer of the contract from the dealership to the finance company a
sale of the contract or merely a pledge of the contract to collateralize a loan
made to the dealership by the finance company?
• How should the cash advance be reported?
• How should the payment of the fixed percentage collection fee be reported?
• Are back-end distributions contingent payments?
• When should the back-end distributions be reported?
• How should the back-end distributions be valued?
• How should interest be computed and reported?
• How should enrollment fees and capping fees be reported?
• Are adjustments to this issue changes in method of accounting?
Sub-Prime/Non-Prime Financing - October 1998; March 1999; March 1999; LTR
9840001; LTR 199909003; LTR 199909002
�� The transfers of customer notes from a used car dealership to an unrelated
finance company are sales.
�� The dealer’s amount realized on the sale equals the cash received from the
finance company plus the fair market value of the dealer’s right to receive
future distribution payments.
�� The FMV of the future payments is not necessarily $0.
�� The distribution payments are contingent and subject to the rules of IRC
�� Each distribution payment must be allocated to principal and interest.
Income Tax Treatment
Since inventory is a material income-producing factor, vehicle dealerships are
required to use the accrual method of accounting. Often, however, dealers use the
cash method to report the transfer of installment contracts to the finance company.
They report only the customer down payment and the advance received from the
finance company as current income. Back-end distributions are often reported in a
later tax period, when received. The primary reasons these transactions are
reported in this manner are because
1. They follow the actual cash flow, or economic reality, of the transactions,
2. It is difficult to assign a value to money which the dealership does not
know if, when or how much will be received. Transactions associated with
non-prime and sub-prime financing must be reported on an accrual basis.
However, it is important to understand all facets of the transactions to
properly account for them.
Two separate transactions occur. First, the vehicle is sold to the customer. Second,
the installment contract is transferred from the dealer to the finance company. The
Tax Reform Act of 1986 repealed the installment method of reporting for dealers in
personal property. Thus, the initial sale of the vehicle by the dealer to the customer
must be reported in full the year the sale occurred. The total sales price of the
vehicle must be reported even if an Installment agreement was executed. The
dealership‘s basis in the vehicle offsets the total sales price to determine the gain or
loss on the sale.
To determine the appropriate tax treatment of the second transaction, it must be
determined if the transfer of the installment contract to the finance company by the
dealer is a sale or a pledge to collateralize a loan from the finance company. No
matter what the character or tax treatment of the second transaction, however, the
initial sale of the vehicle to the customer must be reported in full in the year of the
Sale, Assignment, Loan or Pledge to Collateralize a Loan
Whether the transfer of an installment contract is a sale or a pledge to collateralize
a loan made to the dealership by the finance company depends on the facts and
circumstances. Many of the servicing agreements or other arrangements between
the dealerships and finance companies are worded as if the finance company is
loaning money to the dealership. However, a close review of the provisions of these
agreements often reveals that in substance they are sales. The following factors
tend to indicate the transfer is a sale. The number of factors applicable to a
particular dealership, or the relative importance of one factor to another, must be
considered in determining whether a sale, or some other type of transaction has
1. The terms of the transfer are nonrecourse; that is, the dealership is not
responsible for payment of any defaulted notes or payments (often after 90
2. The transfer gives the finance company unilateral power to dispose of the note
3. The dealership‘s security interest in the financed vehicle was transferred to the
finance company.
4. The finance company receives all files and paperwork related to the customer
5. The finance company handles all collections and other administrative actions on
the customer note.
6. The finance company is entitled to endorse the dealership‘s name on any
payments made to the dealership and any other instruments concerning the
installment contract and the financed automobile.
7. The finance company determines whether the note is in default. The finance
company can waive any late payment charge or any other fee it is entitled to
8. The finance company can repossess and sell or otherwise liquidate the financed
vehicle if default occurs.
9. The dealership‘s customers are notified the note will be assigned to the finance
10. The finance company may or does pledge the customer notes as security for its
own indebtedness.
