Related finance companies (RFCs) were not designed to be a tax-planning vehicle to reduce or defer auto dealership income. If the IRS validity test discovers noncompliance that cannot be explained in the RFC’s or dealership’s documentation, additional taxes and penalties can be severe.
We find that many RFCs and dealers do not regularly review their operating agreements or operations to comply with validity factors for the RFC and its transactions. The process is understandably time consuming and complex. You can rest assured, however, that if the RFC receives an IRS query, then a dealership query often follows.
RFCs are usually set up as S Corporations. The RFC acts as the lender in the dealer’s financing of used vehicles. The notes are sold to the RFC at a discount due to the higher risk the RFC incurs in the transaction. The RFC accrues the income as it is earned from the car buyer’s weekly or bi-weekly payments. The dealership collects cash up front, then books a current and deducted loss for the difference between the full contract and the discounted contract.
IRS Validity Test
According to the IRS, a valid RFC must have the following characteristics.
- When the finance contract is sold to the RFC, title has been transferred to the RFC in accordance with title and lien holder laws
- The discounting of the car dealer’s receivables are sold to the RFC at their fair market value
- There is a written arms-length contract between the dealership and the RFC
- The finance contracts are normally sold without recourse between the two related parties
- The RFC is responsible for repossessions
- The RFC is operated as a separate entity from the dealership and has the following characteristics:
- Adequate capital to pay for the contracts
- Meets all state and local licensing requirements
- Maintains its own bank accounts
- Has its own address and phone number and operates as a separate entity from the dealership
- Maintains its own books
- Has its own employees who are compensated directly by the RFC
- Pays its own expenses
- Customers make payments to the RFC, not to the dealership
The IRS Audit Technique Guide cites two common issues that put the validity of the RFC into question. Either the dealership and RFC do not treat and record the sale and financing properly or it is found that the RFC is operating like a shell company rather than a legitimate separate entity:
- At the time of each transaction, the RFC must show actual cash reserves in its own bank accounts to pay the dealer; the dealer in turn must record receipt of payment for the note. Each entity must have separate journal entries for the transaction. If journal entries don’t match up, the IRS may disallow the transaction.
- As for its validity as a separate entity, if the RFC doesn’t have a separate address and does not advertise itself as a separate company, it factors into the validity test. It must also be proven that the RFC is directly collecting payments and paying actual employees.
If the IRS does not view the RFC as a separate entity by these tests of validity, it will not allow the dealership to claim a deduction for losses on the sale of discounted vehicles to the RFC. It will defer to related party rules under IRS code 267 that do not allow loss deductions in transactions made between related persons. Without proper structuring as a separate operation, an RFC can become a liability.
The RFC may be completely valid, and the legal form can be proven, but dealers and managers must be confident in their ability to show proof and documentation in the event of an IRS query or audit. Sharing staff or running RFC bookkeeping and administration through the dealership to save now can prove costly in taxes and penalties later on. The IRS may determine that the RFC is not a valid separate entity. This finding, in effect, invalidates the cash method of accounting for the sale of notes to the RFC.
Interested in more details about RFCs and auto dealership accounting? Download our whitepaper on RFCs.
Continue Reading: Fair Market Value Test Can Render RFCs Invalid
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. 3, 2015. Updated on February 20, 2018.