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New Vehicle Dealership Audit Technique Guide 2004 - Chapter 14 - Other Auto Dealership Issues (12-2004)

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to either return to the Table of Contents.

Chapter 13 | Table of Contents

Chapter 14 - Table of Contents

  Service Technician Tool Reimbursements
  Manufacturer's Incentive Payments to Vehicle Salespersons
  Shuttling Services and Driver/Shuttlers
  Holdback Charges
  Warranty Advances
  Finance Reserves
  Demonstrator Vehicles
  Other Miscellaneous Issues
  Glossary
  Other Sources of Information
  Court Citations

This chapter discusses three main segments: income issues, compensation issues and other miscellaneous issues. The topics updated and/or added are: compensation issues: service tech tools, manufacturer's incentive, shuttlers' income issues; auto demonstrator vehicles, other miscellaneous: Cores, used car donation programs; a new credit for electric cars; hybrid vehicles; cost segregation and cancellation of dealership franchises.

1. SERVICE TECHNICIAN TOOL REIMBURSEMENTS
The Motor Vehicle Technical Advisor, under the Pre Filing & Technical division of Large and Midsize Business Division (LMSB) Retail Industry finalized the following Coordinated Issue, dated July 21, 2000.

  • ISSUE: Whether amounts paid to motor vehicle service technicians as reimbursements for the use of the technicians' tools are paid under an accountable plan?

  • CONCLUSION: Generally, amounts paid to motor vehicle service technicians (service techs) as tool reimbursements not meet the accountable plan requirements. Amounts paid under an unaccountable plan are included in the employee' s gross income, must be reported to the employee on Form W-2 and are subject to the withholding and payment of federal employment taxes.

FACTS
Motor vehicle service technicians (service techs) are hired as employees by dealerships, repair and body shops, and various other enterprises to perform repair and maintenance services on vehicles. As a condition of employment, service techs are required to provide and maintain their own tools, which are kept on-site at the business locations. Generally, the tools are used exclusively by the technician to whom they belong. Service techs are paid hourly wages.

Instead of paying an hourly wage for the performance of services, many employers bifurcate the hourly wage paid to the service techs into "wages" and "tool reimbursements". These plans purport to fall under the aegis of accountable plans as described in Internal Revenue Code (the Code) section 62 and the regulations thereunder. Under I.R.C. § 62(c) reimbursements for employee business expenses meeting certain requirements are not wages includible in income or subject to the withholding and payment of employment taxes. These plans may be administered either by a third party for a fee or by the employer.

In a typical arrangement, the hourly wage paid to the service tech is divided into a wage portion and a tool reimbursement portion. Income and employment taxes are withheld and paid on the wages, but no income or employment taxes are withheld on the tool reimbursement. Employers use various methods to determine the amount paid as tool reimbursement. For example, the method used might measure the hourly value of the tools the service tech owns multiplied by the number of hours the service tech worked.

The method may consider the type of tool, its useful life, original cost or replacement value, geographic location of the worker and other factors. Alternatively, service techs could be paid a tool allowance or advance not based upon the value of the tools or the expenses incurred in use. None of the methods, however, are directly correlated with or based exclusively upon the actual expenses paid or incurred by the service technician for tools. In a typical arrangement amounts paid as tool reimbursements are not reported on Form W-2, but are sometimes reported on Form 1099.

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APPLICABLE LAW
Wages

In general, wages are defined for Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA) and income tax withholding purposes as all remuneration for employment unless otherwise excluded. I.R.C. §§ 3121(a), 3306(b) and 3401(a). There is no statutory exception from wages for amounts paid by employers to employees for employee business expenses. However, Treasury reg. §1.62-2(c)(4) provides that amounts an employer pays to an employee for employee business expenses under an "accountable plan" are excluded from the employee's gross income, are not required to be reported on the employee's Form W-2, and are exempt from the withholding and payment of employment taxes. Treas. reg. §§ 31.3121 (a)-3, 31.3306(b)-2, and 31.3401(a)-4 of the Employment Tax Regulations, and Treas. reg. § 1.6041-3(h)(1) of the Income Tax Regulations.

Accountable Plan
Whether amounts are paid under an accountable plan is governed by I.R.C. § 62, which includes the provisions on employee reimbursement or other expense allowance arrangements. Section 62 generally defines "adjusted gross income" as gross income minus certain ("above-the-line") deductions. Section 62(a)(2)(A) allows an employee an above-the-line deduction for expenses paid by the employee, in connection with his or her performance of services as an employee, under a reimbursement or other expense allowance arrangement with the employer. Section 62(c) provides that an arrangement will not be treated as a reimbursement or other expense allowance arrangement for purposes of I.R.C. § 62(a)(2)(A) if (1) such arrangement does not require the employee to substantiate the expenses covered by the arrangement to the person providing the reimbursement or (2) such arrangement provides the employee with the right to retain any amount in excess of the substantiated expenses covered under the arrangement.

Under § 1.62-2(c)(1) of the regulations, a reimbursement or other expense allowance arrangement satisfies the requirements of I.R.C. § 62(c) if it meets "the three requirements" set forth in paragraphs (d), (e), and (f) of Treas. reg. § 1.62-2: business connection, substantiation, and returning amounts in excess of expenses.

If an arrangement meets the three requirements, all amounts paid under the arrangement are treated as paid under an accountable plan. Treas. reg. § 1.62-2(c)(2)(i). The regulations further provide that if an arrangement does not satisfy one or more of the three requirements, all amounts paid under the arrangement are paid under a "nonaccountable plan." Amounts paid under a nonaccountable plan are included in the employee's gross income for the taxable year, must be reported to the employee on Form W-2, and are subject to withholding and payment of employment taxes. Treas. reg. §§ 1.62-2(c)(5), 31.3121(a)-3(b)(2), 31.3306(b)-2(b)(2) and 31.3401(a)-4(b)(2).

An arrangement meets the business connection requirement of Treas. reg. § 1.62-2(d) if it provides advances, allowances (including per diem allowances, allowances for meals and incidental expenses, and mileage allowances), or reimbursements for business expenses that are allowable as deductions by Part VI (section 161 through section 196), subchapter B, Chapter 1 of the Code, and that are paid or incurred by the employee in connection with the performance of services as an employee. Section 1.62-2(d)(3)(i) provides that the business connection requirement will not be satisfied if the payor arranges to pay an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur business expenses described in paragraphs (d)(1) or (d)(2).

Section 1.62-2(e) of the regulations provides that the substantiation requirement is met if the arrangement requires each business expense to be substantiated to the payor (the employer, its agent or a third party) within a reasonable period of time. As for the third requirement that amounts in excess of expenses must be returned to the payor, the general rule of Treas. reg. § 1.62- 2(f) provides that this requirement is met if the arrangement requires the employee to return to the payor within a reasonable period of time any amount paid under the arrangement in excess of the expenses substantiated.

Section 1.62-2(k) provides that if a payor's reimbursement or other expense allowance arrangement evidences a pattern of abuse of the rules of section 62(c) and the regulation sections, all payments made under the arrangement will be treated as made under a nonaccountable plan.

The Service has not issued any private letter rulings or technical advice memoranda concerning whether a tool reimbursement arrangement meets the accountable plan requirements. However, in a recent unreported decision, Shotgun Delivery, Inc. v. United States, No. C 98-4835 SC (January 20, 2000) (Appeal pending 9th Circuit), the United States District Court for the Northern District of California granted the government's motion for summary judgment and found that Shotgun's expense reimbursement arrangement with its employees was not an accountable plan within the meaning of I.R.C. § 62(c). The court held that the payments Shotgun made to its employees were wages subject to employment taxes.

