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:: New Vehicle Dealership Audit Technique Guide 2004 - Chapter 11 - Related Finance Companies (12-2004)   Chapter 11 - Table of Contents How does it work? Issue Identification Initial Document request Supporting Law A "Related Finance Company" or RFC, is a financing company owned by an automobile dealership. It provides financing for customers that cannot obtain financing through normal channels. The customer is required to make payments usually at the dealership's location. This type of arrangement is usually advertised by the dealership as a "buy here pay here" plan. The "buy here pay here" plan is common with stand alone used car dealerships, but many new car dealerships utilize this type of plan for their used car sales. How does it work? Dealerships involved in this practice establish a financing entity (herein referred to as a "Related Finance Company" or RFC), typically an S Corporation, which acts as the lender in the dealership's financing arrangement. The same shareholders that own the dealership usually own the S Corporation. When the vehicle is sold, and it is determined that the customer needs special credit assistance, the dealership writes the note at term (high interest rate) with recourse to the RFC. The note is sold at a significant discount to the RFC substantiating the discount by citing high risk. The dealership books a current and deducted loss for the difference between the full contract and the discounted contract. The RFC accrues income as it becomes earned, subject to IRC section 162 deductions. Legitimate Uses of a Related Finance Company There are several valid business purposes for establishing an RFC. An effective RFC removes the collection burden from the dealership; allowing dealership personnel to operate the dealership. Some RFCs are so well managed that their discount rates can be lower than those offered by a third party. The RFC may be more familiar with the contracts it purchases due to its close relationship with the dealership, allowing the dealership to be more selective when it offers credit. An RFC may allow a dealership relief from regulatory restrictions, and to distance itself from adverse publicity resulting from collection activity. A valid RFC should have the following characteristics: When the finance contract is sold to the RFC, title has been transferred to the RFC in accordance with title and lien holder laws The discounting of the car dealer's receivables are sold to the RFC at their fair market value There is a written arms-length contract between the dealership and the RFC The finance contracts are normally sold without recourse between the two related parties The RFC is responsible for repossessions The RFC is operated as a separate entity from the dealership and has the following characteristics: Adequate capital to pay for the contracts Meets all state and local licensing requirements Maintains its own bank accounts Has its own address and phone number and operates as a separate entity from the dealership Maintains its own books Has its own employees and they are compensated directly by the RFC Pays its own expenses The customers are making payments to the RFC, not to the dealership In addition to financing loans, some RFC's will offer other dealer-related services, such as credit life policies, extended warranty coverage and auto insurance coverage. Journal Entries of a properly formed RFC An RFC, operating as a separate business, which has purchased notes from a dealer at FMV, will have the following journal entries: Example #1 Facts: Dealer sells a used car to a customer for $6,300. The entire purchase price is financed for a period of three years. The customer's payments are $175 per month (175 x 36 mo. = $6,300). The customer has a poor credit history. The dealer sells the note to the RFC at a 40% discount, which is considered the FMV. In this example, the RFC does not meet the related party requirements under Section 267. Assume 100% gross profit. Ignore interest income. DEALER (Accrual basis) RFC (Accrual Basis) Account Debit Credit  Account Debit Credit  01-01-X1 Notes Rec - customer 6,300      Sales   6,300 To record sale of vehicle       Cash  3,780     Notes Rec - Customer 6,300        Loss on Discount      2,520 Deferred Revenue          2,520 Notes Rec - Customer     6,300 Cash           3,780 To record sale and transfer of note to RFC at a 40% discount       12-31-X1       Cash 2,100      Notes Rec -customer      2,100 To record payments on note                Deferred revenue 840     Sales     840 To record first year profit. The RFC has recovered 1/3 of the $2,520 discount as income. (840 x 3 = 2,520) 12-31-X2     Cash  2,100       Notes Rec - customer               2,100 To record payments on note        Deferred revenue 840   Sales   840 To record second year profit. The RFC has recovered 2/3 of the $2,520 discount as income. 