A related finance company can provide a useful service to the public when operated to help auto dealerships sell cars to people who need an alternative financing method. This does not mean that every dealer should operate an RFC. Rather than a benefit to the dealer, it can actually be a financial drain due to unnecessary overhead costs. In addition, the Internal Revenue Service has imposed increased scrutiny on RFCs over the last few years to crack down on potential noncompliance issues.
Pros of Creating an RFC
There are pros and cons to RFC creation and operation. Let’s look at the pros first. These entities allow dealerships to work with consumers who have little, no or bad credit. The consumer is able to finance a car through the RFC, separating the dealership from direct payment collections and insulating it from possible bad publicity if the loans default. Because interest rates charged in a “buy here, pay here” car purchase are substantially higher than with traditional loans, an RFC must maintain a larger level of cash reserves. The RFC keeps the default financial risk separate from the dealership.
History shows that when an RFC is involved in collection of auto loan payments, customers are less likely to default than when making payments directly to the dealer. In addition, RFC discount rates may be lower than what a dealer would obtain from third party lenders — resulting in a better profit per transaction.
Another benefit, depending on the licensing and regulatory requirements of the state, is the ability for the dealer to isolate liability for violation of licensing or capital requirements for finance companies. Such violations, if they occurred in the operation of the RFC, wouldn’t affect normal operation of the dealership.
The downside of using a Related Finance Company
In fact, RFCs work very well for dealerships that have approximately $1 million or more in receivables. This is the breakeven point if you look closely at the numbers of any given transaction compared to a straight retail sale as well as the overall net benefit on any income tax deferrals. Even at $1 million, however, dealers and managers need to consider very seriously if the additional overhead costs and administration of an RFC result in an overall financial benefit.
An RFC is, after all, a separate entity and must be operated as such to meet IRS guidelines. This includes many fixed operating costs along with the costs of employing separate staff and ideally maintaining a separate location. Dealers need to factor in the time and money spent on creating the entity and then operating it. You must compare that ongoing expense to the potential savings based on your receivables.
As receivables grow past $1 million, an RFC starts to make more sense. Well-managed RFCs can offer discount rates much lower than rates offered by a third-party lender. Dealers can also rely on RFC experience to be more selective when extending credit, improving the quality of transactions. Proper management is the key, including the burden of ongoing diligence to satisfy IRS requirements. The trouble starts when the structure and operation of the RFC fails to pass the IRS validity test as an entity that is truly separate from the dealership.
Interested in more details about RFCs and auto dealership accounting? Download our whitepaper.
Continue Reading: Does Your RFC Pass the IRS Validity Test?
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. 2, 2015. Updated for content on February 6, 2018.
