Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

When a dealership is the principal on an extended service contract, the sales price of the
service contract constitutes an advance payment and the dealership must include the full sales
price in income when the contract is sold. The exception provided by Rev. Proc. 71-21 does
not apply since the terms of the contracts are 2 years or more, and the services will not be
performed by the end of the taxable year after the year of sale.
The Tax Court specifically addressed this issue in the dealership context in two cases. In
Hinshaw’s, Inc. v. Commissioner, T.C. Memo. 1994-327, the Tax Court ruled that all
amounts collected for extended service contracts were includable in income in the year
received.
When dealers pay a premium to insure their liability under the service plan that they sell, the
term of the insurance is the same as the term of the contracts of 2 to 6 years. Insurance
premiums for policies covering more than 1 year must be amortized ratably over the term of
the policy. Taxpayers using the accrual method of accounting must prorate and deduct
ratably over the term of the policy prepaid insurance premiums. Higginbotham-Bailey-Logan
Co. v. Commissioner, 8 B.T.A. 566 (1927).
In Hinshaw’s, Inc. above, the Tax Court specifically addressed amortization of insurance
purchased to cover the dealer’s risk under the extended service contract. The Court ruled
that the dealership "* * *entered into contracts with its customers that required [it] to protect
the customers from vehicle service costs for up to 7 years. [The dealership] then purchased
insurance to protect itself from having to pay those costs; instead, the costs would be paid by
an insurance company. Since [the dealership] will benefit from this coverage for more than 1
tax year, petitioner must capitalize the cost of the insurance."
In summary, the dealer obligor extended service contracts and insurance is purchased
When a dealership acts as the obligor on an extended service contract and purchase insurance
to cover its risk, it must include in income the full sales price of an extended service plan at
the time of sale, and is allowed to deduct the insurance premium ratably over the term of the
plan.
Service Warranty Income Method (SWIM)
In general, payments received by an accrual method taxpayer for services to be performed in
the future must be included in gross income in the taxable year of receipt. The Service
recognized that this treatment resulted in a significant and unique cash flow problem for
dealerships that sell extended service contracts to customers in connection with the sale of
motor vehicles and immediately pay a third-party to insure their risks under the contracts.
To remedy this situation, the Service made an administrative decision to permit these
dealerships to adopt or change to a special method of accounting for advance payments that
would alleviate the cash flow problem but would generally conform economically to the tax
treatment of advance payments under current law.
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