In Shotgun, the plaintiff, Shotgun, provided courier services. It charged customers an amount, called a tag rate that was based on distance, time required for delivery, waiting time, and weight. The employees used their own vehicles for deliveries and were paid 40 percent of the tag rate. The couriers were compensated with two separate checks. The first check was a "wage check," which paid the couriers a small hourly amount. The second check was for "reimbursement of expenses/lease fee" and equaled 40% of the tag rate minus the amount paid on the wage check. Thus, couriers were always paid 40% of the tag rate. The court found the arrangement was not an accountable plan because it failed to meet the business connection requirement. Under its arrangement, the plaintiff reimbursed its drivers regardless of the actual miles driven or expenses incurred. The court concluded that "as Shotgun's reimbursement arrangement had no logical correlation to actual expenses incurred it was an abuse of section 62(c) an was therefore a nonaccountable plan." That same reasoning applies to tool reimbursements where a portion of the service tech's hourly wage payment is designated as a tool reimbursement, but the amount has no logical connection to the expenses incurred. In the typical tool reimbursement arrangement the employer carves out a portion of the worker' s hourly wage and recasts it as reimbursement for expenses, when in fact the amount treated, as reimbursement is not related the employee's expenses.

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DISCUSSION AND ANALYSIS
Employers typically claim reliance on Rev. Rul. 68-624, 1968-2 CB 424, as authority for designating a portion of an employee's compensation as a payment for the use of tools and excluding that amount from wages. Rev. Rul. 68-624 considers what percentage of the total amount paid by a corporation for the use of a truck and the services of a driver are allocable as wages of the driver for FICA purposes. The facts specify that the corporation hires a truck and driver to haul stone from its quarry to its river loading dock at a fixed amount per load and allocates one third of the amount paid the employee as wages and two-thirds as payment for the use of the truck. The ruling holds that an allocation of the amount paid to an individual when the payment is for both personal services and the use of equipment must be governed by the facts in each case. If the contract of employment does not specify a reasonable division of the total amount paid between wages and equipment, a proper allocation may be arrived at by reference to the prevailing wage scale in a particular locality for similar services in operating the same class of equipment or the fair rental value of similar equipment. 

Although Rev. Rul. 68-624 has not been obsolete, it should not be relied upon to exclude tool reimbursement payments for service technicians from wages. The analysis in Rev. Rul. 68-624 does not comport with current law because it does not consider the application of I.R.C §62(c). Under current law, tool reimbursements can be excluded from wages only if paid under an accountable plan. An employment contract that merely allocates compensation between wages and tool reimbursements will not satisfy the requirements of I.R.C. § 62(c). To exclude employee reimbursements or other expense allowance payments from wages, an employer must establish an accountable plan. An arrangement will qualify as an accountable plan if it meets the three requirements of business connection, substantiation, and return of excess.

Treas. reg. § 1.62-2(d)(1) specifies that the business connection requirement be met only if the arrangement provides advances, allowances or reimbursements for business expenses that are allowable as deductions and are paid or incurred by the employee in connection with the performance of services as an employee of the employer. Thus, not only must an employee pay or incur a deductible business expense, but also the expense must arise in connection with the employment. If an employer reimburses a deductible tool expense that the employee paid or incurred prior to employment, the reimbursement arrangement does not meet the business connection requirement. Further, if an employer pays an advance or allowance based on, for example, fair tool rental value, regardless of whether the employee incurs (or is reasonably expected to incur) the type of business expenses described above, the reimbursement arrangement does not meet the business connection requirement.  Since service techs are generally required to provide their own tools as a condition of employment, expenses paid or incurred in connection with the tools would constitute ordinary and necessary deductible employee business expenses if not reimbursed.  "Paid or incurred" requires that there be an actual expense, not fair rental value or use or some other intangible figure, with which the advance, allowance or reimbursement is associated. In the case of an advance or allowance, the payment by the employer may precede the incurring or payment of the specific expense by the employee, assuming the substantiation requirements are met in a timely manner.

Treas. Reg. § 1.62-2(e)(1) requires that each business expense be substantiated to the payor within a reasonable period of time. Treas. reg. § 1.62-2(g)(1) indicates that, in general, the determination of a reasonable period of time will depend on the facts and circumstances; however, Treas. reg. § 1.62-2(g)(2) provides a safe harbor allowing an advance to be made within 30 days of an expense, substantiation of paid or incurred expenses within 60 days, and the return of excess reimbursements within 120 days of payment or incurring. It is clear from these regulations that an advance or allowance is not intended to be open-ended or unassociated with specific, otherwise deductible, expenses. Amounts paid by the employer not representing specific expenses that are actually incurred by the employee fail to meet the terms of an accountable plan and are considered wages.

In addition to the requirement that substantiation be made on a timely basis, such substantiation of expenses must be detailed and complete. Treas. reg. § 1.62-2(e)(2) requires that, for expenses governed by I.R.C. § 274(d), the employee must submit information sufficient to satisfy the requirements of I.R.C. § 274(d) and the regulations, which deal with substantiating the amount, time, place, and business purpose of the expenses to the employer by adequate records. Treas. reg. § 1.62-2(e)(3) requires that, for expenses not governed by I.R.C. § 274(d), the employee must submit information sufficient to enable the employer to identify the specific nature of the expense and to conclude that the expense is attributable to the employer's business activities. Fair tool rental value, regardless of the accuracy of its estimation, does not satisfy this requirement, as it does not provide any information about the amount of, or the specific nature of, any expenses paid or incurred by the employee. 

The requirements set forth in Treas. reg. § 1.62-2(f) regarding the return of amounts in excess of expenses further clarify that only expenses actually paid or incurred may be treated as paid under an accountable plan. Employees are required to return to the payor within a reasonable period of time any amount paid in excess of expenses substantiated. This section specifies that an arrangement advancing money to an employee to defray expenses will satisfy the requirements of an accountable plan only if the amount of money is reasonably calculated not to exceed the amount of anticipated expenditures and the advance is made on a day within a reasonable period of the day that the anticipated expenditures are paid or incurred. A regular, routine allowance or advance for the rental value or use of tools would not meet this requirement.

Each tool reimbursement arrangement should be reviewed to determine whether the accountable plan rules are met. In addition to the factors previously discussed, there are other factors to take into account. It is relevant to know when the employer began compensating its employees in part with a tool reimbursement program. It should be ascertained whether the arrangement is written, and, if so, the writing should be reviewed to determine if its terms comply with the requirements of an accountable plan.  Such writing may be in the form of a lease, an employee handbook, or an employment contract. Whether the written terms of the arrangement are actually followed is important. The service technicians' understanding of the arrangement also should be considered. Employers frequently assert that it is industry practice to pay service techs for the use of their tools. There is no "industry practice" exception to the accountable plan requirements. After analyzing the tool reimbursement arrangement, a determination can be made whether it meets the accountable plan requirements. 

Documents to Request - Service Technician Tool Reimbursement

  • Employee Contract

  • Employment Handbook

  • Employee Lease Agreement

  • List or Schedule of Service Technicians

  • Forms W-2

Audit Techniques - Service Technician Tool Reimbursement

  1. Determine by review of the tool reimbursement arrangement whether the accountable plan rules are met. There are three requirements:

    • Business Connection 

    • Substantiation

    • Returning amounts in excess of expenses

  2. Determine when the employer began compensating its employees in part with tool reimbursement program.

  3. Ascertain if the arrangement is in writing, and if so, the review for the three requirements of an accountable plan mentioned above.

  4. Examples of written form are: in the form of a lease, an employee handbook or an employment contract.

  5. Ask the employer if the written terms are followed; consider the service technicians' understanding of the arrangement.

  6. There is no industry practice exception to the accountable plan requirements.

  7. Test compliance: Determine if expenses were not substantiated nor excess expenses were returned to the employer within a reasonable amount of time. These unsubstantiated or excess amounts are paid to a Non-accountable plan subject to Employment Taxes. The taxpayer (employer/dealership) is liable for the withholding taxes unless the employer can show the employees related income and employment tax liability has been paid.

