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

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The dealers may tell the revenue agent they intended to recognize, as income, the amount remaining in the reserve when the contracts earn out. However, some dealers will have taken a loan against these funds that cannot be repaid for whatever reason, or have declared a dividend so there is nothing left to recognize when these contracts do earn out. The dealer’s control of the reserve is sufficient to allow them to time the liquidation of this reinsurance company, which may have a large capital loss, with a large capital gain from another source, using the loss to offset the gain. These offshore PORCs often are off the dealership books. The amounts forwarded for the insurance contracts are going to regulated United States insurance companies. Other than the owner, the employees of the dealership may have no knowledge of this PORC. The revenue agent would not know of the existence of the PORC unless told by the dealer. At the beginning of the examination, the agent should ask about the existence of a PORC and reinsurance arrangements. Often determining whether the dealer filed a Form 1120-PC, a Form 1120-L or a Form 990 will lead the agent in the direction of the PORC. We also recommend that, prior to questioning the dealership’s shareholder(s) about related transactions and ownership interests, the initial IDR specifically request the existence of these related returns. If the dealer owns the PORC though, it is possible that the dealership tax return and books and records will not have any indication of the PORC (assuming no interaction whatsoever, e.g. loans, etc.). The agent may then have to request information about the PORC in relation to the dealer’s own personal tax return. Producer Owned Reinsurance Company Issues Some dealers are treating these captive offshore reinsurance companies as organizations qualifying under IRC section 501(c)(15)(A). This section grants tax exempt status to insurance companies or associations other than life insurance companies * * * if the net premiums written for the taxable year do not exceed $350,000. Dealers now file Form 990 where they previously filed Form 1120-PC for the PORC. Form 990 is an information return for tax exempt organizations. The Internal Revenue Manual requires revenue agents to refer the examination of a Form 990 to the Tax Exempt and Government Entities (TEGE). If an agent finds a situation where the PORC is treated as a tax exempt organization the agent should become familiar with IRC section 845 which allows the Service to reallocate the income of a reinsurance arrangement to its true earner where any such arrangement is set up for tax avoidance purposes. The agent may also raise an issue that the Form 990 is an improper filing because the producer owned reinsurance company did not qualify as a tax exempt organization. If this argument can be made then the PORC would be taxed as an insurance company on a Form 1120-PC. A traditional sham argument as discussed in Chapter 12 and outlined below can be used to support the issue. Excise Tax, of about 4 percent per contract, under IRC section 4371, may be due on each 13-5
insurance contract reinsured through the offshore PORC if no Subpart F election has been made to include this foreign source income as worldwide income. If the Subpart F election is made, this income would be taxed as United States income under IRC section 953(d), subject to the Foreign Tax Credit. The offshore PORC would be considered subject to Subpart F because it is a controlled foreign corporation as defined under IRC sections 951(b) and 953(a). There may be an IRC section 482 pricing issue because the PORC is owned by the same shareholder who owns the domestic auto dealership. The PORC may be considered a sham corporation if it has no reason for existence other than diverting or sheltering dealership income for the benefit of the dealer owner. Thorough analysis of these transactions may conclude that profits from the PORC are being channeled into a fund held effectively for the dealers personal use. This arrangement would fail the economic substance test found in the Bail Bonds case and be considered a sham. See Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, (9th Cir. 1987). In Malone and Hyde, Inc.,and Subsidiaries v. Commissioner, 76 AFTR2d Par. 95-5250, the United States Court of Appeals for the Sixth Circuit ruled that payments by a parent corporation to a subsidiary for "insurance" are not deductible. The court distinguished the case from Humana, Inc. v. Commissioner, 881 F.2d 247 in which the brother/sister corporations were allowed a deduction for such payments. The ruling in Malone and Hyde, Inc., above, has wide application to auto dealers. Producer Owned Reinsurance Companies (PORC) that reinsure dealer obligor extended service contracts should be examined carefully to see if they meet the tests outlined in the Court’s opinion. Was the PORC adequately capitalized? Is there indemnification in excess of the capitalization amount? Is there a hold harmless agreement between the PORC and/or the dealership and the fronting company? If so, the risk of loss may not have shifted and the payments may qualify as nondeductible "self insurance." PORCs that reinsure credit life and accident and health policies are more complicated. Since the risk is that of the vehicle purchaser rather than the dealer, it is more difficult to make the argument that risk did not shift. However, the Court began its opinion by stating that it must first determine if the reinsurance company was created for a legitimate business purpose or whether it was a sham. Dealers in states that have no commission cap or dealers who reduce their commission amount after formation of the PORC risk the characterization of the PORC as a sham. Other means may have been available for the dealership to increase its income from the sale of credit life coverage rather than the creation of an undercapitalized, off-shore reinsurance company. The Courts also addressed reinsurance companies in William L. McCurley, et ux. v. Commissioner (T.C. Memo. 1997-371) the Tax Court held that the owners of two automobile dealerships received constructive dividends from a foreign corporation that reinsured credit insurance policies issued through the dealerships. The Court found that the reinsurance company never paid dividends, that it never demanded payment on the notes to the shareholders, that the advances did not bear interest, that the advances were made with reference to ownership interests, 13-6
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Internal Revenue Service Market Seg
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Preface One of the goals envisioned
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Table of Contents Preface .........
