Does Your RFC Make You an IRS Target? Related Finance Company Pros and Cons and Risk Management Strategies

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1 Does Your RFC Make You an IRS Target? Related Finance Company Pros and Cons and Risk Management Strategies By: Banks M. Woodward, CPA, Tax and Business Services Manager Executive Summary 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. With increased IRS scrutiny of the relationship between auto dealerships and these finance arms, however, owners and managers need to take a closer look at entity relationships, operational processes and reporting to avoid additional taxes and stiff penalties down the road. We review the pros and cons of RFCs, key areas for ongoing risk management and allowable methods for supporting cash flow and tax deductions Windcrest Drive Suite 100 Plano, TX Main: w w w. C o r n w e l l J a c k s o n. c o m An Independent Member Firm of BKR International. Firms in Principal Cities Worldwide.

2 Does Your RFC Make You an IRS Target? 1 Related finance companies 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. The timing of IRS scrutiny makes sense. When the economy is good, people are buying cars and dealers are looking for ways to manage cash flow while mitigating tax impacts. However, RFCs were not designed to be a tax-planning vehicle to reduce or defer dealership income. If the IRS 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. There are pros and cons to RFC creation and operation, which we will explore here. We will also outline important areas of risk management, specifically to prove the validity of the RFC as well as allowable discounts and accounting methods for transactions.

3 Why Operate an RFC? 2 Why Operate an RFC? There are several reasons for creating and using an RFC. 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. However, 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. Although this varies state-by-state, in Texas, there are significant Sales Tax benefits for RFCs. Rather than paying sales tax upfront as dealerships are required to do, RFCs are able to pay for sales tax as it is collected from their customers. The downside of RFCs 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.

4 Passing the Validity Test 3 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, the logic of an RFC increases. RFCs may offer discount rates lower than those 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. Passing the Validity Test 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.

5 Characteristics of a Valid RFC 4 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 follow ing characteristics: o Adequate capital to pay for the contracts o Meets all state and local licensing requirements o Maintains its own bank accounts o Has its own address and phone number and operates as a separate entity from the dealership o Maintains its own books o Has its own employees who are compensated directly by the RFC o Pays its own expenses o 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: 1. 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. 2. 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.

6 Be Prepared to Prove Validity 5 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. Be Prepared to Prove Validity Some of the questions that an IRS auditor will ask when determining the validity of the RFC can be helpful when performing due diligence on your own dealership and RFC for purposes of compliance. They include: Before the RFC was formed, did the dealership discount finance contracts to third party finance companies? Who is recorded as lien holder with the department of motor vehicles? Who retains the original car title and tag records? Is the RFC a separate legal entity? o Type of entity for federal and state o Licenses that the RFC holds Ownership of the RFC? (if the RFC is not validated as a separate entity) How was the RFC capitalized (cash, loans, third-party financing, etc.)? Type of books and records maintained by the RFC? The RFC s method of accounting? Types of duties performed by the dealer and the RFC s employees? Who performs: o Credit checks o Credit decisions o Monitoring of loan accounts o Collection of loan accounts o Repossession of vehicles o Management of RFC o Bookkeeping functions of RFC

7 Be Prepared to Prove Validity 6 Has the RFC filed payroll tax returns? Is the RFC located in the same location as the dealer? If in the same building, then: o Are separate offices maintained? o Is there a separate phone number for the RFC? o How are common costs allocated? (Utilities, overhead, etc.) o Are there written agreements for shared costs? Who owns the location of the RFC and the dealer? If it s a related party, then: o What are the rental arrangements? o Are there existing written agreements with each entity? 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. Proving Economic Substance of Discounts Like third-party lenders, RFCs can offer to acquire receivables an 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. RFCs can offer to buy notes at a discount regardless of whether they buy in bulk or choose transactions selectively.

8 Cash and Risk Benefits 7 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 o 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. o 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? o Required weekly payments generally indicate higher credit risk. The dealer s collection history on the loans prior to the discount date o 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 o 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. 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: o Dealer s employees collected payments and performed repossessions o Dealer bared the risks of the credit-worthiness of the notes o 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

9 Cash and Risk Benefits 8 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. Cornwell Jackson s Auto Dealership consulting group can help you understand what to expect in this type of IRS query as well as consult with you on the prime areas of scrutiny as outlined in this article. Helping you mitigate noncompliance risks now will save time and money in the event of a query or IRS audit later. 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 (listed on next page). Follow Cornwell Jackson s blog to stay engaged in the conversation.

10 RFC Checklist 9 Is the RFC a separate legal entity from the dealership? Does the RFC meet all state licensing requirements? Does the RFC maintain proper business licenses? Does the RFC comply with title and lien holder laws? Does the RFC have adequate capital to purchase the notes? Does the RFC have its own address and operate from separate facilities? Does the RFC maintain its own books separate from the dealership? Does the RFC have its own phone number? Does the RFC have its own employees? Does the RFC compensate the employees directly? Does the RFC pay its own expenses? Does the RFC maintain its own bank accounts separate from the dealership? Does the lien holder on the finance contract change from the dealer to the RFC? Does the dealership notify the customer that the finance contracts have been sold? Does the RFC pay the dealership for the contracts at the time of purchase? Does the RFC purchase contracts from unrelated parties? Does the RFC have written contracts with the dealership? If so, do the agreements state how the discount rates are determined? Does the discount rate approximate the actual loss experience? Are the financial contracts non-recourse? Does the RFC handle repossessions? Does the dealership sell any finance contracts to any unrelated finance companies? Does the RFC report income on a pro-rata basis? Did the profit reported on the initial sale of the vehicle exceed the loss on the sale of the finance company? Does the RFC have a business purpose? Did the RFC investigate items such as the borrower's credit history, length of the note, age of the vehicle, and payment history prior to determining the value of the note?

11 Banks M. Woodward, CPA, is a tax and business services manager for Cornwell Jackson CPAs and supports the firm s auto dealership practice group. His clients include small business owners for whom he acts as both a controller and strategic tax advisor Windcrest Drive Suite 100 Plano, TX Main: w w w. C o r n w e l l J a c k s o n. c o m