2. MANUFACTURER'S INCENTIVE PAYMENTS TO VEHICLE SALESPERSONS
Incentive payments received as bonuses, prizes, or other incentive awards paid directly by the automotive manufacture or through the dealer to salespersons are not subject to federal withholding tax (FIT) or federal insurance contribution act (Social Security Tax - FICA). Moreover, these payments are not considered to be self-employment income and are not subject to self-employment tax. These payments are reported as "other income" on their federal income tax return, Form 1040. Revenue Ruling 70-337 explains that the salespersons are under direct control of the dealership, who performs the hiring and training functions and have all common law rules apply at the dealership level. The manufacturer directs payments the dealership or salesperson based on a sales quota or other sales incentive reached. The ruling also explains these payments are not considered wages for purposes of FICA. Similarly, no expenses may be taken on Schedule C to offset incentive payment income. Any ordinary and necessary business expenses incurred by salespersons must be reported on Schedule A subject to the 2% AGI limitation. Revenue Ruling 70-337 explains salespersons are under direct control of the dealership, which performs the hiring and training functions and all common law rules apply at the dealership level.

Publication 3204 provides a summary of how these payments should be reported.

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3. SHUTTLING SERVICES AND DRIVER/SHUTTLERS
A dealership often uses a vehicle transportation business provide services sometimes referred to as "hiking" or a "shuttling" service to transport vehicles to and/or from the dealership. For example, car rental companies will use transportation companies to transport old rental cars to auction sites. The transportation service may be hired by the dealership as an independent contractor. Summarizing the findings in Leb's Enterprises, Inc. v US 2000-1 USTC 50,182 indicate that payments to the drivers performing the services were determined to be employees subject to employment taxes by the employer.

The case involved a vehicle transportation business (Leb's). Leb's provided service for various manufacturers of vehicles and vehicle leasing companies. The various companies hired Leb's to move a vehicle from one location to another. Leb's also provided services for other different companies and Leb's drivers were usually paid a flat rate based upon the distance driven. Leb's treated most of these drivers or shuttlers as independent contractors.

The Revenue Agent reviewed Leb's schedules of payments to workers (drivers), 1099s, employment tax return, reimbursement schedules, time cards, ledgers and interview questionnaires, and determined and had been incorrectly classified as independent contractors. Moreover it was determined that all of Leb's workers did substantially similar work. Leb's treated the workers of its two main clients as employees, but treated its workers from other clients as independent contractors. It also found that many individuals who worked for the two main clients were treated as independent contractors.

The court looked at the taxpayer's consistent treatment of its workers by examining the workers' specific job duties. The court looked at the job performed not the relationship between the workers and the taxpayer. In Ren-Lyn Corp., 968 F. Supp 363 (N.D. Ohio 1997) the court determined that the law does not require that the workers performed identical job duties, only that they perform substantially similar job duties. The court found that the workers performed substantially similar work; however workers for one client were designated and treated as employees, but the other workers were being treated as independent contractors. As a result, Leb's was not entitled to the safe harbor relief provisions under §530.

The court then reviewed the facts about the classification of the workers. The court found that Leb's workers should have been treated and designated as employees and not independent contractors under federal tax laws. This is due to the considerable control of the workers including: means and method, result of individual's work, written instructions about the process and procedures involved in delivering the vehicles to their destination and certain time interval of delivery. Each of the workers were to call Leb's once or twice a day while they were on the road and complete employment applications, take drug tests and attend mandatory meetings. The workers had very little investment in their job.

The court also found support for its holding from the Second Circuit's decision in Avis Rent-A-Car System, Inc. v. United States, 503 F.2d 423 (2d Cir. 1974). In that decision, the Second Circuit held that the workers that performed car shuttling services were employees and were improperly treated and designated as independent contractors under employment tax law.

Documents to Request:

  1. List or schedule of car shuttlers, porters or car drivers

  2. Secure schedule of payments to workers

  3. Secure Form 1099's

  4. Time cards and ledgers

  5. Secure Employment agreement/contracts

  6. Secure copies of independent contractors agreements

Audit Techniques

  1. Review employment tax returns

  2. Inquire about the company's policy on classification of workers

  3. Review Form 1099's and match against list of employees.

  4. Inquire about reimbursement schedules.

  5. Review source documents such as time cards and ledgers.

  6. Review company policy about employment applications.

  7. Review copies of independent contractors agreements.

  8. Have affected individuals answer questionnaires that consider the twenty common law factors in Revenue Ruling 87-41.

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4. HOLDBACK CHARGES
When dealers acquire their new car inventory from manufacturers, usually the invoice includes a separately coded charge for "holdbacks." Dealer holdbacks generally average 2-3 percent of the Manufacturer's Suggested Retail Price (MSRP) excluding destination and delivery charges. These amounts are returned to the dealer at a later date. The purpose of the "holdbacks" is to assure the dealer of a marginal profit.

During the examination, the agent should verify that the dealer is not booking "holdbacks" as part of purchases, cost of sales, in valuing inventories, or as any other deduction for Federal income tax purposes.

 

 

Example 

From "window sticker":   

    MSRP

$10,000

   

    Destination Charges 

400

  

     MSRP Retail Total

$10,400

  

From Dealer Invoice:

    Vehicle Factory Wholesale Price 

$9,000   

    Destination Charges

400   

    Advertising Association

100 1% of MSRP   

    Holdback

300 3% of MSRP   

    Total Invoice Price

$9,800   

Holdback: coded amount is

(300) 3% of MSRP   

Inventory Cost to the Dealer

$9,500   

Dealer makes the following entry on its books:

    Inventory

9,500     

    Accounts Receivable ("Holdback")

300      

    Accounts Payable

  9,800     

Dealer makes the following entry on its books upon receipt of "Holdback" payment from the manufacturer:

    Cash

300     

    Accounts Receivable

 

300

  1. Documents to Request (note, some of these may already be available and previously requested during initial contact with the dealership/taxpayer):

    1. Dealer's Invoices of Vehicle Purchases

    2. Purchases Journal

    3. General Ledger

    4. Sales Journal
       

  2. Audit Technique

    1. Compare the dealer's invoice with the Purchases Journal and the General Ledger to determine whether dealer is correctly reporting  the "Holdback" amounts.

    2. If the dealer properly books the "Holdback" amount at the time the vehicle is purchased, there should not be any reference made to the "Holdback," in the sales journal, at the time the vehicle is sold to the customer.

The Holdback identified as a separately stated charge on the dealer invoice as part of the dealer cost is for example purpose. The amount may show somewhere on the invoice but as information for accounting purposes and not as an element of dealer cost.

  1. Law
    Rev. Rul. 72-326 provides that the dealer cannot include the $300 "Holdback" as an inventory cost. Thus, the car should be included in inventory at $9,500 and the $300 carried in a receivable account from the factory/manufacturer. The manufacturer, on the other hand, is not required to include the "$300 Holdback" in income.

Brooks-Massey Dodge Inc. v. Commissioner 60 T.C. 884 (1973). The amounts of an accrual basis dealer discount held back by the manufacturer under a plan agreed to by the dealer was taxable to the dealer in years the amount was credited to the dealership's account rather than in years received.

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5. WARRANTY ADVANCES
Dealerships perform work on vehicles, as a result of defective materials or workmanship at the time of manufacture. The manufacturer subsequently reimburses the dealership.  Because of the time delay from when the work is completed and the date the manufacturer pays the claim, the manufacturer issues credit memoranda or advances to the dealerships based on an averaging calculation (average of warranty claims submitted in a month) thereby reducing the accounts payable of the dealer for parts purchased from the manufacturer. The purpose of the arrangement is to allow the dealer a credit against amounts owed to the manufacturer before the manufacturer processes the warranty bill.

The amount of the credit is adjusted at the beginning of each year based on the average of the previous 12 months warranty claims filed and approved. Since dealers use an accrual method of accounting, all amounts due it from the manufacturer for warranty work performed through the end of the taxable year are includable in gross income. Accordingly, the amounts represented by the credit memorandum issued by the manufacturer, pursuant to the credit arrangement, are not includable in the gross income of the dealer, but merely represent a reduction of the accounts receivable representing the amount due from the manufacturer for warranty work performed.

  1. Example-Warranty Advances
        Adjusting Journal Entry:
        Credit Memoranda: ABC Manufacturer                                 $10,000
                                           Parts Purchased . ABC Manufacturer $10,000
        To record warranty advances from ABC manufacturer

  2. Documents to Request- Warranty Advances

    1. Credit Memorandums from Manufacturer

    2. Accounts Payable Journal

    3. Accounts Receivable Journal

    4. General Ledger

    5. Dealer Franchise Agreement

  3. Audit Techniques-Warranty Advances

    1. Review adjusting journal entries or reversing entries at year end/beginning of year for warranty advances and compare to Other Income.