11. The finance company bears the credit risk on the customer notes.
12. The dealership is not required to provide financial statements to the finance
company in a manner normally associated with a line of credit or other loan
13. There is no stated interest rate, maturity date, or other specific details normally
associated with a line of credit or other loan arrangement.
Treatment of a Pledge of Collateral (i.e. loan or an assignment)
If the transfer of the installment contract to the finance company from the dealership
is determined to be a pledge to collateralize a loan from the finance company, there
is no income to the dealership upon receipt of the cash advance and no gain or loss
is recognized at the time of the transfer of the contract. The cash advance is
considered a loan. Collections by the finance company are treated in a dual manner
since they must be applied to both the original installment contract between the
purchaser and the dealership (which the dealership still owns), and the outstanding
cash advance loan between the dealership and the finance company.
Dealership Note Receivable (from vehicle purchaser):
Each collection by the finance company is applied against the outstanding
installment note receivable still owned by the dealership. A portion of each
collection is interest income to the dealership, and a portion is applied against the
principal balance of the purchaser‘s note.
Dealership Note Payable (to finance company):
Since the amounts collected are actually retained by the finance company to apply
against the cash advance balance outstanding, a portion of each amount collected
is considered interest expense to the dealership, and the remainder applied against
the advance principal balance. The fixed percentage collection fee retained by the
finance company is current expense to the dealership.
It is anticipated that few, if any, of these transactions are likely to be true loans.
Treatment of a Sale
If the transfer of the installment contract to the finance company is deemed to be a
sale by the dealership, the amount realized on the sale is compared to the dealer‘s
basis in the contract to determine the dealer‘s gain or loss. Per Internal Revenue
Code section 1001(b) the amount realized from the sale is the cash plus the fair
market value of any other property received. This formula appears simple, but is
actually difficult to apply. It is made more complex by the impact of Internal
Revenue Code section 483, which requires deferred payments to be
recharacterized in part as a payment of unstated interest.
The dealer receives cash in the form of advance payments. That is easy to quantify.
However, the dealer also receives the right to back-end distributions. The fair
market value of that right is difficult to determine, since these contracts relate to
non-prime and sub-prime customers who do not have good credit and the back-end
distribution payments are contingent upon the recovery of the upfront cash
advances, collection fees and out-of-pocket costs. Thus, it is difficult to determine
the amount realized from the sale of the installment contract by the dealer to the
finance company.
There is significant debate over the appropriate valuation of the amount realized
upon the sale of the contracts. Some argue that the full face value of the installment
contract should be reported in the year of the transfer. Others maintain that
although some back-end payments may be made, they will be de minimis and
almost never match the remaining balance in the contract after cash advances and
fixed percentage collection fees. Yet others insist that the possibility of receiving any
back-end distributions is so remote it is almost moot, and the fair market value of
the right to receive the back-end distributions is zero.
If the dealership primarily does business with customers having very poor credit and
there is no historical receipt of back-end distributions, it MAY be reasonable to
assign a $0 fair market value to potential back-end payments.
If the dealership does have a history of receiving back-end distributions, these
amounts should be determined from the monthly statements received from the
finance company. A rolling average or some other type of methodology may be
utilized to determine the fair market value of sales occurring in the tax years under
examination and for the future.
The amount of back-end distribution recharacterized as unstated interest may also
be difficult to determine. The regulation requires this amount to be determined by
discounting the back-end distribution at the applicable federal rate from the time the
applicable installment contract was sold until the back-end distribution is made. The
regulations do not explain how to apply this rule when the back-end distributions are
made on a pool of installment contracts. Similarly, the portion of a back-end
distribution that is not unstated interest is a recovery of basis received from the sale
of the installment contract and, if all basis has been recovered, is treated as gain
from the sale. When the back-end distributions are made on a pool of installment
contracts, it is not clear to which installment contract the recovered basis should be
attributed. The following facts and circumstances should be considered when
determining the value of the right to back-end distribution payments includible in the
amount realized on the sale:
1. Has the dealer received any back-end distribution payments?
2. What is the amount of back-end distribution payments received?
3. How long has the dealer been involved in the program with the finance
4. Has the dealer capped any pools of contracts?
5. Are the pools cross-collateralized?
6. Has the dealer‘s involvement in the program with the finance company
been terminated?
