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Independent Used Automobile Dealerships INTRODUCTION 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 Division. Curbstoners 3-47 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 Records 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), 3-48 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 Auctions 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 well. Each auction company is run independently, maintains different records, and has its own procedures. Some common rules and procedures used in the auction industry include: �� 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. 3-49 The seller may set the floor or lowest price that the vehicle may be sold for by the auction. 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 buyer. 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 3-50 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 customer, �� 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 3-51 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. INITIAL INTERVIEW 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. Sales: 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? 3-52 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 programs? 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. 3-53 �� 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 adjustment.) 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 3-54 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? 3-55 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 acquisition? �� 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. Miscellaneous 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? 3-56 9. How does this affect your pricing and valuation practices? 10. If you use a vehicle for business, what records do you keep? BOOKS AND RECORDS 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 accounting. �� 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 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 3-57 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 options: - Sell the car from his or her lot, or - Sell the car at an auction. 3-58 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 source. �� 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 income. �� 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. 3-59 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 Business. 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): 3-60 CUSTOMER 1 CUSTOMER 2 DR CR DR CR 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. 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 3-61 become another source of income for used car dealers in certain parts of the country. 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 3-62 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 commissioners. 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. 3-63 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. 3-64 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. Consignments 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 vehicles. 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 concerns. 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, 3-65 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: DR CR 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 3-66 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. COST OF GOODS SOLD AND PURCHASES/INVENTORY 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 gain. 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 3-67 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 3-68 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 returned. 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. 3-69 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. Issues • 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. Trade-ins 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. 3-70 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 steps: �� 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) requirements, - 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. 3-71 �� 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 market. 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 3-72 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 valuation. 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 inventory. 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. 3-73 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- 262.) EXPENSE ISSUES 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. 3-74 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 expenses. 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. RELATED FINANCE COMPANIES 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 issue. 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 3-75 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 basis. 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 3-76 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. 3-77 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 3-78 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 value. 4. Whether Internal Revenue Code section 267 disallows a loss from the sale of notes receivable by a car dealer to a related finance company. 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 1.267(f)-1(f). 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. WHAT IS A NON-PRIME OR SUB-PRIME FINANCE CONTRACT? 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 3-79 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 DISTRIBUTION. 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, and �� • 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. 3-80 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 issues. 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? 3-81 • 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 §483(f). �� 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, and 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 3-82 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. 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 occurred: 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 days). 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 note 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 collect. 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 company. 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 arrangement. 13. There is no stated interest rate, maturity date, or other specific details normally associated with a line of credit or other loan arrangement. 3-83 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 3-84 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 company? 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? 3-85 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. 3-86 If it is determined that the dealer transferred finance contracts to an unrelated finance company, additional information will need to be requested for each company: 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 company. 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 capping. 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: FACTS: 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 Company 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 $1200. 3-87 Fair market value of contingent contractual right to such payment estimated to be $450. Report as a Loan or an Assignment… (WHAT YOU MAY FIND ON THE DEALERSHIP BOOKS) I. Note Receivable $4,000 Cash (down payment) 1,000 SALES $5,000 Sale $5,000 COS 2,500 NET PROFIT 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 advance 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… (HOW IT SHOULD BE REPORTED) I. Accounts Receivable $4,000 Cash (down payment) 1,000 3-88 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 (250-(17+50)) Notes Receivable (250-33) 217 Interest Expense (Dealer to Fin.Co.) 17 (2000*(10%/12) Collection Fee Expense 50 (250*20%) Interest Income (Dealer held note) 33 (4000*(10%/12)) 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… (WHAT YOU MAY FIND ON THE DEALERSHIP BOOKS) I. Note Receivable $4,000 Cash (down payment) 1,000 Sale $5,000 GAIN ON SALE OF 2,500 VEHICLE(5000-2500) LOSS OF SALE OF (2,000) CONTRACT (4000-2000) To record the sale of the vehicle NET PROFIT 500 II. Cost of Goods Sold 2,500 3-89 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… (HOW IT SHOULD BE REPORTED) I. Note Receivable $4,000 CASH FLOW ANALYSIS Cash (down payment) 1,000 TAX ON Sale $5,000 PROFIT (SALE OF CAR) To record the sale of the vehicle (2500*30%) 750 TAX ON LOSS (SALE OF 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 3-90 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. OTHER ISSUES 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 3-91 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. WEB SOURCES ON INDEPENDENT CAR DEALERS National Independent Auto Dealers Association (NIADA) www.naida.com State Division of Motor Vehicles (See your particular state government listing for address) American Association of Motor Vehicles Administrators www.aiada.org State Independent Auto Dealers Association (Address can be obtained from NIADA web site above) Coordinating Committee for Automobile Repairs (CCAR) www.ccar-greenlink.org (A website devoted to Independent Dealers and the used motor vehicle industry) National Automobile Dealers Association (NADA) (new automobile dealerships) www.nada.org GLOSSARY 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. 3-92 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. 3-93 CUSTOMER FILE - Refer to CAR JACKET. 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 title. 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 3-94 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 customer. 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 illegal. 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. 3-95 PORTERING - See DETAILING above. 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. SHUTTLING - See DELIVERY EXPENSE above. 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 purchased. UNWIND - Reversing a sale due a purchaser's inadequate credit or some other problem with the transaction.. 3-96 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 dealer. 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. STATISTICS: 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 www.mva.state.us/aboutmva/statistics . There are also nationally recognized associations that offer statistics; such as the New Automobile Dealership Association in www.NADA.com