    2. Determine that accounts receivable from manufacturer reflect reduction of income of warranty advance.

    3. Determine that accounts payable of the dealer is reduced for parts purchased from the manufacturer of warranty advance.

    4. Review dealer franchise agreement to for the provision of a credit arrangement on warranty advances or other provisions set up for warranty work.

  4. Law
    IRC section 446(a) provides, in pertinent part, that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. 
    IRC section 451 provides that the amount of any item of gross income shall be included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be accounted for as of a different period.

  5. Rev. Rul. 72-595 
    The amounts represented by the credit memorandum issued by the manufacturer are not includable in the gross income of the dealer, but merely represent a reduction of the dealer's accounts receivable for amounts due from the manufacturer for warranty work performed.

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6. FINANCE RESERVES
One income issue found in new car dealerships has to do with the manner in which Finance Income is reported. When dealerships sell cars, they also arrange financing for the buyer. These finance contracts are usually sold to a financial institution and the dealership typically participates in the income derived from these contracts. The amount of income depends on a pre-arrangement with the financial institution where the dealership earns a greater amount if the financing is more lucrative.

Ordinarily, the financial institution and the dealership establish an account called a "Dealer Reserve Account" that is credited, with the dealership's "commission" for arranging financing for the buyer, when the financing company determines the income allocation. This account may also be charged (reduced) when a contract with recourse to the dealership defaults. In most instances the financial institution holds part of the dealer's reserve to cover contingent events (i.e. in the event the note is prepaid early or the car is repossessed).

I. Example

A dealer sells a car to a customer for the following:
    Sales Price (including Sales Tax and license fees)    $10,000
    Less: Down payment                                                  1,000
    Balance to be Financed                                           $ 9,000

    Finance Charge @ 10 percent                                       900
    Face amount of Installment Note                              $ 9,900

    The dealer sells the note to a finance company that agrees to pay the dealer a 20 percent commission on
    the finance charge, or $180.

The correct way for the dealer to handle the transaction is as follows:
                                                                               Debit             Credit
Cash                                                                         9,000
Finance Charge Receivable                                          180
Customers' account receivable                                                     9,000
Finance Income                                                                              180

See current IRM.

  1. Audit Techniques--Finance Income

    1. Determine the presence of a "deferred income" account.

    2. Inspect the monthly statements submitted to the dealer by the finance company (is).

    3. Probe into the possible existence of related corporations set up to handle the installment notes. See also the chapter on Related Finance Companies in this Guide.

    4. Sample selected transactions to verify that the taxpayer was using the accrual method.

  2. Law
    In Commissioner v. Hansen, 360 U.S. 446 (1959), the Supreme Court held that the amount held back or retained by the finance company is taxable to the dealership at the time the installment note is sold and the dealership has a fixed right to the reserve account.
    Dealers must include in income all amounts placed in the reserve all deposits into the account regardless of use. See Resale Mobile Homes, Inc. v. Commissioner, 965 F.2d 818 (10th Cir. 1992).

COMPENSATION ISSUES
In addition to the normal employment tax requirements applicable to auto dealerships, there are other employment tax considerations unique to the auto industry.

1.  Auto Demonstrator Vehicles
In December 2001, IRS issued Revenue Procedure 2001-56. This revenue procedure provides guidance for the taxation of the personal use of an auto demonstrator vehicle provided by automotive dealers to their employees. This revenue procedure allows the dealer, instead of the salesperson, to determine the taxability of a demonstrator vehicle.  An auto dealership may use any of the methods in the revenue procedure OR may use the existing rules as defined in IRC 132(j)(3) and Reg. 1.132-5(o)(4).

Rev. Proc. 2001-56, and Publication 4230 for taxpayers, provides four methods to determine the amount taxable to the employees:

  • Full Exclusion Method - clarifies the existing rules under current law. This method provides complete exclusion from taxation for the use of a demonstrator vehicle.

  • Simplified Out/In Method - provides simplified record keeping requirements for the Full Exclusion Method.

  • Partial Exclusion Method - allows for partial taxation of an auto demonstrator vehicle with limited record keeping requirements. Most auto dealerships are expected to adopt this method.

  • Full Inclusion Method - allows a dealership to use the Annual Lease Value tables, as defined in Treas. Reg. 1.61-21(d)(2)(iii), to determine the taxable value of a demonstrator.

If the auto dealer cannot qualify for one method, the dealer may qualify for one of the other three methods.

In order to use any of the first three methods, the driver of the demonstrator vehicle must qualify as a full-time salesperson and the dealership must have a written policy. A sample written policy is included in Appendix A and B of the revenue procedure. 

The rules to qualify as a full-time salesperson are: [ref. IRC 132-5(o)(5)]

  • Must be a full-time employee of an automobile dealer

  • Must spend at least half of a normal business day performing the functions of a floor salesperson or sales manager

  • Must directly engage in substantial promotion and negotiation of sales to customers

  • Must derive 25% of his or her gross income directly as a result of sales activities

The written demonstrator agreement must contain the following:

  • Prohibit the use of the vehicle outside of normal business hours by individuals other than full-time salespeople

  • Prohibit the use of the vehicle for personal vacation trips

  • Prohibit use outside of the sales area in which the dealership's sales office is located

  • Prohibit storage of personal possessions in the vehicle

  • Employer must reasonable believe that the salesperson complies with the written policy

Any full time employee of the dealership can use the fourth method.

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Full Exclusion Method1
The Full Exclusion Method allows for full exclusion from taxable income, the use of a demonstration automobile by a full-time automobile salesperson. This method clarifies the existing tax treatment of auto demonstrators under IRC 132(j)(3) and Reg. 1.132-5(o)(4).

It is expected that most dealerships will NOT adopt this method.

Simplified Out/In Method2
The Simplified Out/In Method provides a simplified method for a dealer to document the use of a demonstration automobile by a full-time automobile salesperson. Under this method, the total miles that a demonstrator is used during normal working hours is considered business miles and only mileage outside of normal working hours is considered.

For each demonstrator, the dealer must record the mileage at the end of the day and again at the beginning of the following day. The miles driven during this time cannot exceed the salesperson's commute plus 10 miles. The employer must determine if the personal miles exceed an average of 10 miles per day, no less often than monthly. If the average personal miles are less than 10 miles per day, and all other requirements of this section are met, the salesperson's use of the demonstrator is not taxable. 

The taxpayer is required to maintain the following records:

  • Evidence that the salesperson's personal use by mileage was calculated no less often than once each calendar month. This may include:

    1. Records identifying each demonstrator assigned to each salesperson

    2. Records identifying the total mileage for each demonstrator

    3. Records supporting the total use outside of normal working hours. Employer should maintain records of out and in mileage of the demonstrator for each day it is used.

    4. Records identifying the round trip commuting mileage of each salesperson assigned a demonstrator from the salesperson's home to the dealer's sales office.

The employee is not required to maintain any records except to the extent the employee is required to provide information to the dealer to allow the dealer to maintain the records as noted above.

Partial Exclusion Method3
The "Partial Exclusion Method" provides that an amount is to be included in the taxable income of a full-time salesperson at least monthly for the use of the demonstrator vehicle. Under this method, the dealer is not required to keep any records documenting the use of the demonstrator.

The taxable amount is obtained from the table below and is based upon the value of the vehicle. The taxable amount applies for each day a salesperson is provided a demonstrator, including non-work days.

Value of the Demonstration Automobile         Daily Inclusion Amount
                    0 - $14,999                                                         $3
            $15,000 - $29,999                                                     $6
            $30,000 - $44,999                                                     $9
            $45,000 - $59,999                                                   $13
            $60,000 - $74,999                                                   $17
            $75,000 and above                                                  $21

Full Inclusion Method4
The Full Inclusion Method is available to any full-time employee of the dealership. This method allows an automobile dealer to use the Annual Lease Value tables [Ref 1.61-21(d)(2)(iii)] to determine the amount the employee must include in his or her income for their use of a demonstrator vehicle. This method does not allow any reductions in
the inclusion amount for the employee's business use.

