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

Example 1
Fast Auto is a small used car dealership reporting income on Schedule C. In pre-audit it was
noticed that inventory was small in comparison to Gross Receipts. An examination was
initiated and a physical inspection of the premises revealed that there were about 20 older but
completely restored cars for sale at high prices. Also at the lot was a large garage where cars
were being restored and worked on. The taxpayer was asked about the operation and stated
that vehicles were purchased at wrecking yards or from individuals at low prices and then
were restored and sold as exotic automobiles. The taxpayer also stated that under the Lower
of Cost or Market rules, inventory was maintained at cost without adjustment and that given
low gross receipts, the UNICAP rules of IRC section 263A were not applicable. Market was
not considered because the type of vehicles were so unique no comparison could be made for
valuation purposes. All parts purchased to restore the vehicles were expensed in the period
paid, as were associated wages.
Although the UNICAP rules do not apply to the taxpayer, all of the parts, labor and unique
supplies (special paint, special bolts, etc.) increase the basis of the automobile to which they
apply and therefore are contained in the cost accordingly. Although the industry is
specialized, the dealer is in an area of expertise with others and given mainstream publications
on exotic cars with advertisements, market value can be estimated. Most importantly, the
owner’s experiences and typical high markup show that cost is lower than market and
therefore market is irrelevant to the dealer for inventory purposes. The roll over adjustment
would be to increase ending inventory accordingly in the first open year and carry the
adjustments forward to the current year.
IRC section 263A – Uniform Capitalization Rules
IRC section 263A, provides uniform capitalization rules that apply to the production of property
and the acquisition of property for resale. Treas. Reg. section 1.263A-1 states, "all costs that are
incurred with respect to real or tangible personal property which is produced, or property which is
acquired for resale, are to be capitalized with respect to such property."
Treas. Reg. section 1.263A(d)(2)(i) provides the following regarding resale activities:
1. The rules apply to all wholesalers and retailers.
2. Average annual gross receipts must be over $10 million over the prior 3 years.
3. If the taxpayer corporation was not in existence for 3 years, the average is based on the
number of years it has been in existence. The costs that must be capitalized in the ending
inventory include certain indirect costs pertaining to:
a. Costs incurred for offsite storage and warehousing
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