New Vehicle Dealership Audit Technique Guide 2004 - Chapter 9 - Advertising Associations (12-2004)


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Chapter 9 - Table of Content
Supporting Law

Most dealerships advertise through the use of an advertising association. An advertising association is a separate entity whose purpose is to buy advertising on behalf of its members. Dealerships pay a predetermined amount to fund the advertising association. The association is usually a corporation, but it can be a Section 277 association or a non-profit entity. Dealerships, and/or their shareholders, are members of the advertising association, and can own its stock. The members elect a Board of Directors who operate the association. Most advertising associations do not have a profit motive. 

An association is usually organized by

  • Franchiser (Manufacturer)

  • Ownership

  • Geographic area

Franchiser (Manufacturer)
Most dealerships participate in an advertising association that is sponsored by the dealerships’ franchiser. This association advertises on behalf of the manufacturer for the type of cars sold by the dealer. For each car purchased by the dealer, a set amount from each vehicle invoice is sent to the advertising association. This amount is separately stated on the invoice. This can be a flat amount or a percentage of the purchase price of the vehicle, including options. The franchiser or the advertising association determines the advertising contribution. Dealerships deduct this as advertising expense, or as part of Cost of Goods Sold.

A dealer may own franchises in separate locations and use an advertising association to advertise on behalf of the franchises. In this situation, it is possible, but rare, for the advertising association to be a related party of the dealer. Usually an advertising association has many dealership members.

Geographic Area
It is common for a municipality to designate a parcel of land for auto franchises. This is usually a small geographical area that makes it possible for a customer to shop for several brands of vehicles without having to travel to several locations. This is commonly referred to as an auto mall. The auto mall is often established by a city in order to increase sales tax revenue. The auto mall’s dealers usually pay fees to an advertising association that advertises oh behalf of the auto mall.

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Interview Questions

  • Determine if the dealership is a member of one or more advertising associations

  • Inquire if the dealer is a member of the Board of Directors, which is responsible for the association funds.

  • Inquire how the dealer accounts for advertising fees and rebates on the dealer’s tax return

Documents to Request

  • Obtain a copy of the advertising association’s tax return, if the dealer is a related party.

  • Statements from the advertising association that show how the dealer’s funds were accounted for.

Audit Techniques
Most adjustments result from related party transactions, timing adjustments, double deductions or unreported income. Follow the flow of advertising funds:

  • Were the funds spent on advertising?

  • When were the funds spent?

  • Who spent the funds?

Determine where the advertising expense is being deducted on the return. As stated earlier, the most common areas are the advertising expense account, or as part of Cost of Goods Sold. The vehicle invoice will have a separately stated item for advertising expense. Trace this to the books to determine where this is being deducted.

Typically, when a dealer becomes a member of an advertising association sponsored by a franchiser (manufacturer), the dealer signs an authorization that allows the franchiser to add a pre-determined amount to his vehicle invoice for each vehicle delivered to the dealer. The franchiser collects these funds and transmits them to the advertising association. The advertising association spends the funds for advertising on behalf of the members.

Issue Identification
Some issues that may arise during the examination of advertising associations are:

Unreported Income
It is common for the association to return excess funds not spent within the calendar year to the dealerships. This rebate should be reported as income on the dealership’s return or offset against the advertising expense. 

The rebate may be in the form of a management fee, travel and entertainment reimbursement or some other form of compensation. This should be reported as income.

The rebate may be credited as a liability or other expense.

If the advertising association does not spend all of the funds it has collected, and does not return the funds to its members, the courts have determined that these funds are not income to the dealers. (Ford Dealers Advertising Fund vs. Commissioner, 55 T.C. 761 (1971) aff’d 456 F22 2SS (5th cir. 1972 and Greater Pittsburg Chrysler Dealers Association of Wester PA v. US, 77-1 USTC 9293, W.d.a. 1977 Non Acq. 1974-2 CB 5) The taxpayers argued that the advertising association acted in the capacity of a trustee for the funds and that the funds were restricted. The courts agreed.

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Double Deductions
As stated earlier, vehicle invoices separately state the advertising expense. If this amount is included as part of Cost of Goods Sold, there should not be a separate expense on the return. If a dealership is on the LIFO method of inventory, advertising fees are not included as part of Cost of Goods Sold.

Timing of Deductions
For franchise (manufacturer) arrangements, the dealer can deduct the advertising expense in the year paid based on the payment of the advertising amount and that the dealer can reasonably expect that the amounts will be used for advertising within 3 ½ months of the following year (1.461-4 and PLR 9243010 issue #5).

However, for associations that are related parties, a dealership cannot deduct advertising expenses until the advertising association has provided the advertising. Regulation 1.461-4(d)(2) states that if the liability of a taxpayer arises out of the providing of services to the taxpayer by another person, economic performance occurs as the services or property is provided.

The tax returns filed by advertising associations are usually not complicated but may not show all of the year’s activity. They may reflect the following:

  • Rebates sent to the dealerships may be shown on the return as Returns and Allowances. A schedule may be attached.

  • “Other income” is usually interest income.

Section 277 returns

IRC 277 states that expenses attributable to furnishing services or other items of value to members can only be deducted with respect to member income. General and administrative expenses not associated with furnishing services or other items of value to members, such as interest expense, may be deducted with respect to nonmember income.

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.

In TAM 9429003, the Service determined that an advertising association was a Section 277 member organization because the association’s primary purpose was to furnish goods or services to its members for a purpose that was not exempt from taxation. 

The association’s corporate purpose was to collect, and expend funds for advertising, and promote the products and services of its member dealers. The contributions paid by the dealers were voluntary. The dealers elected a board of directors to act on behalf of all of the members of the association, for their exclusive benefit. They did not receive compensation. The IRS determined that IRC 277 was enacted to address this type of organization.

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Supporting Law
IRC section 446(b): If the taxpayer’s treatment of income and expenses relating to the advertising association distorts income, a change of accounting method is required. 

IRC section 481(a): Prior period adjustments resulting from a change in accounting method should be used to compute the open year deficiency.

IRC section 7701(a)(3): For Internal Revenue Code purposes, the term "corporation" includes associations and joint-stock companies.

Rev. Rul. 74-318: Where an advertising association has discretionary control in the use of the advertising fees paid by the member dealerships and the manufacturer, amounts are includable in gross income with ordinary deductions allowable.

Rev. Rul. 74-319: An advertising fund established by franchise dealers, administered under a written contract by the manufacturer who receives and bills non-refundable fees, spends the accumulated funds on national advertising only (for the dealer's benefit), accounts for the funds separately in the books, and carries yearend balances as a liability to the dealers, is an association taxable as a corporation.

Treas. Reg. section 1.461-4(d)(2): Advertising fees are deductible when economic performance occurs, i.e., when the money is spent on advertising. 

Ford Dealers Advertising Fund vs. Commissioner, 55 T.C. 761 (1971) aff’d 456 F22 2SS (5th cir. 1972 and Greater Pittsburg Chrysler Dealers Association of Wester PA v. US, 77-1 USTC 9293, W.d.a. 1977 Non Acq. 1974-2 CB 5) state that excess funds not spent by the advertising association, and not returned to its members, are not income to the member dealers.

PLR 9429003 addresses an advertising association that qualifies as an IRC 277 organization.

Boating Trade Ass’n of Metro. Huston vs. U.S. 35 AFTR2d 1228 (SD Tex. 1975) states that arranging for a business service such as advertising, is a service organization that qualifies as an IRC 277 organization.

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