Some Tax Considerations for Subprime Lending
© 1997 By Michael C. Gray, CPA
The IRS believes that "Buy Here, Pay Here" is a legitimate business practice that auto dealers may abuse to secure tax benefits they are not truly entitled to. It is significant that Chapter 8 of the industry audit guide for Independent Used Car Dealers is devoted to Related Finance Companies.1. "Buy Here, Pay Here" is also discussed in Chapter 3 of the Guide, Gross Receipts, under Dealer Financing.
There are many tax issues and opportunities relating to these contracts that makes them attractive audit targets. If the dealer and his or her tax advisors are properly prepared, they will be better able to defend their tax positions.
The Installment Method.
Under the installment method, income is reported in proportion to the cash received from the customer on the contract. The installment method is not available for sales of personal property, such as motor vehicles.2. Any dealer still using the installment method should apply to the IRS for a change of accounting method.
Taxpayers other than banks and thrift institutions must use the "specific charge-off method" and cannot use the "reserve method" of accounting for bad debts.3. The taxpayer must be able to prove the debt was worthless or partially worthless in order to claim a tax deduction. In evaluating the worthlessness of the debts, the value of collateral securing the debt and the financial condition of the debtor are considered.4.
When writing off an account as a bad debt, the dealer should document collection efforts, including any legal action taken.
Adjustments to Income in the Year of Sale.
Notes received for the sale of property are generally valued at face value and treated as cash when a solvent obligor's promise to pay is unconditional and assignable, not subject to setoffs, and of a kind frequently transferred at a discount not substantially greater than the prevailing premium for the use of money.5.
In some cases, taxpayers have established that the note should be valued below its face amount because of the financial condition of the debtor. The argument is based on the All Events Test, which determines when income must be accrued.
Under the All Events Test, income must be accrued when 1) the taxpayer's right to receive the income is fixed, and 2) the amount of income is ascertainable with reasonable accuracy.6.
Income that is of doubtful collectability or that is reasonably certain to be uncollected does not accrue until it is collected, because the taxpayer does not have an unconditional right to receive the income.
To defer the accrual of income under the doubtful collectability exception, there must be a reasonable doubt as to collectability when the right to receive the income arises or by the end of the taxpayer's tax year. 7.
The taxpayer bears the burden of proof to show that the debtor's financial condition makes payment improbable and that there is reasonable doubt as to the collectability of the income. 8.
If the amounts owed are legitimately not accrued because of doubtful collectability and the debt is subsequently paid, the payment is reported as income in the year of receipt. 9.
The key to this technique is to reduce gross income in the year of sale. The adjustment must not be reported as a bad debt. Again, documentation must be included in the file for each note showing the reasoning for the adjustment and how the amount of the adjustment was determined.
The gross income adjustments should agree to the books and records of the taxpayer. Otherwise, the IRS could claim the books and records are an "admission against interest" by the taxpayer. (The IRS believes when a taxpayer is claiming a higher value for financial reporting, that value should be used to clearly reflect income.)
Adjusting the books and records may make reconciling them to the sales tax returns more difficult when preparing the returns and when explaining adjustments for sales tax audits.
Another difficulty in claiming income adjustments for Subprime Lending is that each transaction stands on its own. You can't claim a 15% adjustment "across the board" for all notes received.
Related Finance Companies (RFCs).
Many taxpayers believe that setting up a separate finance company will solve their documentation problems relating to subprime lending. They believe notes can be sold at discounts comparable to those demanded by outside financing companies, and the dealership should be entitled to a tax deduction for the discount, resulting in a deferral of the income.
In tax audits, transactions with related companies are more carefully examined to assure the related companies are legitimate, separate operations and the transactions have economic substance.
Here are some of the items listed in the industry audit guide for the IRS agent to confirm:
"The RFC should notify customers of the purchase of their notes."
"The RFC and the dealership should have a purchase contract for the receivables that both complies with appropriate state law and provides evidence of how the FMV (fair market value) of the receivables was determined."
"The RFC should pay the dealer at the time of purchase. The RFC can generate the cash to make the payment from any combination of capitalization of the RFC, bank or third party borrowings, or borrowings from related entities or shareholders. Borrowings from related entities or shareholders can diminish the validity of this factor." 10.
If all or a portion of the discount is found to be without economic substance, the IRS has the authority under IRC §482 to reallocate the income between the taxpayers.
Even if the above issues are resolved, the IRS has an additional provision to limit deductions for the sale of the note at a discount. No deduction is generally allowed for the sale or exchange of property, directly or indirectly, for sales between certain related taxpayers. The provision includes sales between an individual and a corporation owned more than 50% by that individual, two corporations more than 50% owned by the same interests, or a corporation and a partnership more than 50% owned by the same interests. 11.
There is an exception in the Treasury Regulations that permits a deduction relating to the sale of accounts receivable up to the amount of gross income reported by the seller to an unrelated party. 12.
When the buyer and seller are corporations more than 50% owned by the same interests, the loss is deferred on the tax return of the seller until the buyer collects the amount receivable or sells it outside the group, at which time the seller reports the loss. 13.
When the buyer and seller aren't related corporations, the buyer reduces its gain on the subsequent payoff of the note by the amount of any loss disallowed to the seller by applying the related party rules. 14.
The best defense to this situation may be for the seller to claim the lower value at the time of sale based on the All Events Test, followed by the sale to the finance company, for administrative convenience, at no gain or loss.
Financial Asset Securitization Trusts (FASITs).
Congress created a new way to finance consumer debts in the Small Business Job Protection Act of 1996. 15.
A FASIT is a pass through entity that is wholly owned by a C (regular non-pass through) corporation. The FASIT may issue asset-backed securities that are treated as debt for federal tax purposes. The intention is to open the securities markets for consumer debts as they have been for mortgages in the FNMA and GNMA programs.
For details, see your tax advisor.
Structuring and claiming tax benefits relating to subprime lending is not for the faint of heart. In order to justify the effort and expense required to document and defend your position, Buy Here, Pay Here must represent a significant revenue source for your business. Now that the IRS has cleaned up its backlog of tax shelter cases, corporate audit activity is expanding, with special attention given to auto dealers as high-profile, high revenue potential taxpayers. Having your existing documentation and procedures reviewed by a tax advisor to tell you whether you are prepared for a tax audit can be a worthwhile investment.
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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.
1. The Independent Used Car Dealer MSSP Guide was released by the IRS on May 30, 1996. Many of the issues covered in the Guide are pertinent to new motor vehicle dealers as well. The Guide was jointly developed by the IRS and the National Independent Automobile Dealers Association.
2. Internal Revenue Code (IRC) Sections (§) 453(b)(2)(A), 453(l)(1)(A).
3. IRC §166.
4. Treasury Regulations §1.166-2.
5. Cowden v. Commissioner, 61-1 USTC ¶ 9382.
6. Treasury Regulations §§1.446-1(c)(1)(ii), 1.451-1(a).
7. James Lumber Co. v. Commissioner, 37-2 USTC ¶ 936, Cuba RR Co. v. Commissioner, 9 TC 211 (1947).
8. James Lumber.
9. Corn Exchange Bank v. U.S., 2 USTC ¶ 455.
10. The Independent Used Car Dealer MSSP Guide, Chapter 8.
11. IRC §267.
12. Treasury Regulations §1.267(f)-(1)(f).
13. IRC §267(f).
14. Treasury Regulations §1.267(d)-1.
15. Small Business Job Protection Act of 1996, §1621.
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