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Car Dealership Tax Audit Defense

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    For owners of car and truck dealerships that are selling new cars, used cars, or both it probably comes as no surprise that the IRS and state tax agencies like the California Franchise Tax Board and Board of Equalization keep a close watch on dealerships. Part of the reason for this focus and attention is that a significant amount of income and revenue passes through most dealerships. However, the focus is even more rigorous due to the numerous risk factors present in the industry. The IRS and other tax agencies believe that these risk factors present an increased likelihood of tax evasion and tax fraud. Therefore, it is prudent for owners of a car or truck dealership to prepare for a tax audit before it ever occurs. By doing so you can avoid potentially serious tax problems that can disrupt or even kill your business.

    Lately, the IRS has started numerous audits of new and used car dealerships as part of a campaign to catch tax evaders. The agency also initiated many criminal investigations, a sizeable portion of which involved violations of cash reporting requirements. As a car dealer, it is best to get tax advice from experts in this field for your protection. You may be at the risk of incurring hefty tax, penalty, or interest charges, in a best-case scenario, and facing criminal tax prosecution in a worst case scenario, if you are given incorrect advice.

    Car Dealerships Often Possess High-Risk Factors for Tax Audits

    Most owners or investors into a car dealership believe that their investment is above-board and therefore should not attract any additional suspicion or scrutiny. However, when the owner or investor finds themselves facing an audit, they may wonder why the IRS or state tax agency is taking such an aggressive approach. They may even wonder why it feels like the agent already assumes that they are guilty of at least some tax impropriety.

    The reason for this approach to many dealership tax audits stems from the fact that numerous risk factors that the IRS sees as making tax fraud more likely are often present. To start with and especially in the used car industry, cash transactions are reasonably common. Since cash does not leave a trail like payment by check or credit card, the IRS views it as more likely to be used to commit fraud. Employees with access to cash may misappropriate it for their own goals or needs. Alternatively, business owners may believe that the lack of a clear trail can allow them to divert and understate cash income.

    Beyond the presence and use of cash at auto businesses, issues regarding vehicle inventory and accounting for gain or loss is often an area of concern. The IRS is likely to check to see if your method of valuation for used cars is reasonable and based on a sound rationale such as an accepted vehicle valuation guide. Furthermore, many auto dealerships isolate the vehicle sales and lending aspects of their businesses. Use of a related finance company (RFC) or other complex financial arrangements can also give auditors the impression that you are conducting paper transactions to evade taxes.

    The IRS Is Aware of Common Techniques Used to Minimize Income and Reduce Taxes

    Due to auditing hundreds if not thousands of auto dealerships nationwide annually, the IRS is keenly aware of areas where business owners believe that they can “fudge” the numbers or otherwise fraudulently reduce their taxes. In the auto dealership industry, many of these efforts are centered around vehicle trade-ins that are frequently offered to potential customers. As a starting place, it is essential that the dealership records the ACV of the trade-in after making a reasonable valuation. This is an essential step because a vehicle is property and buying and selling property gives rise to a need to account for capital gain and loss. At least some auto dealerships, the value of the trade-in may be misreported to generate a loss.

    However, trade-in and vehicle valuation issues are only one area where vehicle dealership owners commonly misreport or otherwise attempt to reach a more favorable tax outcome despite the reality of the company’s finances. Other areas that the IRS or California state tax auditors are likely to explore also include:

    • Potential issues created by inclusion or noninclusion of sales taxes in the gross sale price.
    • Potential tax issues stemming from the inclusion or noninclusion of licensing or titling fees in the sale price.
    • If the dealership sells warranties or ongoing service contracts, is this post-sale income accounted for?
    • Does the dealership RFC serve business and economic purposes or does it merely exist for tax purposes?
    • If the car or truck was financed, is there interest income?
    • Does any other post-sale income exist?

