If your business provides finance and extended service contracts, warranties, or other insurance to its customers there are several issues:
What is it?
Related Finance Companies refer to the self-financing arrangement pursued by some dealerships, new and used, where individuals for whom financing cannot be obtained through normal channels. The customer is required to make payments usually at the dealership's location.
How does it work?
Dealerships involved in this practice establish a financing entity, typically an S-Corporation, which acts as the financial institution in the dealership's selling arrangement.
When the vehicle is sold, and it is determined that the customer needs special credit assistance, the dealership writes the note at term (high interest rate) with recourse as the lender. Then the note is sold at significant discount to the entity substantiating the discount by citing high risk. For more information, refer to the Independent Used Car Dealer Guide.
If you own two entities (regardless of the type of entity) and you own more than 50% of each entity, any loss from the exchange of property between these entities may not be deductible. For more information refer to IRC section 267.
Extended Service Contracts
Motor vehicle dealers sell two basic types of extended service contracts (also known as mechanical breakdown contracts or multi-year service warranty contracts) for used cars and as a supplement to the standard manufacturers' warranty for new cars. The first type is between the customer and an unrelated underwriter. The dealer is merely an agent for the underwriter and keeps as profit the difference between the sales price of the contract and the "cost" paid to the underwriter.
The second type is a contract between the customer and the dealer. For this type the dealer may buy insurance covering his or her risk or be "self-insured". If the dealer buys insurance, the income and expenses should be reported in the year of receipt, and any prepaid insurance must be amortized over the life of the policy.
The taxpayer can elect to mitigate this situation by filing Form 3115 (PDF) to request changes in accounting methods. Revenue Procedures 97-38 (PDF) and 2011-14 (PDF) explain the filing procedures, which allow taxpayers to report income ratably as they expense the insurance ratably.