7. Has the finance company changed the dealer‘s collection rating since
joining the program?
8. What is the historical rate of default for the dealer‘s customer base?
9. Has the current customer base changed?
10. How does the taxpayer value the right to back-end distribution payments?
11. Have the terms of the servicing agreement between the dealer and the
finance company changed?
Audit Techniques
At the initial interview, ask the taxpayer if any retail installment agreements for the
customer purchases of vehicles are transferred to any unrelated finance companies.
The taxpayer may use more than one finance company or switch from one finance
company to another. Almost any finance institution, including major banks and
financing arms of major vehicle manufacturers) may be involved with non-prime or
sub-prime paper.
If you interview the accountant or preparer, he/she may not be aware that the dealer
is transferring any finance contracts since the audit plan may not include reviewing
vehicle jackets or supporting documentation. It is imperative that the dealer be
asked directly.
Sub-Prime Records
Ask the dealer to provide the vehicle jackets. These jackets are usually an envelope
(or sometimes a file folder) for each vehicle, which includes all of the dealer‘s
documentation related to that vehicle such as the sales invoice, purchase invoice,
copy of the title, and repair receipts. The outside of the jacket often also lists
detailed information about the vehicle‘s purchase and sale, including the dates,
amounts, and individuals or companies involved. These jackets also may contain
the dealer‘s records pertaining to the transfer of the installment contract to the
finance company.
Look through the jacket for a retail installment agreement specifying how the
customer will pay for the vehicle. Sometimes the retail installment agreement
specifically states that it will be transferred to a finance company. In addition, the
dealer usually receives a payment voucher from the finance company that shows
the customer‘s name and amount received, and these vouchers may be in the
vehicle jacket. The dealer also prepares other paperwork as required by the finance
company, copies of which have been kept and retained in the jacket or a separate
finance file. This includes the non-prime or sub-prime customer‘s verification of
employment and utility bills to show the home address, the computation of the
advance to be received from the finance company, the insurance information form,
and the notice of security interest.
If it is determined that the dealer transferred finance contracts to an unrelated
finance company, additional information will need to be requested for each
1. Servicing Agreement (also referred to as the dealer agreement). The
Servicing Agreement defines the responsibilities of the dealer and the
finance company. It provides definitions, explains the advances and how
the collections will be applied, and shows how the agreement can be
terminated. In addition, if the finance company changes the advance
computation or other provisions of the agreement, an addendum or other
notification of the changes may be provided to the dealer by the finance
1. Dealer Manual & Other Literature. The dealer Manual may contain
various items of information, including a sample of customer paperwork
with detailed advance computations. The finance company may also send
the dealer literature on new programs or new features such as pool
2. Account Statements -The finance company sends statements (usually
monthly) to the dealer summarizing advances, collections, fees, and other
pertinent information. The summary may also show detail by customer of
the last payment date, amount of payment, and if the account was written
off as a bad debt.
Example of Accounting Entries:
The transfer of the installment contract to the finance company may or may not be
recorded in the dealer’s books. You should not rely on the presence or absence of
accounting entries to determine if the transactions have been reported properly.
The following provides representative examples of how you may find the
transactions to be reported and how they should be reported:
Sales Price $5,000 Sale Price by Dealer to Purchaser
Cash (Down Payment) 1,000 Down Payment from Purchaser to Dealer
Accounts Receivable 4,000 Installment Contract Recorded on
Dealer’s Books
Cash (advance) 2,000 Advance to Dealer from Finance
Cost of Goods 2,500 Dealer’s Cost of Vehicle Sold
Monthly Payments 250 Monthly Payment per Contract
Interest Rate 10% Rate of Interest Charged to Purchaser
and by Finance Company to Dealer
FMV of BE Distribution 450 Potential Max Back-End Distribution of
Fair market value of contingent contractual right to such payment estimated to be
Report as a Loan or an Assignment…
I. Note Receivable $4,000
Cash (down payment) 1,000 SALES $5,000
Sale $5,000 COS 2,500
To record the sale of the vehicle
II. Cost of Goods Sold 2,500
Inventory 2,500
To record the cost of the vehicle sold
III. Cash 2,000
Advance Payable to Finance Company 2,000
To record advance received from the finance company
IV. Advance Payable to Finance Company 250
Notes Receivable 250
To record collections received and applied by the finance company to offset the
V. Cash 100
Accounts Receivable 90
Interest Income 10
To record back-end distribution payment from finance company. Amounts and
interest rate estimated.