The dealer is required to include the taxable amount in the employee's wages no less often than monthly.

Annual Lease Value Table
Value of Demonstration Automobile             Daily Inclusion Amount
              $0 - 2,999                                                               $ 3
            3,000 - 4,999                                                               4
            5,000 - 5,999                                                               5
            6,000 - 7,999                                                               6
            8,000 - 8,999                                                               7
            9,000 - 10,999                                                             8
            10,000 - 11,999                                                           9
            12,000 - 12,999                                                         10
            13,000 - 14,999                                                         11
            15,000 - 15,999                                                         12
            16,000 - 17,999                                                         13
            18,000 - 18,999                                                         14
            19,000 - 20,999                                                         15
            21,000 - 21,999                                                         16
            22,000 - 23,999                                                         17
            24,000 - 24,999                                                         18
            25,000 - 25,999                                                         19
            26,000 - 27,999                                                         20
            28,000 - 29,999                                                         21
            30,000 - 31,999                                                         23
            32,000 - 33,999                                                         24
            34,000 - 35,999                                                         25
            36,000 - 37,999                                                         27
            38,000 - 39,999                                                         28
            40,000 - 41,999                                                         29
            42,000 - 43,999                                                         31
            44,000 - 45,999                                                         32
            46,000 - 47,999                                                         34
            48,000 - 49,999                                                         35
            50,000 - 51,999                                                         36
            52,000 - 53,999                                                         38
            54,000 - 55,999                                                         39
            56,000 - 57,999                                                         40
            58,000 - 59,999                                                         42

Annual Average Look Back Method5
The "Annual Average Look Back Method" is available for a dealer to determine the value of his or her demonstration vehicles provided to its salespersons when the dealer is using the Partial Exclusion Method or the Full Inclusion Method. This method may be used to value the dealerships' demonstrators instead of valuing each demonstrator individually.

The value of any new demonstration automobile is based on the average sales price of all vehicles sold in the prior year. It is calculated by taking the sum of the sales prices of all new car and truck sales in the prior calendar year and dividing that sum by the number of new vehicles sold in the prior year.

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Example:

In 2001, (Manufacturer's Statement) New Car Gross Receipts: $23,226,000

The dealership sold 948 vehicles

$23,226,000 = $24,500 annual average vehicle
948 vehicles

Using the table provided for the Partial Exclusion Method, the amount calculated above is between $15,000 to $29,000 range and the daily inclusion amount accordingly is at $6.00/day.

Using the table provided for the Full Inclusion Method. The amount calculated above is between $24,000 - $24,999 range and the daily inclusion amount accordingly is at $18/day.

The average sales price must be determined in January of each year and must be applied no later than February of that year. In the above example, for each month ending on or after February 1, 2002 to January 31, 2003, the dealer includes in the employees W-2, $6 per day under the Partial Exclusion Method and $18 per day under the Full Inclusion Method.

Some manufacturers' statements state the value of demonstrator vehicles as a separate line item. The dealership is permitted to use this value instead of the broader New Car Gross Receipts item. However, the dealership must the same method from year to year.

Consistency is required
Revenue Procedure, 2001-56, Question 34 provides several examples of determining the annual average sales price of a demonstrator vehicle. For example, if the dealership operates more than one franchise at a single physical location, the annual average sales price for all salespeople may be based on the combined sales of all franchises operating at that store.

If a salesperson is only provided demonstration automobiles from a single franchise operating out of the store, the dealer may base the annual calculation of value of that salesperson on the sales of the specific franchise. In that case, the value for all salespeople in the store must also be based on specific franchises.

The dealer can use this method for used car demonstrators. Questions 33 and 34 address scenarios for used car demonstrators. 

Documents to Request

  • The dealership's written demonstrator policy

  • Payroll records including W-2's and payroll journals

  • Listing of employees that were given a demonstrator vehicle

  • Determination of the valuation of the demonstrator vehicles

Audit Techniques
The dealership is not required to make an election to use any of the methods in Revenue Procedure 2001-56. Upon examination, ask the dealership which method, if any, the dealership adopted.

As stated earlier, it is expected that most dealerships will adopt the Partial Exclusion Method. The agent should verify the following:

  • The dealer has a qualified written policy, the policy was communicated to employees, and there is no evidence that the salesperson violated the written policy. 

    • Documentation of communication to employees of the policy may include a copy of a poster notifying employees, a copy of a letter or electronic communication, or signed statements by the employees acknowledging receipt of the written policy. 

  • Payroll records should indicate that withholding and income are properly accounted for on a monthly basis

    • The dealer is not permitted to elect under IRC 3402(s) not to withhold income taxes from the portion of the vehicle fringe benefit required to be included in the employees' W-2.

      • The monthly withholding requirement is intended to substitute for more specific record keeping requirements for substantiating the use of the demonstrator. Annual inclusion and withholding of other employment taxes with respect to noncash fringe benefits allowed under Announcement 85-113, 1985-31 I.R.B. 31 is unavailable under the methods provided by this revenue procedure. 6

  • Salespersons are assumed to have the use of a demonstrator for every day of the period under consideration. If the dealer states otherwise, he or she should be able to provide evidence.

  • The dealer should be able to support the determination of the value of the demonstrators. If the dealer has multiple franchises, locations and/or has used vehicles for demonstrators, the dealer must be consistent in the valuation method
    that is employed. 

If a dealership does not qualify for one method, the dealer may still qualify to use one of the other methods described in the revenue procedure.7

Examples:

  • If a dealership attempts to use the Simplified Out/In method and does not qualify (i.e. average personal miles > 10 miles per day), the dealer can use the Partial Exclusion method as long as the correct tax is withheld from the salesperson.8

  • If a dealership attempts to use the Partial Exclusion method and does not qualify (i.e. employee not a full-time salesperson), the dealer can use the Full Inclusion method as long as the correct tax is withheld from the salesperson.9

Inadvertent Errors
Revenue Procedure 2001-56, Question 51 addresses inadvertent payroll errors. If an error is identified and corrected during the calendar year, the dealership is permitted to use the revenue procedure. If the error is NOT corrected within the calendar year, the dealership must determine the taxable amount under the general valuation and substantiation rules.

Employees other than full-time salespeople

If the employee provided the use of a demonstrator is not a full-time salesperson, the full exclusion and the partial exclusion methods do not apply. The employer may use the full inclusion method to determine the value of the demonstrator, but cannot reduce the taxable amount to account for business use by the employee.

Treas. Reg. 1.274-6T provides other methods for excluding from an employee's income a portion of the value of the use of a demonstrator. This regulation generally allows an employer implementing certain written policies restricting personal use to account for commuting and de minimis personal use by any employee by including the $1.50 per one-way commute provided under Treas. Reg. 1.61-21(f)(3) in the employee's income and providing other evidence allowing a determination that use was actually limited.

Questions 48-50 in the revenue procedure address other applications of Treas. Reg. 1.274-6T.

General Valuation Rules
If a dealer does not use any of the above methods and the method he or she does use does not qualify under the code and regulations, the dealer must use the general valuation rules to value the use of the demonstrator vehicles.

2.  Fringe Benefits
Often, a dealership permits its employees, shareholders, or directors to use its automobiles or purchase them at a discount. This benefit is includable in the recipient's gross income unless it is excludable by a specific statutory provision. In the case of automobiles provided by a dealer, one of the following may be applicable: no additional cost services, defined in IRC 132(b); qualified employee discounts, defined in IRC section 132(c); and working condition fringes, defined in IRC section 132(d).

Qualified Employee Discounts
The amount of any discount provided to an employee on the purchase of an automobile from the dealer is excludable from the employee's gross income to the extent that the rules of IRC section 132(c) are satisfied. The exclusion applies if the property or service is provided at no charge, at a reduced price, or the benefit is provided through a partial or total cash rebate. Only that portion of the discount that falls within the guidelines is excludable from income. Any discount in excess of that amount must be included in the employee's income.