    The above captures some of the more common areas where dealership tax fraud can occur. While agents are almost certain to check these potential troublespots, agents and auditors from the IRS and California’s state tax agencies are also aware of and check for many other potential tax issues.

    For example, if you are a seller of used motor vehicles, all your gross receipts are presumed to be subject to tax unless you can prove otherwise. If you do not timely obtain a valid resale certificate, you will be potentially relieved of liability for the sales tax only where you show either that the purchaser, in fact, resold the property or is holding it for resale and did not use the property for any purpose other than retention, demonstration, or display, or that the purchaser consumed the property and reported or paid the tax directly to the taxing authority.

    Why Do You Need an Expert to Handle Your Affairs?

    When a taxing authority, like IRS, California Franchise Tax Board, and Board of Equalization, are not satisfied with the accuracy of the income tax and sales and use tax returns filed, it is allowed to base its determination of the tax due upon the facts contained in the returns or upon any information that comes within its possession. It is your responsibility to maintain and make available for examination on request all records necessary to determine the correct tax liability, including bills, receipts, invoices, or other documents of original entry supporting the entries in your accounting records.

    The bad news is that deficiency determinations and assessments for unpaid taxes are normally entitled to a presumption of correctness so long as they are supported by a minimal factual foundation. We see it often that when experts are not engaged by a car dealer, proper records and documentation are not provided to auditors. This allows the taxing authorities to then utilize alternate audit methods to obtain information regarding a car dealer’s purchases, which can lead to some very grave consequences. Let us demonstrate by use of an example.

    Suppose you are a seller of used motor vehicles. You reported total sales of a certain amount and claimed deductions for non-taxable sales of the same amount, reporting no taxable sales. You get an audit notice and consult your tax preparer, who advises you that producing purchase records should be enough. As a result, the taxing authority decides to utilize alternate audit methods. It contacts auto auctions in your area and obtains information regarding your purchases of vehicles for a three-year period. It also obtains information from the Department of Motor Vehicles’ (DMV) database to identify the vehicles that you did not sell at retail. In the revised audit, the authority establishes a hefty deficiency measure, which includes your unreported taxable sales. You ultimately get a Notice of Determination stating a ridiculous amount of tax, a negligence penalty, and applicable interest. Our job is to make the likelihood of such a scenario happening as low as possible.

    In the case of an appeal based on unreported taxable sales, unfortunately, a taxing authority, such as IRS, CDTFA, FTB and EDD, only has a minimal, initial burden of showing that its determination was reasonable and rational. Once the taxing authority meets its initial burden, the burden of proof shifts to you to establish that a result differing from the taxing authority’s determination is warranted; you would be well-advised not to let things get to this stage.

    Dealership Related Finance Companies Are Often an Audit Focus

    As mentioned above, related finance companies (RFC) are often a focus of an audit. There are valid purposes behind an RFC and good reasons to organize a car dealership around one. For instance, an RFC can insulate the dealership business from the risks inherent in lending money and providing financing. Use of an RFC can also allow the dealership to avoid needing to consider financial regulatory and licensing aspect for the dealership entity. Use of an RFC can also improve the company’s ability to collect on unpaid debts and engage in repossession efforts since the client-facing dealership will not be involved in the collection proceedings.

    Despite the potential benefits of an RFC, numerous aspects must be thoroughly considered to avoid non-compliance with tax laws and other laws. The failure to properly form and administer an RFC could mean that certain tax credits or deduction will be disallowed by the IRS or state tax agency. Essentially, there are a number of technical requirements such as the RFC must be a distinct legal entity and it must also have its own address, books, and records. However, the main thrust of an audit is often concerned with whether the RFC has both an economic purpose and a business purpose; merely having a business purpose alone is not sufficient. If the use of the RFC and its deductions are disallowed, a significant tax liability is extremely likely.

