It’s one of the most stress creating notices anyone can receive. The Internal Revenue Service wants to conduct an audit.

And for buy-here, pay-here operators, the complexities of explaining how their businesses function to a federal regulator who might not be at all familiar with how a typical BHPH store and related finance company work in tandem can create many kinds of headaches.

Steven Goldberg touched on three major areas where BHPH dealers can sharpen their records and practices in order to make an IRS audit a little less stressful, resulting in an outcome leaving the operators with less gray hair and indigestion. Goldberg is one of the partners with Shilson, Goldberg, Cheung & Associates, a Houston-based accounting firm that specializes in handling the complex needs of keeping accurate compliant records in BHPH.

“Overall, the trend for IRS audits oddly enough is actually down. There are fewer audits overall,” Goldberg said. “However, what they’re doing is they’re identifying issues and industries they want to focus on, and they’re stepping up their audits in those areas. And for that reason, there’s been an increase for dealerships and related finance companies.

“There is an old saying that everyone gets picked for an audit once in their lifetime,” Goldberg added during the Compliance Academy conducted earlier this year by the National Alliance of Buy-Here, Pay- Here Dealers.

“If you do have that once in a lifetime experience, I hope that you are well prepared and end up with one with no changes. That’s the best kind,” he went on to say.

Bad Debt Expense Challenges

It’s a deduction nearly every BHPH operator takes, maybe even the biggest one on an annual federal return. The bad debt expense can be taken to ease income tax burdens, but it’s not without potential pitfalls.

“Everyone who is doing that and deducting their bad debts, you have a higher chance of being selected for an audit by the IRS,” Goldberg said.

“Pretty much all auditors are telling me that they see a lot of abuse in this area. That’s why the IRS is focusing so much on this area with dealerships and related finance companies,” he continued. “The complaints I’m hearing from the auditors is they’re seeing a lot of abuse because people are repossessing the car, selling the car at auction and not reporting the proceeds from the auction. They’re just pocketing the cash and walking away.”

Goldberg relayed that IRS examiners say they’ve seen BHPH operators assign vehicle values as low as $10, not counting units that were totaled and left stores with little choice because there wasn’t the opportunity to liquidate the vehicle at auction for much money or resell the unit.

“I will tell you — the IRS auditors might not know your business really well, but they are well versed on bad debts,” Goldberg said.

Goldberg indicated that IRS officials often want policies on how operators handle repossessions, timetables for when vehicles are repossessed and debts are written off , as well as correspondence the collections department had with customers.

“One of the most important aspects of bad debts is to utilize the guide book to determine the value of your repossessions,” said Goldberg, who noted the readily available data from providers such as Black Book, Kelley Blue Book and NADA Used Car Guide.

“Obviously, if you sell your vehicle at auction, you know what it is worth. You’ve got the money from the auction,” Goldberg continued. “But a lot of people will recycle their vehicle back into the dealership. When that happens, I guarantee the IRS auditor will look at the value of it. No matter what value you put, they will challenge it unless you can prove its fair market value. The best way to do that is with a guidebook.

“It’s the difference between a long audit and a short audit,” he went on to say. “It’s the difference between winning an audit with no change and losing an audit. Use a guidebook from a third party.”

Information Opens Up More Investigations

Goldberg pointed out that the IRS has been expanding audits to include more entities a BHPH operator might have. In the past, he said auditors might have focused solely on a dealership while leaving alone an operator’s finance company as well as potential real estate businesses.

“Government regulations and information available to them is extreme. They have so many reporting requirements at their fingertips they can draw on,” Goldberg said.

“Now they’re saying, ‘I’m here and this is a related party. As long as I’m talking about the dealership, I think we should open up the finance company, maybe rental properties.’ They’re adding much more time to the audit because they’re opening up other entities as well,” he continued.

Part of the reason for these elongated investigations is the volume of data and information that’s readily available. Goldberg indicated that he’s been involved in audits recently where examiners already scoured records from the state Department of Motor Vehicles before ever arriving at the dealership.

He added the owner’s personal finances and other files are leveraged by the IRS, too.

