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

Chapter 12
Extended Service Contracts – "Dealer Reserve Accounts"
When a dealership acts as obligor on an extended service contract it may chose to cover its
risk through an arrangement other than insurance such as by placing a portion of the sales
price in an "reserve" (also known as an escrow or trust account) maintained by an
administrator. The dealer generally, establishes the selling price of the contract, retains a
portion as "commission" and forwards the remainder to an administrator. The administration
agreement may require the establishment of an "escrow" "reserve" or "trust" account to
provide for the dealer’s obligations under the contract.
The administrator acts as "trustee" of the funds and retains a portion of the funds submitted to it
as a fee for its services. Funds in the "reserve" account are used to meet the obligations of the
dealer including payment for repairs to covered vehicles. The amounts placed in reserve may be
based on actuarial standards and the dealer may have certain sales requirements. When certain
conditions are met, the dealer is entitled to a return of unused reserve funds at the expiration of
the extended service contract. Unless the contract is cancelled, the retail customer does not
receive any portion of the unused reserve funds, even if no repairs are made to the covered
vehicle. Often the funds deposited in the reserve accounts earn investment interest that is
deposited into the reserve. Funds placed in the escrow account do not constitute payments for
insurance.
Sometimes the program includes a provision for purchasing "stop loss" or "excess loss" insurance
that may pay for claims if the reserve or escrow account does not contain adequate funds. The
payments for stop loss or excess loss coverage may constitute payments for insurance.
Dealership that sell service contracts and cover their risk under a reserve program must include
the entire sales price of the extended service contract in income in the year the contract is sold.
Payments to the reserve account do not constitute payments for insurance. The dealership may
deduct payments for claims as incurred.
Reserve, escrow, or trust extended service contract plans do not qualify for the Service Warranty
Income Method of reporting income.
The Tax Court addressed similar issues in Hinshaw’s, Inc. above and Rameau Johnson et al. 108
T.C. No. 22, Affirmed by 8th Circuit Court of Appeal 84 AFTR2d. Par. 99-5073; No. 98-1324
(July 21, 1999).
In Rameau Johnson, the dealerships retained a portion of the contract price as profit and
forwarded the remainder to the administrator for deposit in an escrow account, for payment of
administration fees, and for the purchase of excess loss insurance. The escrow amounts earned
investment income. Dealers received distributions from the escrow accounts, within certain
limitations, for specified purposes such as compensation for covered repairs, cancellations, and
the release of "unconsumed reserves" at the expiration of a contract. The dealerships included in
current income the profit portion of the contract price but included the escrow amounts as they
were released.
12-1