    Frequent Interview Pitfalls

    The IRS provides guidance to its examiners on conducting income tax examinations in the car dealership industry. The guidance incorporates practical procedures and techniques that are unique to the car dealership industry. The IRS hopes that these procedures and techniques, combined with the examiner’s good judgment, skill, and experience, will allow the examiner to uncover deficiencies and unreported income. Don’t be fooled by the IRS’s claim that: “The use of these techniques does not imply that the object of the examination is to find a deficiency; the objective is to determine whether the reported income and expenses have been accurately reported;” finding deficiencies and unreported income is exactly why the examiner is at your doorstep. In all tax examinations & investigations, the initial interview is of paramount importance. Let us include here some of the important queries that you can face.

    The questions can be divided into three major categories: Income Sources, Sales, and Inventory Items. Regarding your Income Sources, the examiner is likely to ask you about the types of sales transactions your dealership entered into for the year under examination. If you entered into any sales at auctions, the examiner might ask you to state the particular auctions. The questions will revolve around your sales to wholesalers, sales to other dealers, consignment sales, scrap sales, and whether your dealership engaged in any in-house financing of vehicle sales.

    Regarding the Sales category, the CDTFA examiner may ask you whether you reported the sales taxes in the gross sales price or whether the licensing fees or titling fees are included in the sales price, or what is your recording process if you assign a value to a trade-in vehicle that is over market value to make a sale of a vehicle to a customer.

    Regarding the Inventory Category, you are likely to be asked how your inventory is valued, and you may be asked to produce your inventory records and computations. You may be asked about the acquisition of vehicles at auctions and from wholesalers. You should also be prepared to answer questions on the log/record of titles for all vehicles sold for the year.

    We strongly advise you to avoid seeking guidance from your original preparer if you think there is any discrepancy on the returns that are at issue. The reason is he/she will have a very strong incentive to throw you under the bus to avoid criminal charges against him/her for aiding and abetting tax evasion. You need to hire a dual licensed Criminal Tax Defense Attorney and CPA that can offer you the attorney-client privilege and that has a staff of Kovel Accountants that also grant you attorney-client privilege so that the very professionals you hire cannot be forced to become a witness against you. At the Tax Law Office of David W. Klasing, we are equipped with all the tools to meet all the challenges that may arise.

    Preparation for an audit is crucial. We pride ourselves on our ability to never be surprised by anything raised by the IRS, CDTFA, FTB, or EDD agents conducting audits of car dealers. We know exactly what needs to be disclosed and, more importantly, what does NOT need to be disclosed by you to the agent during the course of your audit. For us, preparation for an audit involves unearthing all facts and conducting independent research based on our understanding of the issues likely to be raised. For instance, if unreported income may become an issue in the audit, we will review your bank statements, 1099s, and other evidence of income to get an idea of whether a material discrepancy between taxable income received and reported for the year exists. If you claimed deductions relating to a home office, we will conduct visits to your home to verify the legitimacy of the deduction and then plan accordingly. If your business is under examination, a visit to your place of business to review its record-keeping and accounting processes would be essential. If your sale of an investment property appears to be an issue in the examination, we will obtain copies of the settlement sheet and the sales agreement and review publicly available information regarding the sale. These are just examples of situations that may arise–the key point is that thorough preparation is vital, and, to the extent possible, we do whatever is necessary so that the audit does not yield anything that you weren’t prepared for.

    Almost every audit can reveal errors in a return. People are inherently prone to mistakes, and the summation of an entire year’s financial activity on a tax return presents countless opportunities to err. But not every error or deficiency in tax constitutes, or even presents the risk of, criminal tax fraud. Before an audit becomes an eggshell audit, there must be the spectre of criminal tax fraud, and it is our job to recognize when your conduct rises to that level and take preventive steps. But what is an “eggshell audit”? The term refers to the possibility that the subject of a civil audit could, under pressure, crack open and provide information leading to a referral for criminal investigation and prosecution. Our goal when advising a client facing an eggshell audit is clear: the resolution of the audit without a referral by the civil examiner to the IRS’s criminal investigation division (CID). Without the help of an expert, reaching that goal can be difficult, complex, and perilous.

