Related finance companies have been around for a long time…and so have the IRS guidelines for valid RFCs that auto dealerships must follow for tax compliance.
Like third-party lenders, RFCs can offer to acquire receivables at a 25-40 percent, up-front discount of fair market value (FMV). Problems arise, however, when the discount is not based on FMV or when the dealer cannot prove an actual benefit from the transaction of either improving cash flow or shifting risk.
After the transaction, if the dealer is still directly responsible for the asset in terms of collecting payments, owning title, or collecting any insurance proceeds, for example, the IRS will question whether a sale of property actually occurred.
Discounts on Fair Market Value
A discount is typically acceptable in nearly all transfers of receivables. The level of discount is influenced by credit history, past payment history, time on the note and age of the vehicle. Related Finance Companies can offer to buy notes at a discount regardless of whether they buy in bulk or choose transactions selectively.
The IRS can consider the following in determining whether a dealer sold receivables to an RFC at fair market value:
- Car jackets for loans that were sold to the RFC compared to loans that were sold to third parties
- Could the debtor have obtained financing from third parties or was it unlikely? The car jacket usually includes a credit report on the borrower. If the discount rate is large, the customer will have a poor credit history.
- If these loans were sold to the RFC at FMV, then similar loans sold to third parties will have a similar discount rate.
- Frequency of payments on the loan required: weekly, biweekly, or monthly?
- Required weekly payments generally indicate higher credit risk.
- The dealer’s collection history on the loans prior to the discount date
- Poor customer collections decrease the value of the note receivables.
- Average dealer markup on dealer-financed sales compared to the average dealer markup on third-party financed and cash sales
- If the markup is the same, then the face amount of the note should be the FMV of the note on the loan date. To the extent the markup is higher on dealer-financed sales, the FMV of the loans are less than their face value on the loan date.
In addition to these considerations of FMV, the IRS will look at the date of the discount relative to the date of the loan transaction. The closer the discount date is to the loan date, the less likely that factors such as a change in interest rates could impact the FMV calculation.
Related Finance Companies: Cash and Risk Benefits
The IRS may also determine that the transfer of dealer notes to the RFC was not a true sale of property based upon the following factors:
- Upon the transfer of the notes, the dealer still had burdens of ownership:
- Dealer’s employees collected the payments and performed repossessions
- Dealer bared the risks of the credit-worthiness of the notes
- Dealer’s financial position did not change when the notes were transferred to the RFC
- RFC was thinly capitalized
- Dealer, not the RFC, was responsible for repossessions
- Title was not transferred to the RFC and RFC could not have sold the notes
- Borrowers were not notified that the loan was reassigned to the RFC
- If a vehicle was damaged in an accident, the dealer (not the RFC) had the right to any insurance proceeds
- No written sales contracts were drawn up between the dealer and the RFC
If the IRS determines that no actual sales transaction took place with an entity separate from the dealership, auditors may perform a tax adjustment calculation.
This calculation equals the dealer’s increase in taxable income, which can be substantial depending on the number of transactions in a given tax year or years. All other unrelated income or expenses of the RFC will also remain on the RFC return.
Again, it can be very complex and time-consuming to regularly review the multiple areas of your entity forms, operations, transactions and tax reporting to ensure full compliance with the IRS on related finance company operations. This is why many dealerships fall short in the event of an IRS query.
To help you determine if it’s the right time to review financial management of your auto dealership or RFC operations, the IRS provides a helpful checklist of common questions to consider.
Download Cornwell Jackson’s whitepaper and checklist on RFC risk management.
Scott Bates is an assurance and business services partner for Cornwell Jackson and supports the firms auto dealership practice. His clients include small business owners for whom he directs a team that provides outsourced accounting solutions, assurance, tax compliance services, and strategic advice. If you would like to learn more about how this topic might affect your business, please email or call Scott Bates.
Blog originally published Dec. 4, 2015. Updated on March 6, 2018.