12-31-X3      Cash 2,100   Notes Rec - customer    2,100 To record payments on note        Deferred revenue 840   Sales   840 To record third year profit. The RFC has recovered the remaining 1/3 of the $2,520 discount as income. Note that if the customer had defaulted on the loan, the balance in the RFC's deferred revenue account will never be recognized. Issue Identification Tax issues arise when the dealership and the related finance company do not treat the sale and financing properly or when the RFC is merely a shell corporation that does not engage in any business activities. EXAMPLE #2: Background: DEALER is a dealership that sells new and used cars. DEALER has a separate used car lot and advertises itself as a ¡§buy here pay here¡¨ lot. DEALER finances most sales at the maximum legal interest rate. RFC, a finance company, is created with capital contributions from DEALER to purchase notes receivable from DEALER'S used car lot. The notes receivable are purchased at a discount. In essence, RFC is a factoring business. Both DEALER and RFC file their income tax returns as an S corporation. DEALER uses the accrual method of accounting. However, RFC uses the cash method of accounting. The same shareholder owns 100% of both DEALER and RFC. RFC is located in the offices of DEALER. RFC has no employees and does not have a business address or telephone listing of its own. DEALER'S employees maintain all of RFC's books and records. RFC does not have any funds with which to purchase notes receivable from any car dealership. It does not have any loans or lines of credit with any financing institution or its shareholders. RFC does not advertise, has no telephone listing or business office, and does not solicit business. No other dealers are aware of its existence. RFC purchases notes from DEALER at a 40% discount. The RFC makes no attempt to select the better performing notes. There are no documented negotiations of discount rates, the particular notes to be purchased, or other elements commonly found in factoring agreements. DEALER never receives cash at the time of sale from RFC. This is because RFC has no cash with which to pay DEALER. Rather, DEALER and RFC set up intercompany accounts to recognize the 60% due DEALER. The DEALER collects the payments from the customer. At the time the DEALER collects the payments from the customer, RFC recognizes income and reduces the loan balance due DEALER. DEALER sells several of the notes receivables to unrelated entities at a discount.  However these entities buy only the most current or best performing notes receivable. When such sales are consummated, DEALER receives cash, title is transferred to the buyer and DEALER relinquishes its files. When DEALER factors the notes receivable to RFC, the note files are not relinquished. Title is not transferred to RFC. DEALER maintains the control of the note files and record keeping for RFC. Journal entries (made by the taxpayer): On 01/01/X1, DEALER forms an RFC and invests $3,780 in capital contributions. On 01/01/X1 DEALER sells a used car to a customer for $6,300. The entire purchase price is financed. The car is financed for three years. The customer's payments are $175 per month. DEALER sells the note to RFC at a 40% discount. Assume 100% gross profit. Ignore interest income. DEALER (Accrual basis) RFC (Cash Basis) Account Debit  Credit Account Debit Credit 01-01-X1         Investment in RFC 3,780     Cash 3,780      Cash    3,780 Common Stock/PIC    3,780 To record investment in RFC To record capitalization of RFC                  Notes Rec-customer 6,300                Sales      6,300 To record sale of vehicle               Notes Rec - RFC  3,780       Notes Rec - Customer 6,300      Loss on Discount        2,520 Deferred Revenue      2,520 Notes Rec - Customer      6,300 Notes Payable - Dealer      3,780 To record sale and transfer of note to RFC at a 40% discount To record purchase of note from Dealer 12-31-X1 Cash 2,100      Deferred revenue 840       Note Rec -customer      2,100 Sales      840 To record first year payments from customer ($175 x 12 mo.) To record first year profit. The RFC has recovered 1/3 of the $2,520 discount as income. (840 x 3 = 2,520)     Cash 1,260   Notes Payable - Dealer 1,260   Notes Rec - RFC   1,260 Cash   1,260 To record RFC's payment of loan To repay Dealer loan ($3,780 / 3) 12-31-X2 Cash 2,100   Deferred revenue  840   Notes Rec - customer     2,100 Sales     840 To record second year payments from customer To record second year profit. Cash 1,260    Notes Payable - Dealer 1,260     Notes Rec - RFC    1,260  Cash    1,260 To record RFC's payment of loan  To repay Dealer loan 12-31-X3 Cash 2,100   Deferred revenue 840   Notes Rec - customer   2,100 Sales    840 To record third year payments from customer To record third year profit. Cash 1,260   Notes Payable - Dealer 1,260     Notes Rec - RFC   1,260 Cash     1,260 To record RFC's payment of loan To repay Dealer loan Issues Whether there has been a change in method of accounting when an RFC is used to defer income. Adjustment: The $2,520 is adjusted to $840 per year to match the RFC's recognition. Whether Internal Revenue Code Section 267 disallows a loss from the sale of notes receivable by a car dealer to an RFC. Same adjustment as above. DEALER cannot take the $2,520 loss until RFC recognizes it into income.  