VI. Service Fee 20
Accounts Receivable 20
To record collections received by finance company applied to the service fee.
Report as a Loan or an Assignment…
I. Accounts Receivable $4,000
Cash (down payment) 1,000
Sale $5,000
To record the sale of the vehicle
II. Cost of Goods Sold 2,500
Inventory 2,500
To record the cost of the vehicle sold
III. Cash 2,000
Advance Payable to Finance Company 2,000
To record advance received from the finance company
IV. Advance Payable to Finance Company 183
Notes Receivable (250-33) 217
Interest Expense (Dealer to Fin.Co.) 17
Collection Fee Expense 50
Interest Income (Dealer held note) 33
To record collection of first $250 payment
Reported correctly, the dealership must include ordinary interest in its taxable
income rather than applying all the payments as an offset to notes receivable.
Reported As A Sale…
I. Note Receivable $4,000
Cash (down payment) 1,000
Sale $5,000
CONTRACT (4000-2000)
To record the sale of the vehicle NET PROFIT 500
II. Cost of Goods Sold 2,500
Inventory 2,500
To record the cost of the vehicle sold
III. Bad Debt Expense 2,000
Cash (advance) 2,000
Note Receivable 4,000
To record the sale of the finance contract
Note that instead of assigning value to the right to receive future back-end
distributions and interest, a bad debt expense was taken to write off the dealer’s
remaining basis in the installment contract. This has a significant impact on the net
outcome of the transactions, as shown above.
Reported As A Sale…
I. Note Receivable $4,000 CASH FLOW ANALYSIS
Cash (down payment) 1,000 TAX ON
Sale $5,000 PROFIT
To record the sale of the vehicle (2500*30%) 750
II. Cost of Goods Sold 2,500 CONTRACT)
Inventory 2,500 (1550*30%) (465)
To record the cost of the vehicle sold
III. Cash 2,000
Back-end Distributions Receivable 450
Loss on Sale of Installment Contract 1550
Note Receivable 4,000
To record the sale of the finance contract
IV. Cash 600
Back-end Distributions Receivable 600
Reported properly, the correct loss is $1550, not $2000. Note that back-end
distributions that are paid will include unstated interest calculated under the
principals of Regulation section 1.483-4.
1. Enrollment Fee - The dealership may pay a nonrefundable fee to the finance
company to join the finance company‘s program. This fee is an IRC section 263
capital expenditure and may not be currently deducted under section 162. The
Servicing Agreement between the dealer and the finance company meets the
definition of a supplier-based intangible under section 197(b) of the Code and has a
15 year life beginning with the month in which the contract was executed. Since the
agreement does not have a fixed duration of less than 15 years, the exception from
inclusion under section 197(e) (4) (D) of the Code does not apply.
2. Pool Capping Fee -The dealership may pay a nonrefundable fee to the finance
company to cap the pools. The same reasoning used for the enrollment fee can be
applied to the pool-capping fee. The fee covers a period of time, which is probably
not specified in years because it is based on the number of contracts involved. This
fee would also fall under section 197 of the Code because it is a supplier-based
intangible with a value resulting from future acquisition of services pursuant to a
relationship in the ordinary course of business with a supplier of services to be used
by the taxpayer. The fee would be amortized ratably over a 15-year period
beginning with the month in which the fee was paid.