Documents to Request

  • Listing of employees and related parties that received an employee discount

  • Determination of how the dealership determined the excludable amount.

Audit Techniques
The maximum excludable discount that an employee can receive on an automobile is the dealer's gross profit percentage on that automobile multiplied by the price at which it is offered to non-employee customers. See IRC section 132(c)(2)(A) and (B). For purposes of this rule, an ¡°employee¡± includes current employees, spouses of employees, and dependent children of employees, etc. See Treas. Reg. Section 1.132-1(b)(1). Accordingly, discounts provided to non-employee shareholders and directors are not excludable from gross income under this rule. The amount of any discounts provided to these individuals should be treated as a constructive dividend.

3.  Working Condition Fringes

  1. General Rule
    An employee's use of an employer-provided automobile is excludable from gross income as a working condition fringe only to the extent the following three requirements are met:

    1. The employee's use of the automobile is related to the dealer's trade or business;

    2. The employee would have been entitled to a deduction for a business expense or for depreciation (IRC sections 162 or 167) if he or she had purchased the automobile that was provided by the employer; and

    3. The business use of the automobile must be substantiated by adequate records under the substantiation requirements of IRC section 274(d). See Treas. Reg. Section 1.132-5(c).

An "employee" includes current employees, partners who perform services for the partnership, directors, and independent contractors. See Treas. Reg. Section 1.132-1(b)(2).

Documents to Request:

  • List of employees that received a vehicle whose value was excluded from their gross income.

Audit Techniques
Auto demonstrator vehicles do not qualify as a working condition fringe. Auto demonstrator vehicles will not qualify under Rule #2 above. Vehicles granted as a working condition fringe should be scrutinized as disguised demonstrator vehicles.

4.  Unreasonable Compensation - C Corporations
Most auto dealerships are closely held corporations with a few shareholders. The general manager (sometimes the minority shareholder) is the person who runs the day-to- day operations of the dealership. His or her duties may include: hiring, training, promoting and supervising personnel; maintaining relations with the manufacturer; developing advertising; writing and placing advertising copy; establishing lines of credit and flooring arrangements. However, in most cases the majority shareholder/president of the dealership is the highest compensated employee. Pension contributions are a form of compensation and should be considered in determining whether the amounts deducted as compensation are reasonable.

It is customary for automobile dealerships to pay top management employees incentive bonuses based on a percentage of net profits in addition to their basic monthly salaries, regardless of whether such employees own stock in the dealership. Often the officers and other key employees are paid relatively modest salaries, which are supplemented by the bonuses.

Documents to request

  • Payroll records of highly compensated employees

  • Listing of year-end bonuses.

  • Corporate minutes

  • Dealership Franchise Agreement

Audit Techniques
In order to determine if unreasonable compensation issue exists, the following factors should be present:

  • Salary and bonuses are in excess of industry practice without a valid business reason.

  • The officer/shareholder is not the primary responsible person for the level of growth, productivity and financial success of the dealership.

  • If large year-end bonuses were paid, there is no evidence of a pre-determined formula or other industry accepted method of determining the amount paid.

  • The shareholder is a relatively new franchise owner with little previous experience, yet the owner's compensation is in excess of the franchiser's guidelines.

IRS has litigated many reasonable compensation cases. In the cases where IRS was successful, the above factors were present.

Audit trail

  • Obtain documentation of salaries and wages (paid and accrued) for the managers of the various departments by inspection of Forms W-2 and the payroll registers. Yearend bonuses are reflected as accrued salaries and a detail of the employees would reflect amounts paid to the managers.

  • Review the corporate minutes for the authorization of salaries and bonuses. The minutes may reveal the method of determining salaries and bonuses, economic and financial concerns of the corporation and the dividend history of the corporation.

  • Dividends paid should be reflected on Schedule M-2 and as a reduction to the retained earnings account.

  • Review of prior year tax returns (4 years) could indicate whether the officers had been underpaid in prior years and establish a salary history for the officers.

  • Examine the travel and entertainment expense with the intent of scheduling the officer/shareholder's activities (business and non-business) throughout the year.

  • The Dealership Franchise Agreement may provide information as to working capital agreements ("Minimum Capital Standard Agreements") and identify certain key employees of the dealership (i.e., president, general managers and shareholders).

  • Employee specific factors include:

    • Educational level and experience

    • History of salary increases and changes in responsibility or productivity

    • Employee contributions to the success and growth of the business

    • Comparison of officer's salaries with other comparable dealership

The following court cases have addressed compensation for auto dealerships:

Automotive Investment Development, Inc vs. Commissioner, T.C. Memo. 1993-298. The Court determined that the compensation paid to the owner was reasonable. The officer purchased marginally successful dealerships and increased their profitability dramatically. The owner paid himself according to a formula that was widely adopted in the automotive industry.

Lloyd Schumacher Chevrolet-Buick, Inc. v. United States, 80-2 U.S.T.C. (CCH) Paragraph 9576. The Court held that the compensation paid to the owner was reasonable. The owner was solely responsible for all operations. The increase in sales was attributed to the actions of the owner and the bonus formula he paid himself was reasonable.

Castle Ford, Inc. v. Commissioner, T.C. Memo. 1978-157. The Court revised the compensation paid to its owner. The owner was paid a salary several times higher than his salary paid in the prior year. The owner was able to substantiate part of the increase because the large increase in profits was due to his effort. However, since he had full control of his salary, part of this was considered excessive.

Good Chevrolet v. Commissioner, T.C. Memo. 1977-291, CCH 34,606(M). The Court determined that the compensation was reasonable because of the officers' qualifications, the requirement of minimum working capital, and compensation and bonuses were computed based on a predetermined formula.

Osborne Motors, Inc. v. Commissioner, T.C. Memo. 1976-153. The Court held that the compensation paid to its owners was reasonable. The owners were responsible for all material operations and success of the dealership. Even though the owners spent 3 months of the year out of the area, they reviewed financial information frequently and made decisions based upon that information.

Superior Motors, Inc. v. Commissioner, T.C. Memo. 1974-187. The Court revised the compensation paid to its owner. The Court determined that the bonus paid was not consistent with established industry practice.

Skyland Oldsmobile, Inc. v. Commissioner, T.C. Memo. 1972-17. The Court found that the salary and bonus paid to its CEO was reasonable. The CEO worked long hours, was responsible for all phases of its business, and was responsible for the dealership's improved condition.

East Tennessee Motor Company v. United States, 453 F.2d 494. The Court held that the owner's salary was unreasonable. There was no specific formula used in determining whether his salary was reasonable or unreasonable or was payment for something other than services rendered.

Van's Chevrolet, Inc. v. Commissioner, T.C. Memo. 1967-172. The Court revised the compensation paid to its shareholder. The shareholder did not have a set bonus formula in accordance with industry guidelines.

City Chevrolet Company v. Commissioner, 228 F.2d 894 (4th Cir. 1956). The Court determined that the owners' compensation was unreasonable because the owners did not have an established arms-length salary policy.

Key Buick Co. v. Commissioner, T.C. Memo. 1976-303. The Court revised the compensation paid to the corporation's president. The officer was a part time employee and his salary was not determined by an established policy.

University Chevrolet Company, Inc. v. Commissioner, 16 T.C. 1452 (1941). The Court determined that the compensation paid to the sole owner was excessive. The owner's previous salary determination under a bonus-stock purchasing arrangement adopted by the manufacturer to obtain and establish dealers is not determinative of reasonable compensation of the same officer after he becomes owner of all of the stock.

OTHER MISCELLANEOUS ISSUES
As this section is introduced, several of these fees such as Enrollment and Pool Capping fees refer to sub prime financing. Refer to the Sub Prime Finance chapter for further information.

A.   Enrollment Fee - Generally, dealers must pay an enrollment fee to enter into an agreement to transfer notes to a finance company. The dealership may pay a nonrefundable fee to the finance company to join the program. Pursuant to TAMs (IRS Letter Rulings 9840001, 199909002, and 199909003, this fee is an IRC section 263 capital expenditure and is not deductible 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 of the Code does not apply.

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.