    Car Dealers In California Must Obtain a Seller’s Permit and Ensure State Sales Tax Compliance

    A number of California-specific regulatory and financial obligations apply to car dealerships located in and conducting business in the state. To start, all persons or entities in California who sell at least three vehicles in a 12-month period are retailers. All California retailers are required to apply for and obtain a seller’s permit. Individuals and entities holding a California seller’s permit are obligated to collect and remit sales and use tax to the Board of Equalization. Certain exceptions can apply to this rule, for instance, if the car is sold to a foreign buyer who will not use the vehicle in California. Effective January 1, 2021, used vehicle dealers have new reporting and payment requirements. Please see the New Legislation Affecting Used Vehicle Dealers section below for more information.

    One important aspect regarding the duty to report and pay sales or use tax at the statewide tax rate is the fact that certain localities have their own applicable district taxes. Retailers should ensure that the entire tax obligation is being collected and not just the county portion. Furthermore, the California Board of Equalization cautions that it is not always possible to determine the correct rate by mailing address alone. While the agency makes several research resources available, it is often prudent to consult with a tax professional so that a small initial error does not grow into a major tax liability.

    New Legislation Affecting Used Vehicle Dealers

    California recently enacted new laws, which introduce new requirements for licensed used vehicle dealers to pay the applicable sales tax, including district taxes, on their retail sales of motor vehicles directly to the Department of Motor Vehicles (DMV) when they submit a vehicle registration application.

    Beginning January 1, 2021, the California Department of Tax and Fee Administration (CDTFA) changed the filing frequency for all used vehicle dealers to a monthly reporting basis and requiring detailed transaction information, including any retail sales of vehicles to be submitted with the sales and use tax returns.

    Moreover, beginning January 1, 2021, newly licensed dealers, dealers whose seller’s permits were reinstated within the last two years, and dealers with a previous finding of underreporting within the last two years are required to pay sales tax to the DMV when they submit a motor vehicle registration application to the DMV.

    Beginning January 1, 2023, all other used vehicle dealers will be required to pay sales tax to the DMV. The DMV will notify you when your payment method is scheduled to change. You must continue to timely remit the sales tax due to CDTFA until the DMV transitions you to the new payment process. Once you are transitioned, please accurately provide your seller’s permit number on the Report of Sale that you provide to the DMV to ensure your sales tax payments are correctly applied to your CDTFA sales and use tax return.

    Beginning January 1, 2021, you are required to provide the following information about your retail sales of vehicles with your sales and use tax returns:

    • Report of Sale number
    • Selling price reported to DMV, if applicable, and
    • Sales tax and/or penalty amounts paid to the DMV, if applicable

    The selling price reported to DMV generally does not include other charges related to the vehicle, including but not limited to document fees, smog certification fees, and mandatory warranties. These other charges must be reported on line 1, Total Sales.

    At the time you submit a vehicle registration application with the DMV, the DMV will assess the sales tax due on the transaction. Failure to timely submit an application for registration or transfer registration of your vehicle with the DMV will result in the DMV imposing penalties on the transaction, including a 10% penalty based on the sales tax due.

    If you are selling a motor vehicle that does not require you to submit an application for registration with the DMV, you must pay the sales tax directly to the CDTFA when you file your sales and use tax return.

    If you have been notified by the DMV that you should make sales tax payment(s) directly to the DMV and you mistakenly sent the sales tax payment(s) to the CDTFA, you may be required to pay applicable penalties and/or interest imposed as a result of not timely paying the sales tax. You do not need to notify the DMV that you made payment to the CDTFA. CDTFA will assess penalties and/or interest on your sales tax payment made to the CDTFA, if applicable. In the future, you must pay sales tax to the DMV for your retail sales of motor vehicles when you submit your registration applications to the DMV.