Whether IRC 482 applies to the loss claimed by a dealer from the sale of notes receivable to an RFC, should be disallowed because the RFC existed only in form, and the transactions between the dealer and the RFC lack economic substance. Dealer not allowed a loss on discount of $2,520 if a valid sale did not occur. Whether IRC section 482 applies to the loss claimed by a dealer from the sale of notes receivable to an RFC because the notes receivable were sold at less than the fair market value amount. If the RFC is valid, revenue agent can accept the sale to the RFC, but adjust the discount to the FMV If the RFC is not valid, revenue agent can disallow the entire loss from the sale Whether a dealer and an RFC 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). Under this section, a dealer is allowed to defer a loss on related party sale of a note receivable until the note is transferred outside the controlled group. In order to qualify under this section, the note must have been sold at FMV. Note that the RFC has recorded the receipt of the notes receivable from the customer; however, it is the dealer that is receiving the payments from the customer. Audit Techniques Determine the ownership percentages between the dealership and the RFC. If the common ownership is greater than 50%, then IRC 267 applies. If the RFC is on the cash basis, determine if its method of accounting should be changed to the accrual method. Determine if the notes were sold at their FMV to the RFC. If not, then consider the following arguments: If the TP is a member of a controlled group, then the dealer is not entitled to loss deferral pursuant to Reg. 1.267-1(f). If the loss should be disallowed under IRC 482 If the RFC lacks economic substance, the transactions between the dealer and the RFC should be disallowed. Change of accounting method IRC 267(a)(2) requires that income and expense transactions between related parties are required to maintain the same method of accounting. Therefore, the RFC must recognize income at the same time as the dealer. This, in effect, puts the RFC on the accrual basis. Reg. 1.446-1(d)(1) defines the rules for taxpayers engaged in more than one business.  This section states that if a taxpayer is engaged in more than one business, a different method of accounting may be used for each trade or business, provided the method used for each clearly reflects income. However, no trade or business will be considered separate and distinct unless a complete and separable set of books and records is kept for each trade or business [Reg. 1.446-1(d)(2)]. If by reason of maintaining different methods of accounting, there is a creation or shifting of profits or losses between the businesses so that the income of the taxpayer is not clearly reflected, then the trades or businesses of the taxpayer will not be considered to be separate and distinct [Reg. 1.446-1(d)(3)]. Deduction disallowance An alternative treatment is that no deduction is allowed to the dealership until the cash is actually received and recognized as income by the finance company. Loss disallowance - V IRC 267 In general, if the common ownership between the dealer and the RFC is greater than 50%, the dealer is not entitled to deduct a loss on the sale of notes to the RFC. [IRC 267(a)(1)]. IRC 267(b) lists the relationships that are governed under IRC 267(a)(1). However, if the dealership is an S corporation qualifying as a member of a controlled group (at least 80% common ownership), then the S corporation is entitled to loss deferral until the note is transferred outside of the controlled group [IRC 267(f)]. In order for the taxpayer to qualify for loss deferral under this rule, the sale of the receivable between the dealer and the RFC must be at FMV. [Reg. 1.267(f)-1(f)]  Lack of economic substance The discounting transactions must have economic substance. The primary reason for selling receivables are to obtain cash (improve cash flow) or to shift risk. An RFC typically deals with a customer base that generally has poor or non-existent credit. The default rate on buy here/pay here notes is substantially higher than on general bank loans. A separate RFC removes the financial risk from the dealership entity. This economic fact is recognized both by the interest rates charged by the dealer or finance company and the reserves that independent finance companies generally maintain. If both of these are missing, it is a good indication that the sales transactions lack economic substance. TAM 9704002 is a blue print for a related finance company. The RFC was formed by the dealership shareholder. There was a "transfer" of contracts to RFC at less than face value. The dealership deducted losses on transfer. The TAM concluded that the transactions were not "arm's length" and that they lacked economic substance. The factors that were considered were: The RFC was