B.   Pool Capping Fee - When the finance company decides that the pool notes should be closed (usually at around 100 notes), the dealership may pay a nonrefundable fee to the finance company to cap the pools. This is done so that the dealership will have a better prospect of receiving back end payments. 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 not specified in years because it is based on the number of contracts involved. This fee would also fall under IRC § 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.

C.   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. The fee is deductible as the services are provided by the finance company in accordance with the economic performance rules of IRC §461.

D.   Mark to Market - Section ¡×475 of the Internal Revenue 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 was 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 amended Section 475. Mark-to-market can no longer be used for a receivable that is produced from the sale of non-financial goods or services by a taxpayer whose principal activity is the selling or providing of non-financial goods and services.

E.   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, an IRC §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 §446. The facts and circumstances of each situation must be considered to determine if a change in method has occurred.

Documents to Request . Change of Accounting Method

  • Form 3115 for Request for Approval of Change of Accounting Method, including termination of LIFO inventory valuation method.

Audit Techniques:

  • IRM, Section 4.10.3, Examination Techniques, [Revision date: 2001-07-31] Changing a Taxpayer's Method of Accounting.

  • If the taxpayer has terminated its LIFO election, review return for Schedule M-1 and ¡°other Income¡± for LIFO recapture. Request schedule of 481(a) adjustments.

  • Review computations for appropriateness and compliance.

F.   Used Car Donation Programs - Due to an increasing number of advertisements for used car donations to charity, concern has arisen for two claims made in some of the advertising. In one instance, a charity enters into an agreement with a for-profit company. For a fee, the for-profit company will conduct the entire campaign with little or no involvement by the charity. The for-profit company begins with the solicitation of used auto donations, followed by the vehicle pickup and then final disposition of the vehicle. To be deductible as a gift "to" charity, used cars must, in actuality be given "to" the charity or, at the least, an agent of the charity. The arrangement described above does not qualify as an agency relationship because the charity is not supervising the activity. Thus, the donor is not be entitled to a charitable deduction in any amount. The other concern is proper valuation of the donated vehicle. Some promotions claim full blue book value regardless of vehicle's operating condition. The term "blue book" appears to describe many valuation lists prepared by many different companies. Generally, however, these lists only value used cars "in running condition" (not poor or inoperable condition). Lastly, the charity should be legitimate. Referrals of individual donors may be made to Exempt Organizations now known as Tax Exempt & Government Entities Business Operating Division).

Documents to Request:

  1. Form 8282 from the Exempt Organization that shows the Employer Identification Number

  2. A qualified appraisal of the vehicle to the donated charity must accompany statement

Audit Techniques:

  1. Ask if the taxpayer is related to the exempt organization

  2. To confirm exempt status go to the Cumulative List of Exempt Organizations Publication 78 which is an online search tool that allows users to select an exempt organization and check certain information about its federal tax status and filings.

  3. Inquire about fair market value of donated car- possibly overvalued? Was a used car-pricing guide considered in determining the fair value? 

  4. Inquire if the dealership is acting as a 3rd Party and making  payments to the charity for the donated vehicles during fund raising programs. If so, the donated goods exception (section 513(a)(3)) to the unrelated business income tax provisions might not apply. Contact Exempt Organizations for assistance. An EO referral Form 5666 for a collateral examination request may be necessary.

Law: 170(c) (2); 170 (f)(8) and Revenue Ruling 2002-67

Revenue Ruling 2002-67 discusses the car donation issue: a privately owned car dealership administers a section 170(c)(2) charity's car donation fundraising program as its authorized agent. In the examples provided, one individual donates a car in excellent condition to the dealership and another donates a car in poor condition.

The IRS concludes that the donor's transfer of the car to the charity's authorized agent may be treated as a transfer to the charity. Also, the authorized agent may give to the donor the contemporaneous written acknowledgment required by section 170(f)(8).  Finally, the IRS concludes that the donor may use an established used car pricing guide to determine the car's fair market value as long as the comparison is for the same make, model, and year, is sold in the same geographical area, and in the same condition as the donated car. If not, the donor must use some other reasonable method.

For information regarding a charity's obligation to report amounts paid and received in connection with fund-raising programs, see Instructions for Form 990 and Announcement 2002-87, 2002-39 I.R.B. 624.

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G.   Credit for Qualified Electric Vehicles:

IRC section 30(a) allows a credit for up to 10% of the cost of a qualified electric vehicle limited to a maximum credit of $4,000 with no carryback/carryover of any unused credit. The credit is shown on Form 8834 and can be claimed by an individual who buys one for their personal use (does not have to be used in a trade of business).

Toyota and Honda have come out with a gasoline/electric "hybrid" type vehicle, which runs on gasoline but has battery powered drive mechanism, which does not require a charger hookup since the gasoline engine charges the battery (batteries). The Form 8834 cautions that such "hybrids" do not qualify. See next section on Hybrid Vehicles

H.  Clean .Fuel vehicle property -  Hybrid Vehicles: Manufacturer' s certification of incremental cost Revenue Procedure 2002-42 sets forth a process that allows a taxpayer who purchase certain clean-fuel vehicle property to rely on a manufacturer's certification of the incremental cost of the property for purposes of the clean-fuel vehicle property deduction under Code Section 179A.

This procedure applies to motor vehicles (other than buses, trucks, and vans with a gross vehicle weight rating greater than 10,000 pounds) that are propelled by both a gasoline internal combustion engine and an electric motor that is recharged as the motor vehicles operate (hybrid vehicles) and that otherwise meet the requirements of §179A.

Qualified Motor Vehicles

To be eligible for the deduction under §179A, a motor vehicle must: 

  1. Meet the applicable federal and state emissions standard respect to each fuel by which the vehicle is propelled

  2. Be manufactured primarily for use on public streets, roads, and highways

    1. Have at least four wheels; and

    2. Not operate exclusively on a rail or rails.

Section 179A and this revenue procedure do not apply to motor vehicles that are primarily powered by electricity and qualify for the credit provided in §30 or to motor vehicles that are used predominantly outside the United States.

Deduction Amount Limitations.
Under §179A, except in the case of any truck or van with a gross vehicle weight rating greater than 10,000 pounds or any bus with a seating capacity of at least 20 adults (not including the driver), the maximum cost that may be taken into account when determining the deduction is:

  • $2,000 for motor vehicles placed in service on or before December 31, 2003.

  • The $2,000 maximum is reduced by 25 percent for motor vehicles placed in service in calendar year 2004,

  • 50 percent for motor vehicles placed in service in calendar year 2005,

  • and 75 percent for motor vehicles placed in service in calendar year 2006.

  • No deduction is allowed for motor vehicles placed in service after December 31, 2006.

  • No deduction is allowed with respect to the portion of the cost of any property taken into account under §179.

Procedure
.01 Original Equipment Manufacturer's Certification. An original equipment manufacturer (or in the case of a foreign original equipment manufacturer, its domestic distributor) may prepare a certification concerning the incremental cost of permitting the use of electricity to propel its vehicles. The certification should contain the following information:

(1) The name and address of the certifying entity;
(2) The make, model, year, and any other appropriate identifiers of the motor vehicle; and
(3) A statement disclosing the total per-vehicle cost to acquire and install the motor vehicle's electric motor and related generating, storage, and delivery equipment. If the total cost exceeds $2,000, the statement may so indicate without disclosing the specific amount of the cost.

The certification should be signed by an officer of the original equipment manufacturer (or, in the case of a foreign original equipment manufacturer, an officer of its domestic distributor). This original signed certification must be sent to:

Internal Revenue Service, Industry Director,
Large and Mid-Size Business, Heavy Manufacturing and Transportation,
Metro Park Office Complex--LMSB,
111 Wood Avenue, South
Iselin, New Jersey 08830.

02 Internal Revenue Service's Acknowledgment. The Internal Revenue Service will review the original signed certification and issue an acknowledgment letter to the original equipment manufacturer (or, in the case of a foreign original equipment manufacturer, its domestic distributor). This acknowledgment letter will state whether purchasers may rely on the certification.