3. Servicing Fee -The Servicing Agreement between the finance company and the
dealer will specify the fee charged by the finance company to the dealer to collect
the receivables (servicing fee). The servicing fee is usually a percentage of the
finance contract. The deductibility of the servicing fee is not an issue if the transfer
of the finance contract is deemed to be a sale because it is factored into the amount
realized on the sale. If the transfer is deemed to be a loan or an assignment, the
servicing fee is not currently deductible when the finance contracts are transferred
to the finance company; rather it is deductible based on economic performance.
The fee should be deducted as the services are provided by the finance company.
4. Mark to Market - Section 475 of the Code opened a small window of opportunity
for auto dealers to elect section 475 to mark receivables to market value. For
section 475 to apply, the dealer must have held (owned) the receivable at THE END
OF THE APPLICABLE TAX YEAR. If the transfer of the installment contract to the
finance company is determined to be a sale, section 475 does not apply since the
dealer no longer owns the receivable. The IRS Restructuring and Reform Act of
1998 amends IRC section 475 effective for the tax years ending after 7/22/98. The
mark-to-market accounting rules were not intended to be used by dealers in nonfinancial
goods and services to obtain a loss deduction that otherwise would not be
available. Mark-to-market no longer can be used for a receivable that is produced
from the sale of non-financial goods or services by a taxpayer whose principal
activity is the selling or providing non-financial goods and services.
5. Change in Accounting Method - Depending on how the dealer has reported the
transactions, audit adjustments may require a change in method of accounting. If
so, a section 481(a) adjustment will be made at the beginning of the year of change,
usually the first open year under examination. The current year adjustment will be
made pursuant to IRC section 446. The facts and circumstances of each situation
must be considered to determine if a change in method has occurred.
National Independent Auto Dealers Association (NIADA)
State Division of Motor Vehicles
(See your particular state government listing for address)
American Association of Motor Vehicles Administrators
State Independent Auto Dealers Association
(Address can be obtained from NIADA web site above)
Coordinating Committee for Automobile Repairs (CCAR)
(A website devoted to Independent Dealers and the used motor vehicle industry)
National Automobile Dealers Association (NADA)
(new automobile dealerships)
A.A.M.V.A. - American Association of Motor Vehicle Administrators. The
association consists of the various state motor vehicle department administrators.
ACV - ACTUAL CASH VALUE - The wholesale value assigned to a trade-in or
purchase. The ACV will usually differ from trade-in allowance (the credit allowed
customer on purchase of vehicle). ACV becomes cost adjusted by reconditioning
costs and other costs. The ACV is determined by the dealer at the time of purchase
or trade, based on valuation guides and adjusted for the specifics of each vehicle.
ACV can be higher or lower than the trade-in allowance.
AUTO AUCTION - Auto auctions are generally of two types. Dealer Auctions are
open to licensed car dealers only. Public auctions are open to every one. Selling
prices are set through competitive bidding on each vehicle rather than by the seller.
BIRD DOG FEES - A fee paid for a customer referral. The referral may be made by
a licensed or unlicensed individual and may be regulated or unregulated by the
particular state.
BLACK BOOK - One of several publications listing wholesale and retail price
ranges of used vehicles. See guidebook below.
BOOK VALUE - The wholesale value of a given used vehicle in a specific market
area at a particular time of the year, as determined by a recognized wholesale
appraisal guide book.
BROKER - A middleman who locates vehicles for other dealers, usually on a
commission basis. A broker does not take title or possession of the vehicles,
whereas a wholesaler takes possession and title of the vehicles.
BUY HERE/PAY HERE DEALER - A dealer that offers in-house dealer financing for
the vehicles sold. (Dealer provides financing either on his or her own or through a
separate finance company owned and run by the dealer. Usually the finance
company will share employees and office space with the dealership.) Also see
Related Finance Company.