undercapitalized There were no written sales contracts There were no cash payments between parties There were no employees or facilities Purchasers were not informed of the transaction Lien holder was not changed Profits were loaned to related entities or shareholder PLR 9704002 addresses transactions between and RFC and a dealer. The IRS determined that no sale consummated between the RFC and the dealer. Note: Private Letter Rulings (PLRs) AND Technical Advisory Memorandums (TAMs) are addressed only to the taxpayers who requested them. Field Service Advisory¡¦s (FSAs) are not binding on Examination or Appeals, nor are they final determinations. Furthermore, Section 6110(k)(3) provides that PLRs, TAMs and FSAs may not be used or cited as precedent. The IRS determined that the transfer of dealer notes to the RFC was not a sale of property based upon the following factors: Upon the transfer of the notes, the dealer still had burdens of ownership: Dealer's employees collected the payments and performed repossessions Dealer bared the risks of the credit-worthiness of the notes Dealer's financial position did not change when the notes were transferred to the RFC RFC was thinly capitalized Dealer, not the RFC, was responsible for repossessions Title was not transferred to the RFC RFC could not have sold the notes, because they did not have legal title Borrowers were not notified that the loan was reassigned to the RFC If a vehicle was damaged in an accident, the dealer, not the RFC had the right to any insurance proceeds. There were no written sales contracts between the dealer and the RFC Determination if a loan is sold at FMV The following factors should be considered in the determining whether a dealer sold its receivables at FMV: Request a sample of car jackets for loans that were sold to the RFC and loans that were sold to third parties. Compare the following: Was the debtor unable or unlikely to obtain financing from third parties to finance the purchase? The car jacket usually includes a credit report on the borrower. If the discount rate is large, the customer will have a poor credit history. Review the car jackets of sales where the loans were sold to third parties and compare those to loans sold to the RFC. If the loans were sold to the RFC at FMV, then similar loans sold to third parties will have a similar discount rate. How often are payments on the loan required: weekly, biweekly, or monthly? Required weekly payments generally indicate higher credit risk. Prior to the discount date, what is the dealer's collection history on the loans? Poor customer collections decrease the value of the note receivables. Determine the average dealer markup on dealer-financed sales and the average dealer markup on third party financed and cash sales. The dealer may already have this information available. If the markup is the same, then the face amount of the note should be the FMV of the note on the loan date. To the extent the markup is higher on dealer-financed sales, the FMV of the loans are less than their face value on the loan date. Example: Cost Basis                   2,100         2,100 Plus: Markup               2,100         3,150 (100%, 150% respectively) Sales Price                   4,200         5,250 Less: Down payment      (200)          (200) Loan Amount 4,000                        5,050 Discount to FMV        (1,050)                                     4,000 $1,050 / $5,050 = 21% Accordingly, there is a 21% difference among the face amount of the note, $5,050 and the FMV of the note, $4,000 when the loan is made.  If the dealer discounted the $5,050 note by 21% within a few days of the loan to its RFC, then the loan was most likely made at FMV. If instead, the dealer discounted the $5,050 the following day to its RFC at a 30% discount for a sales price of $3,535 ($5,050 x .70), then the note was sold for less than its FMV of $4,000. This results in the $1,515 loss on the loan sale being deferred ($5,050 loan amount (basis) less sales price of $3,535 = $1,515 loss). Other factors to consider: Were the loans offered for sale to third party loan discounters? What were the terms of the offer and how do they compare with the terms of the actual sales to the RFC? Compare the credit worthiness and sale terms with similar transactions of the RFC. How soon after the loan date were the loans discounted? The closer the discount date is to the loan date, the less chance of significant factors that could lead to a FMV different than the face amount of the receivables. Are the notes receivable discounted or sold on an individual note by note basis? Varying discount rates is indicative of individual note discounting. A flat discount rate for specific time periods is indicative of bulk discounting. Are all notes discounted, or does the RFC pick and choose the notes it acquires? What is the credit checking procedure of the dealer before selling a vehicle with in-house financing? Compare this to the credit checking procedure of notes sold to third parties. What steps did the dealer take to determine