Goldberg shared an anecdote that resonated with the crowd gathered in Las Vegas for NABD’s compliance event. IRS spotted that a BHPH operator opened a casino account, but another individual withdrew the winnings. Auditors suspected the operator was paying an employee “under the table,” according to Goldberg.

“These things are starting to come up because of all the information that’s out there,” he said. “It’s almost like you’re getting audited by the IRS all the time because of this access to information that you might not have seen three or four years ago.”

Inventory Accounting Compliance

Goldberg reminded operators about the correct way BHPH operators should determine and record the cost of their inventory. The total inventory cost is computed as the price a dealer paid for a vehicle plus reconditioning costs.

For example, if an operator bought a vehicle for $5,000 and spent another $300 to recondition the unit, that piece of inventory would be recorded as $5,300 on the dealership’s tax return.

Goldberg emphasized the process can become more complicated if the operator and accounting professional choose to take an inventory write-down on tax returns. He reiterated the value guide books can provide to ease the clash a dealer might have with the IRS over this issue during an audit.

“For those who take an inventory write-down you can pick a cost and compare it to the market value, you’re allowed to take an inventory write-down on your return,” Goldberg said.

“What not to do is say, ‘I think 20 percent is good for this year. I’ll take 20 percent.’ Th at’s not how you want to do it,” he continued. “You want to look at each and every car and compare the costs of what it took to make it ready and compare it to the value of the car. Whichever number is lower for that inventory, that’s the number you use.

“Once again, the IRS auditor assumes because he doesn’t know your industry very well that you’re going to low ball that fair market value. That’s going to be just like bad debts. They’re going to assume you low ball,” Goldberg went on to say.

So what’s the best weapon to use in this battle during the audit? Reports from service providers, according to Goldberg.

“Where to win on this issue is you’re going to have to show them a report from a third party,” he said. “Just like for your repos, you want to use a guidebook for your write downs to determine the fair market value of your cars.

“The auditors will spend lots of time on your inventory if you don’t use a guidebook,” Goldberg added. “The last thing you want is for the auditor to determine the value of your vehicles. The guidebook takes it out of his hands.”

CHECKLIST FOR RELATED FINANCE COMPANIES

The following check sheet can provide a quick test of the validity of your BHPH lot and related finance company (RFC). If the answers to the questions below are no, the issue probably merits further analysis.

ORGANIZATION

1. Is the RFC a separate, legal entity from the dealership?

2. Does the RFC meet all state licensing requirements?

3. Does the RFC maintain all required, local business licenses?

4. Does the RFC comply with title and lien holder laws in its area?

5. Does the RFC have adequate capital to pay for the contracts?

6. Does the RFC have its own address and operate from separate facilities?

7. Does the RFC have its own telephone number?

8. Does the RFC maintain its own books, separate from the dealership(s)?

9. Does the RFC have its own employees?

10. Does the RFC compensate the employees directly?

11. Does the RFC pay its own expenses?

12. Does the RFC maintain its own bank accounts, separate from the related dealership(s)?

OPERATION

13. Does the lien holder on the finance contract change from the dealership to the finance company?

14. Does the dealership notify customers that the contracts were sold?

15. Does the RFC pay the dealership for the contracts at the time of purchase?

16. Does the RFC purchase any contracts from unrelated companies?

17. Does the RFC have written agreements with the dealership(s)?

18. If so, does the agreement state how the discount rate was determined?

19. Does the discount rate approximate the actual loss experience?

20. Are the finance contracts non-recourse?

21. Does the RFC handle repossessions?

22. Does the dealership sell any finance contracts to unrelated finance companies?

23. Does the RFC report income on a pro-rata basis?

24. Did the profit reported on the initial sale of the vehicle exceed the loss on the sale of the finance contract?

25. Does the RFC have a business purpose?

26. Did the RFC investigate items such as the borrower's credit history, length of the note, age of the vehicle, and payment history prior to determining FMV of the note?

CONCLUSION

An adjustment is appropriate when the note is not discounted at fair market value to a “controlled financier” or when the related finance company arrangement is an economic sham. If such is the case, then adjustments should be made to assign income to the proper year it was incurred in connection with the rules aforementioned.

Source: Shilson, Goldberg, Cheung & Associates