CAR JACKET (DEAL JACKET) - The complete history of a vehicle from the time it
is purchased to its sale. The jacket should contain, in addition to the purchase and
sale price, any invoices and costs associated with repairs, delivery and parts. It
also contains any Federal Trade Commission and state required notices such as
odometer statements, Vehicle Identification Number (VIN), stock number and
records of the sales transaction. The jacket is normally a folder containing all the
information; however, some dealers may maintain a ledger sheet or index card on
each vehicle instead of the folder.
CHARGE BACK - A loan financed through the dealer is paid off sooner than the
loan term. The finance company will make the dealer pay back part of the
commission. This also happens with insurance commissions.
CURBING - Sale of a vehicle by an unlicensed dealer from a shopping center
parking lot or similar area. See CURBSTONER.
CURBSTONER - An unlicensed dealer. These "merchants" sell in violation of the
law, usually from shopping center parking lots or similar areas. Since each state
has different licensing requirements, the definition of a "curbstoner" will vary from
state to state.
DEAL - The completed sale of a vehicle or truck to an individual or another dealer.
DEALSHEET - The sales order or invoice showing the sale of a vehicle to an
individual or another dealer.
DELIVERY EXPENSE - Transportation of used vehicles from the point of purchase
to the dealership, or the cost incurred to transport autos involved in a dealer trade.
This activity may also be referred to as hiking or shuttling.
The service may be done by the owner, a towing service, self-employed individuals,
or employees. This expense may lead to an employment tax issue depending on
facts and circumstances.
DETAILING - To prepare a vehicle for resale. This usually includes cleaning, minor
repairs and cosmetic work. Detailing is often used synonymously with
reconditioning. This may be done by the dealer, an outside business, or individuals
brought in to do the work. Also called Portering. This expense may lead to an
employment tax issue.
DISCOUNT - The difference between the asking and list price established by the
dealer and the final sales price of a vehicle.
DOCUMENTARY (DOC) FEE - A fee charged for processing or handling the
documentation of a sales transaction. May also be called procurement fee or
processing fee.
DOMEBOOK(TM) - A journal used by small businesses to help organize income and
expenses on a monthly basis. It has separate monthly pages for receipts,
purchases, and other expenses.
DOUBLE DIP - Person with a loan for the purchase of a vehicle and with additional
outside financing for down payment that may or may not be shown as a lien on the
FLOORING/FLOOR PLANNING - Costs incurred in obtaining inventory, usually
through loans from a bank or other financial institution. Includes interest on the
loans. Some dealers may be utilizing auction floor plans for the purchase of
vehicles. This is a growing industry and one that will probably become common in
the next few years.
GUIDEBOOK - A book used to value trade-ins and vehicles in inventory. It is also
used for sale purposes. The most common guidebooks used in the industry include
the Kelley Blue Book, NADA Used Car Guide, "Black Book," "Red Book," "Gold
Book," CPI Book, and Galves. There are other publications that may be used on a
regional basis. Guidebooks are often referred to as the Black Book, Blue Book,
Yellow or Gold Book. Each of these publications is recognized by the industry as
one of the official used vehicle guides for determining values of used cars. The
popularity of a particular book varies by region.
HIKING - See Delivery Expense above.
IN-HOUSE FINANCING - Financing provided by the dealer. Also known as Buy
Here/Pay Here.
KELLEY BLUE BOOK - One of several publications listing wholesale and retail
price ranges of used cars. See guidebook above.
L O C - Line of Credit, usually from a bank. A loan on which the dealer can take out
money whenever needed; similar to a checking account with interest charged. The
line has a maximum amount that can be outstanding at any time. Similar to floor
planning, but not used solely for purchases of inventory.
N.A.A.A. - National Auto Auction Association
N.A.D.A. - National Automobile Dealers Association
N.A.D.S. - National Auto Data Service
NET SALES PRICE - Sales price less any trade-in allowance or discounts.
N.I.A.D.A. - National Independent Automobile Dealers Association.