the FMV of the loans before they were sold? What steps did the RFC take in determining the FMV of the loans before they were acquired? Has the prime interest rate increased or decreased since the date of the loan? The FMV of a loan decreases if interest rates increase. Computation of Adjustment Adjustment: Change the RFC¡¦s accounting method to accrual. This adjustment is made when the agent is accepting the RFC as a separate business entity, but income is distorted due to IRC 267 and 446. Finance contract discount-losses claimed                                        xxx a Subtract installment collections reported as income                       (xxx) b Add IRC 481 adjustment (year of change only)                              xxx Equals: Increase to taxable income                                                xxx                                                                                                      === This number should reflect the finance contract discount deductions or losses claimed by the dealer on contracts discounted, assigned, or sold to the RFC. These amounts are usually included in the car dealer's cost of sales amounts but may be reflected as a separate line item. If the RFC reported any income on the finance contract principal collections, this amount is subtracted out here. This is necessary because we are requiring the car dealer to use the accrual method, and any income reported by the RFC subsequent to the date of sale is a duplication of already reported income. Note that interest income is not adjusted on the RFC return, and remains fully taxable to the RFC. Adjustment: Disallow the RFC for tax purposes. This assumes that the agent has determined that the sales of the receivables to the RFC are not recognized for tax purposes because the sales have no economic substance. All other unrelated income and expenses of the RFC remain on the RFC return. If the RFC is a C corporation, the 1120 may have an unusable NOL. Finance contract discount-losses claimed                                           xxx Add RFC net taxable income or subtract net taxable loss                  xxx Subtract installment collections reported as income                           (xxx) Add IRC 481 adjustment (year of change only)                                  xxx Equals: Increase to taxable income                                                    xxx Initial Document Requests All agreements for the following parties including but not limited to amendments, restatements: Dealer and the RFC RFC and its shareholders RFC and all other related parties A finance contract which has been discounted which is representative of other contracts. Copies of the discount agreement and a sample copy of a discounted contract for contracts that is utilized with unrelated third parties. A copy of a completed loan agreement A copy of credit, collection and repossession policies in effect A copy of all notes and or written loan agreements between the RFC, the dealer, its shareholders, and any other related party including renegotiated notes A copy of all licenses and permits for the RFC by any government agency  A copy of all promotional literature, brochures or other information furnished to the owner, manager, and/or key employees in conjunction with the decision to form an RFC  A copy of any Forms 3115 filed for either the RFC or the dealership. Initial Interview Questions During your initial interview, determine the following: Before the RFC was formed, did the dealership discount finance contracts to third party finance companies? Who is recorded as lien holder with the department of motor vehicles? Who retains the original car title and tag records Is the RFC a separate legal entity Type of entity for federal and state Licenses that the RFC holds Ownership of the RFC How was the RFC capitalized (cash, loans, third-party financing, etc) Type of books and records maintained by the RFC The RFC's method of accounting Types of duties performed by the dealer and the RFC's employees Determine who performs the following, and for which entity Credit checks Credit decisions Monitoring of loan accounts Collection of loan accounts Repossession of vehicles Management of RFC Bookkeeping functions of RFC Has the RFC filed payroll tax returns? Is the RFC located in the same location as the dealer? If the location is in the same building, ask the following: Are separate offices maintained? Is there a separate phone number for the RFC? How are common costs allocated? (Utilities, overhead, etc) Are there written agreements for shared costs? Who owns the location of the RFC and the dealer? If a related party, ask the following Rental arrangements Existence of written agreements Since the RFC was created Does the dealer sell contracts to third party finance companies? Are these discounted? Has the amount of dealer financing increased? If yes, by how much? Has the taxpayer modified the level of customer credit risk he or she would self-finance? Has the taxpayer modified: Collection procedures? Repossession