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

The court laid out a simple, but potent rule as the governing principle in this case: Money
diverted to a sham is taxable to the true owner.
The court held that the corporate form of (FIR) should be disregarded and the income of
(FIR) should be deemed received by (D).
The court felt (D) was engaged in sham transactions. The court cited several factors
concluding the transactions lacked economic substance:
a. Reduction of Commissions - This served no normal business purpose. The activity
wrongfully reduced (DLRS) taxable income and improperly allocated income to (FIR).
b. "Over-submits" - (D) knew (FIR) did nothing to earn this income. (D) knew this
arrangement was risky for tax purposes. The court felt (D) knew these overpayments
constituted a large portion of the "principal" for his retirement plan, and as constituted,
over inflated (DLRS) expenses; wrongfully allocating income to (FIR).
c. The insurance contracts do not demonstrate any risk shifting or distribution. The court
felt the agreements constituted a captive insurance arrangement. The dealership who took
out the $500,000 letter of credit makes that related corporation, not the offshore
reinsurance company, at risk in the insurance arrangement. There is no unrelated business.
d. The carelessness in which (FIR) was formed denotes a sham insurance relationship. The
court specifically cited, among other factors; organizing offshore to escape regulation,
lack of capitalization, the erroneous and undocumented computation of reserves shows a
disregard for standard insurance practices. Additionally, modifications were not entered
into, and the $500,000 letter of credit from (DLR) to establish mandated "reserves" were
cited.
e. The court did not address the issue of constructive dividends because all income was
allocated to (D).
The court felt the interest earned by the annuities was taxable to (D). There was no risk
shifting involved. The intent of the arrangement was to use the annuity interest to pay claims
and to forward the principal to (D) upon termination of all service contracts. The annuities, in
essence, were self-insurance reserves and the evidence shows they were owned by (D).
4. Reasonable Compensation
Concerning the reasonable compensation question, the issue was basically one of
compensation versus dividend. The court sustained the government’s disallowance of (D)’s
compensation as an expense stating (D) did not establish his formula for determining
compensation was valid.
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