ONE PAY - Single payment contract for delivery of vehicle. Allows dealer to deliver
vehicle to customer immediately rather than waiting for loan approval. Customer
usually is obtaining own financing and will pay the sales price in full once financing
is provided by the lender. This is often reflected by a demand note from the
OPEN TITLE - A title signed by the seller that has the buyer’s name left open or
blank. Also called a skip title. Generally, transferring a vehicle with an open title is
OVERALLOWANCE - The excess of trade-in allowed over the auto’s ACV. This is
used as a means to close the deal. Usually, the difference is made up by
decreasing the discount on the vehicle purchased.
PACKAGE DEAL - The purchase of two or more vehicles for a lump sum price.
This generally occurs between dealers and is one way to sell a vehicle that
otherwise would be difficult to move.
RATE SPREAD - A rate spread occurs when a dealership had made arrangements
to write vehicle loans for a financial institution. The dealership will pre-arrange the
amount of interest rate that the financial institution will charge on vehicle loans to
buyers. The dealership will then write loans at a higher rate and receive the excess
interest generated by the loan as an income payment from the financial institution.
REASSIGNED TITLE - A title transferred from dealer to dealer which may not
require processing by the state in which the dealer operates.
RECONDITIONING - Any work done to prepare a vehicle for sale. Includes parts,
labor, cleaning, and other work done on a vehicle. May be part of detailing or
portering expense.
RELATED FINANCE COMPANY (RFC) - A finance company owned and operated
by the dealer. Shows up as a separate entity for tax purposes.
REPO - Repossession of a vehicle when the purchaser defaults on the loan.
SKIP - Renege on payment of a loan. The term also applies to a buyer who can't
be located, that is, took off in the middle of the night for parts unknown.
SLED - A vehicle with an actual cash value (ACV) of $300 or less. Also known as a
clunker, iron, roach, or pot.
SPIFF - A cash incentive paid to salesmen for selling a special vehicle, such as one
that has been on the lot for a long time.
SUBLET - To have work performed by outside vendors, usually when the dealer
either is not equipped for the work, or is unable to perform the work within a
reasonable time.
TRADE-DOWN - A retail customer trades a vehicle for one of lesser value. Will be
found only with retail deals.
TRADE-IN - An item taken in by a dealer as part of a deal on the sale of a vehicle
from the dealer's inventory. Usually another vehicle, but may be a boat,
motorcycle, camping trailer or other items agreed on by the dealer and customer.
Value of the item is deducted from the amount due on the sale of the vehicle
UNWIND - Reversing a sale due a purchaser's inadequate credit or some other
problem with the transaction..
UPSIDE DOWN - A sales situation where the trade-in has an ACV less than the
remaining loan amount on the vehicle.
USED CAR LOG - A record of all purchases of and sales of used vehicles, usually
showing the year, make, identification number, date purchased, date sold, who it
was purchased from and who it was sold to. Requirements will vary from state to
state. This book may be referred to as a Police Book or State Log in some parts of
the country.
VEHICLE IDENTIFICATION NUMBER (VIN) - The unique identification number
assigned to a vehicle by the manufacturer. The VIN is used to specifically identify
which vehicle is being sold or traded.
WARRANTY - Protection plan or guarantee on the vehicle and/or certain systems
such as the drive train offered by a dealer. Length of warranty varies from dealer to
WASHOUT - A series of sales transactions where the trade-in of a prior sale is sold
partially in exchange for another trade-in. For example, Car A is sold for cash plus
trade-in of Car B. Car B is then sold for cash and the trade-in of Car C.
WHOLESALER - Specializes in selling vehicles to other dealers for an agreed
price. Unlike a broker, the wholesaler takes possession and title of the vehicle.
They do not sell to the general public. These transactions may be subject to state
and local sales taxes depending of your state requirements. Retail dealers also will
sell wholesale to other dealers.
SPOT DELIVERY - A sales situation where the buyer takes the vehicle home
subject to financing approval. If financing is not approved, the customer must return
the vehicle.
Each State has plenty of information on the average sales of used and new cars.
Check your individual state’s motor vehicle department for more detail. An example
of what can be found is the State of Maryland web site
There are also nationally recognized associations that offer statistics; such as the
New Automobile Dealership Association in

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