procedures? What percentage of finance contract customers are unable to obtain financing elsewhere due to poor or no credit? Discounting of finance contracts: How is FMV determined for both the contracts sold to the RFC and contracts sold to third parties? What is the amount of the discounts? How is the discount determined? Have there been any significant changes in business practices since the formation of the RFC? What fees, if any, are paid by either the dealership or the RFC? Example of fees are acquisitions fees per contract, collection service fees, repossession fees Repossessions Which entity makes the decision to repossess a car? Who reports the repossession gain or loss on the contract? How is the transfer of the vehicle back to the entity treated for book and for tax purposes? Supporting Law IRC 267a: No deduction is allowed for losses between the following related persons: Family members [IRC 267(b)(1)] And individual and a corporation, when the individual owns more than 50% of the outstanding stock [IRC 276(b)(2)] Two corporations which are members of the same controlled group [267(b)(3)] IRC 267(f) and Reg. 1.267(f)-1(f) define "controlled group" for purposes of IRC 267(b)(3). It allows an S corp to defer a loss until the note is transferred outside the group. However, the note must have been sold at FMV IRC 267(a)(2) requires that income and expense transactions between related parties are required to maintain the same method of accounting. Reg. 1.446-1(c)(2)(i) provides that in any case which it is necessary to use an inventory, the accrual method of accounting must be used with regard to purchases and sales unless otherwise authorized by the Commissioner. Reg. 1.446-1(d)(1), (2), and (3) define "separate and distinct"¨ trade or businesses. IRC 453(b)(2): an installment sale accounting method cannot be applied to disposition of inventory of the taxpayer. IRC 482: The examining agent can attribute income among related entities in a manner that clearly reflects income. Reg. 1.482-1A(b)(1) states that the standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.  IRC 9722: if a principal purpose of any transaction is to evade or avoid liability under the IRC, tax may be computed without regard to that transaction. PLR 9704002 addresses transactions between and RFC and a dealer. The IRS determined that no sale consummated between the RFC and the dealer. Commissioner v. Hansen, 59-2 USTC 9533, 360 US 446, 3 L. Ed 2d 1360, 79 S. Ct. (1959), and Resale Mobile Homes, Inc. 92-1, USTC 50,282, aff'g 91 TC 1085 (1988) held that the dealers are required to report as income the full amount of their sales without reduction for finance or holdback reserves. Transfer of title cases Higgins vs. Smith, 40-1 USTC 9169, 308 U.S. 473, 84 L. Ed 406, 60 S. CT 355 (1940).  Title has to transfer in order to have a sale. Lyon Co. v. US 78-1 USTC 9379, 435 US 561, 573 (1978) states that if no formal title has passed, ownership of property has not transferred. Economic substance court cases Rice's Toyota World, Inc v. Commissioner, 81 TC 184, 209 (1983) requires business transactions to meet a minimum threshold of a business purpose or economic objective. Moline Properties, Inc v. Commissioner, 43-1 USTC 9464, 319 U.S. 436, 87 L. Ed. 1499, 63 S. Ct. 1132 (1942), covers sham corporations. Lucas v Earl, 281 U.S. 111 (1930): income is taxable to the earner. Coliss v. Bowers, 2 USTC 525, 281 US 376, 378 (1930) stated that taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed - the actual benefit for which the tax is paid. Gregory v. Helvering, 293 U.S. 465 (1935), the court concluded that sham transactions are not recognized for federal income tax purposes and losses generated by such transactions are not allowed. RFC CHECKSHEET Is the RFC a separate legal entity from the dealership?   Does the RFC meet all state licensing requirements?   Does the RFC maintain proper business licenses?   Does the RFC comply with title and lien holder laws?   Does the RFC have adequate capital to purchase the notes?   Does the RFC have its own address and operate from separate facilities?   Does the RFC maintain its own books separate from the dealership?   Does the RFC have its own phone number?   Does the RFC have its own employees?   Does the RFC compensate the employees directly?   Does the RFC pay its own expenses?   Does the RFC maintain its own bank accounts separate from the dealership?   Operation:   Does the lien holder on the finance contract change from the dealer to the RFC?   Does the dealership notify the customer that the finance contracts have been sold?   Does the RFC pay the dealership for the contracts at the time of purchase?   Does the RFC purchase contracts from unrelated parties?   Does the RFC have written contracts with the dealership?   If so, do the agreements state how the discount rates are determined?   Does the discount rate approximate the actual loss experience?   Are the financial contracts non-recourse?   Does the RFC handle repossessions?   Does the dealership sell any finance contra