03 Purchaser's Reliance. Copies of the certification and acknowledgment may be made available to purchasers. Except as otherwise provided in the acknowledgment, a purchaser of a hybrid vehicle may rely on the certification concerning the incremental cost of permitting the use of electricity to propel the vehicle.

I.   Cost Segregation
This issue relates to the reallocation of building costs from 39 year to 5, 7 or 15-year MACRS property. It is applied to buildings that are purchased, constructed, renovated or expanded.

An example is "Building Related Costs" and many consulting firms rely on Hospital Corp of America, Inc. v. Commissioner, 109, T.C. 21 (HCA case) Not acquiesced: FSA 2001-1001

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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.

  • Identification of Tangible personal property

  • Not required for normal operation or maintenance of building

  • HCA 5-Year Property identified as

    • Allocable portion of electrical system

    • Wiring for telephones and televisions

    • Carpeting and vinyl tile

    • Vinyl wall covering

    • Plumbing and exhaust systems for kitchen equipment

    • Corridor handrails

    • Room partitions

  • Reclassified into shorter depreciation periods

The court case found its focus of inquiry was the ultimate use of property. The Service acquiesced the legal conclusion but not the use of the structural components.  Chief Counsel Advice (CCA) 199921045 mentioned the following:

  • Structural component or tangible personal property is a facts and circumstances assessment

  • No "bright line" test exists

  • Studies must be based on contemporaneous records

  • It must not use reconstructed data, estimates, or assumptions with no supporting records

  • A change in the recovery period is a change in the method of accounting.

  • Revenue Procedure 99-49, 1999-2, C.B. 725 allows for the change using the automatic provisions set forth in the procedure

Audit Techniques:

  1. Review Taxpayer's depreciation schedules

  2. Look for recently constructed, renovated, or purchased real property

  3. Look for re-allocations of the cost of real property that was placed in service in the past from 39-year to 5,7, or 15 year MACRS.

  4. Present in all industries.

Documents to Request:

  1. Request the taxpayer's work papers and supporting documentation

  2. Engineering Referral.

This methodology is being promoted by tax consultants, manufacturing industries and accounting firms; and under study by the Large and Mid-Size Business division. 

J.   Oldsmobile Dealer Franchises and Involuntary Conversion (Internal Revenue Code §1033) treatment - The treatment of payments for Oldsmobile dealers is still being discussed. This section will be updated as the law changes. In July 2002 Senate Bill 2726 was introduced due to the decision of General Motors to eliminate the Oldsmobile product line in December 2000. GM offered Oldsmobile dealers other dealership opportunities to assist in the phase-out of that line. A revenue ruling is pending at the writing of this section. 

There is a private letter ruling issued in 2002 which applies specifically only to that dealership.

At issue:
    Does the cancellation of Oldsmobile franchises qualify for capital gains treatment?

The requirements for capital gain treatment are:

  1. Disposition is a sale or exchange

  2. The asset is a capital asset defined in Internal Revenue Code §1221.

Proposed ruling:

  1. Amounts received by the dealer qualify as amounts received per Internal Revenue Code §1241 and Treasury Regulations 1.1241-1(c)

  2. This applies to marketing or marketing/servicing agreements

  3. The distributor must have substantial capital investment, i.e. the Oldsmobile dealership qualifies.

  4. However, franchises qualify as an amortizable IRC §197 asset

    1. §197 assets are NOT capital assets

    2. EXCEPTION to §197 is gain from sale or exchange for IRC §1231 assets (property used in a trade or business for over one year qualifies as §1231 property)

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Conclusion

  1. This ruling is for the Automobile industry only

  2. The distributor agreement is a franchise under §1253(b)(1)

  3. The dealer has substantial capital investment

  4. The gain from cancellation is a capital gain.

GLOSSARY
Cost Segregation: The reallocation of building costs from 39 year to 5, 7 or 15-year MACRS property

Enrollment Fee: Generally, dealers must pay an enrollment fee to enter into an agreement to transfer notes to a finance company.

Finance Reserves: The manner in which Finance Income is reported. Ordinarily, the institution and the dealership establish an account called a "Dealer Reserve Account" that is credited, with the dealership's "commission" for arranging financing for the buyer, when the finance company determines the income allocation.

Holdback Charges: When dealers acquire their new car inventory from manufacturers usually the invoice includes a separately coded charge for "holdbacks"

Pool Capping Fee: When the finance company decides that the pool notes should be closed (usually at around 100 notes), the dealership may pay a nonrefundable fee to the finance company to cap the pools.

Shuttling service: To transport vehicles to and/or from the dealership; hence a car shuttler is a person who performs those services.

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)

Service Techs: Also known as automobile mechanics, motor vehicle technicians; a person who services motor vehicles

Warranty Advances: An account established when dealerships perform work on vehicles, as a result of defective materials or workmanship at the time of manufacture. The manufacturer subsequently reimburses the dealership and charged against the account.

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Other Sources of Information

IRC sections: § 62(c), 170, 179A, 197, 274, 446, 451, 475, 481(a), 483, 501 and 1001, 1221, 1241, 3121(a), 3306(b) and 3401(a).

IRM, Section 4.10.3, Examination Techniques

Revenue Ruling 70-337: explains salespersons are under direct control of the dealership, which performs the hiring and training functions and all common law rules apply at the dealership level

Rev. Rul. 72-326, provides that the dealer cannot include the $300 "Holdback" as an inventory cost.

Rev. Rul. 72-595 The amounts represented by the credit memorandum issued by the manufacturer are not includable in the gross income of the dealer, but merely represent a reduction of the dealer's accounts receivable for amounts due from the manufacturer for warranty work performed.

Revenue Procedure 99-49, 1999-2, C.B. 725, superceded by Rev. Proc. 2002-9 allows for the change using the automatic provisions set forth in the procedure Revenue Ruling 2002-67 discusses the car donation issue: a privately owned car dealership administers a section 170(c)(2) charity's car donation fundraising program as its authorized agent.

COURT CITATIONS
Avis Rent-A-Car System, Inc. v. United States, 503 F.2d 423 (2d Cir. 1974). The Second Circuit held that the workers that performed car shuttling services were employees and were improperly treated and designated as independent contractors under employment tax law.

Brooks-Massey Dodge Inc. v. Commissioner 60 T.C. 884 (1973). The amounts of an accrual basis dealer discount held back by the manufacturer under a plan agreed to by the dealer was taxable to the dealer in years the amount was credited to the dealership's account rather than in years received.

Commissioner v. Hansen, 360 U.S. 446 (1959), the Supreme Court held that the amount held back or retained by the finance company is taxable to the dealership at the time the installment note is sold and the dealership has a fixed right to the reserve account.

Leb's Enterprises, Inc. v US 2000-1 USTC 182 the court found that payments to the drivers performing the services were determined to be employees subject to employment taxes by the employer

Ren-Lyn Corp., 968 F. Supp the court determined that the law does not require that the workers performed identical job duties, only that they perform substantially similar job duties. The court found that the workers performed substantially similar work; however workers for one client were designated and treated as employees, but the other workers were being treated as independent contractors. As a result, Leb's was not entitled to the safe harbor relief provisions under §530.

Shotgun Delivery, Inc. v. United States, No. C 98-4835 SC (January 20, 2000) (Appeal pending 9th Circuit), the United States District Court for the Northern District of California granted the government's motion for summary judgment and found that Shotgun's expense reimbursement arrangement with its employees was not an accountable plan within the meaning of I.R.C. § 62(c)

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__________FOOTNOTES__________

  1. Revenue Procedure 2001-56, Questions 8-10

  2. Revenue Procedure 2001-56, Questions 11-25

  3. Revenue Procedure 2001-56, Questions 26-39

  4. Revenue Procedure 2001-56, Questions 40-47

  5. Revenue Procedure 2001-56, Questions 33-34

  6. Revenue Procedure 2001-56, Question 37

  7. Revenue Procedure 2001-56, Question 1

  8. Revenue Procedure 2001-56, Questions 10 and 25

  9. Revenue Procedure 2001-56, Question 29

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Chapter 13 | Table of Contents

Page Last Reviewed or Updated: 16-Jan-2014