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

Contract Construction
Generally, a dealership should be fully aware when they are a principal. Most contracts
explicitly state the dealer is a principal or an obligor. Try to ascertain whether the dealer
entered into this contract free of mistake or duress of the insurance company. Absent such a
finding, the dealership should not be allowed to use parol evidence to interpret the contract,
having it conform to the dealership’s immediate needs.
Some dealers may claim they are not principals, even though the contract explicitly states
they are.
The courts have followed the IRS’s interpretation of these contracts determining the dealer a
principal, where the facts warrant. They have held that the surrounding circumstances and
parol evidence of a transaction may be considered by the IRS if the contractual terms of an
agreement are unclear or ambiguous. The court determined in, Rochester Development
Corporation v. Commissioner, T.C. Memo. 1977-307, CCH 34,630(M), that the surrounding
circumstances and parol evidence of a transaction may be considered by the IRS if the
contractual terms of an agreement are unclear or ambiguous. See Commissioner v.
Danielson, 378 F.2d 771 (3rd Cir. 1967) cert. denied, 389 U.S. 858 (1967), Joan S. Schatten
v. United States, 746 F.2d 319 (6th Cir. 1984), and Johnie Vaden Elrod v. Commissioner, 87
T.C. 1046 (1986).
However, parol evidence will not be allowed where there is no such ambiguity and the terms
are clear. Where the contract is not vague and ambiguous the courts have indicated they will
narrowly construe the terms of the contract and uphold its clear meaning. For a taxpayer to
challenge the Commissioner’s construction of an agreements clear and unambiguous form,
some federal circuit courts have held the taxpayer must show proof that the agreement was
unenforceable because of mistake, undue influence, fraud, or duress. See Rochester
Development Corporation v. Commissioner, T.C. Memo. 1977-307, CCH 34,630(M).
Change in Accounting Method Concerns and IRC section 481(a)
Treas. Reg. section 1.446-1(a) defines method of accounting as not only the overall method
of accounting of the taxpayer, but also the accounting treatment of any item. A method of
accounting is established by the proper treatment of an item in the first year that the taxpayer
has the item or by improper treatment of the item in the first 2 years that the taxpayer has the
item. A material item is one involving the timing of its inclusion or deduction. A change in
method does not include correction of mathematical or posting errors or tax computation
errors or of an item not involving a question of timing.
Treas. Reg. section 1.446-1(e)(2)(ii), states a material item is any item which involves the
proper time for the inclusion of the item in income or the taking of a deduction.
A method of accounting involves the consistent treatment of a material item. A material item
is any item that involves the proper time for the inclusion of an item in income or the taking
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