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The Reinsurance Transaction .......
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Part 1 General Focus and Procedure
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1. Type A Return Information Schedu
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Percentage has gone down. The incre
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the principal shareholders to finan
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Rents $ 500,000 Interest $ 50,000 C
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Conclusion "Financial status" is on
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Chapter 2 Getting Started The key t
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entities and their purpose and rela
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It is recommended that officer comp
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Chapter 3 Standard Audit Index Numb
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Chapter 4 Books and Records Charact
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c. Reconcile (2): Beginning Trial B
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3 Repair Order Sales 4 Parts Sales
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Conclusion Although intimidating at
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Chapter 5 Balance Sheet Why do we c
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When an adjustment to a balance she
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Part 2 Inventory Chapter 6 General
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. Purchasing c. Handling, processin
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dealerships use specific identifica
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Chapter 7 LIFO Background Overview
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A Short History of LIFO Application
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improper inflation through unwarran
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Introduction Chapter 8 Computing LI
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The double extension index formula
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as one item, there would probably n
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(existing items) and non-comparable
Page 61 and 62: The current-year costs that can be
Page 63 and 64: Assuming the dealership elects LIFO
Page 65 and 66: matching of revenues and costs. Thu
Page 67 and 68: section 1.471-9. Both of these regu
Page 69 and 70: providing to the credit subsidiary
Page 71 and 72: Under elections made prior to Decem
Page 73 and 74: Base Year Cost 9112 $224,000 You ha
Page 75 and 76: BLS Sanity Check A simpler means to
Page 77 and 78: CYC = Current Year Cost. This is th
Page 79 and 80: Computation of 1993 Increment and R
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Page 83 and 84: Specific Identification Increment M
Page 85 and 86: which may be identified by a unique
Page 87 and 88: Step # 3 For each item category, ad
Page 89 and 90: Step # 10 Compute the total cost of
Page 91 and 92: 1991 Inventory Value at Current Yea
Page 95 and 96: Dealers may offer the contracts as
Page 99 and 100: 2. Principal/Obligor A principal is
Page 101 and 102: Rev. Proc. 97-38 provided for an al
Page 103 and 104: Contract Construction Generally, a
Page 105 and 106: Rev. Proc. 97-27 provides the admin
Page 107 and 108: The Court ruled that when the deale
Page 109 and 110: Considerations for Forming a Produc
Page 111: The Reinsurance Transaction To illu
Page 115 and 116: (1979). The Service’s position is
Page 117 and 118: While not all captive situations in
Page 119 and 120: 3. IRC section 845 tax avoidance 4.
Page 121 and 122: section, seemingly compliant arrang
Page 123 and 124: 2. By owner A dealer may own dealer
Page 125 and 126: Rules and Regulations Many rules re
Page 129 and 130: One of the assets specifically iden
Page 131 and 132: Where a covenant may be enforced it
Page 135 and 136: 1. Spread income over a number of y
Page 137 and 138: RELATED FINANCE COMPANY CHECKSHEET
Page 141 and 142: 3. Question the taxpayer directly w
Page 145 and 146: Technicalities Under the provisions
Page 149 and 150: Cash 300 Accounts Receivable 300 2.
Page 151 and 152: The dealer sells the note to a fina
Page 153 and 154: For purposes of this rule, an "empl
Page 155 and 156: 10) relationship of stockholder-off
Page 157 and 158: purely for services. See Treas. Reg
Page 159 and 160: Howard Sole, Inc. v. Commissioner,
Page 161 and 162: Milford Motor Co. v. United States,
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new pool for additional, subsequent
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6. The finance company is entitled
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when the back-end distributions are
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The transfer of the installment con
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Report as a Loan or an Assignment
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Reported as a Sale… (How it Shoul
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Other Sources of Information IRC se
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Part 4 Appendices Appendix A Initia
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2) Adjusting Journal Entries 3) Tax
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k. Do you receive rebates from anyo
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f. Employee Benefits 1) Form 5500?
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Appendix B Balance Sheet Section -
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. Dealership financing If the deale
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f. Dealer Reserve Holdbacks 3. Inve
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Once the existence of a shareholder
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Despite the fact the computation ma
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corporate minutes if material. d. L
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Appendix C Definition of an Item Co
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two cars of the same model can vary
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Appendix D An Analysis of the Wrigh
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(D) also moved (DLRS) income to be
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The court did not allow (D)’s cla
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Appendix E Glossary The following t
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FIFO: An inventory cost flow assump
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PLATFORM: A vehicle platform is the
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