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

2. Principal/Obligor
A principal is a party to the contract who assumes the risk contemplated in the contract, is
directly responsible for any ensuing liabilities that may arise and derives compensation from
the profit built into the product sold. The principal in the automobile context will generally
insure the obligations undertaken in these contracts with a third party insurer, but remains the
primary obligor to the consumer.
As a principal/obligor, dealers should include in income the full amount received from the
consumer for the mechanical breakdown contract. The amount remitted for the insurance
premium should then be amortized over the term of the contract.
Dealer "Agent" Extended Service Contracts
If the extended service contract is between the vehicle purchaser and an administrator,
insurance company or other party, the dealership acts as an agent and earns a commission.
Generally, the dealership determines the selling price of the extended service contract and
forwards a portion to the administrator based on a "cost schedule." The commission income
must be accrued when the contract is sold. The commission amount is the difference
between the extended service contract selling price and the amount the dealer forwards to the
administrator, insurance company, or other party.
Dealer "Obligor" Extended Service Contract
When the extended service contract is between the vehicle purchaser and the dealership, the
dealership is the "obligor" or "principal" on the contract. When a dealership acts as obligor
or principal, it may purchase an insurance policy that insures its liability under the service
contract. Thus, there are two transactions: one between the dealer and the customer, and the
second between the dealer and an insurance company.
Dealerships that sell dealer obligor contracts and purchase insurance to cover their risks often
report the income in a manner similar to a dealer agent contract, i.e. report only the
commission income. To properly account for a dealer obligor contract, the dealership must
include in income the entire sales price of the service contract.
Generally, taxpayers that determine their taxable income using the accrual method of
accounting must include advance payments in income when received. The Supreme Court
applied this rule in Automobile Club v. Commissioner, 353 U.S. 180 (1957) to membership
dues collected 1 year in advance. The rule was also applied to service contracts in Streight
Radio and Television, Inc. v. Commissioner, 280 F.2d 883 (7th Cir. 1960) where the
taxpayer had unrestricted use of the funds.
Rev. Proc. 71-21, 71-2 C.B. Page 549 provides for an election to defer advance payments for
services where the services are to be performed by the end of the next tax year.
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