    If you paid sales tax to the DMV and do not file your sales and use tax return with the CDTFA, CDTFA will contact you to resolve any sales and use tax returns you failed to file. If you do not file your sales and use tax return(s), an estimated billing may be issued to you, which may include interest and penalties.

    If you received a notice from the DMV stating that you are required to pay sales tax on your retail sales of vehicles directly to the DMV, and you believe you received this notice in error, you must contact the DMV to correct and/or verify your licensing information with the DMV. If you received a special notice or other related material from the CDTFA indicating you are a used vehicle dealer, but you do not make retail sales of vehicles and you already confirmed with the DMV that you are not licensed to sell used vehicles, you must update your registration information with the CDTFA. You may do so by contacting the CDTFA office near you.

    The new rules do not affect a licensed new motor vehicle dealer. If you are a licensed new motor vehicle dealer, you are not required to pay sales tax directly to the DMV, even if you make retail sales of used motor vehicles. Additionally, your filing frequency will not be changed. If you received a notice from the DMV stating that you are required to pay sales tax on your retail sales of motor vehicles directly to the DMV, and you believe you received this notice in error, you must contact the DMV to correct and/or verify your licensing information.

    California Car Dealerships are Beholden to Record-Keeping Requirements

    It is essential to note that California car and truck dealerships are subject to minimum record-keeping requirements. You must keep adequate records that support the amount of tax that is due. You may be required to present the records to the CDTFA in an audit. Failure to maintain accurate records could result in negligence or intent to evade tax and may result in penalties. Likewise and as set forth above, associated RFCs have their own set of requirements that must be satisfied. For instance, the California Board of Equalization recognizes that the inventory of a used car dealer, “will come from a variety of sources including trade-ins on sales of other vehicles, retail auctions, or from other new and used car dealers.” In order to accurately track inventory the BOE recommends these minimum records be kept:

    • An inventory number and car envelope should be assigned for each vehicle.
    • Details regarding the vehicle and sale should be placed in the proper spaces on the envelope.
    • The minimum details that should be included are the source of purchase, date of purchase, description of the vehicle, and price/cost.
    • Report of sales books must also be obtained from the California DMV. Sales records must be maintained in numerical sequence.
    • If selling a vehicle for resale, resale certificates must be obtained from the customer.
    • If vehicles are sold for interstate or use outside of California, vehicle dealers are urged to obtain and maintain notarized proof of this fact with evidence. Relevant evidence can include a company’s out of state address.

    Generally, California’s Sales and Use Tax Law requires adequate records for a minimum of four years. The failure to keep these records could lead to penalties for the noncompliance with record keeping statutes. Failures can also lead to adverse inferences or determinations by the auditing agent.

    If you are being audited, retain all records for the audit period until the audit is completed to support any differences that may arise from the audit.

    Sales Documents – New Vehicle Dealers

    Most new vehicle dealers have detailed records that reflect their daily operations. These records are prescribed by the major automobile manufacturers. You will generally have a stock book listing all vehicles delivered into your inventory from the manufacturer. Typically, you will use different sales journals such as new car retail, new car fleet, new car commercial, etc., to track your different types of sales transactions. Your basic sales document is the motor vehicle contract and sales agreement, usually containing four copies for the deal jacket, customer, financing company, and your own files. You will also have a report of sale books obtained from the DMV for all new vehicle sales. These forms must be maintained in numerical sequence, including copies returned to the DMV or voided.

    Sales Documents – Used Vehicle Dealers

    Your inventory will come from a variety of sources, including trade-ins on sales of other vehicles, retail auctions, or from other new and used car dealers. You will generally use car envelopes and inventory books to track your sales. You should assign an inventory number to vehicles with car envelopes prepared for each unit. Details of each purchase and sale should be placed on the proper lines on the printed face of the envelope. All documents of purchase, reconditioning, and sale are then inserted in the envelope.

    If you use an inventory book as a combination purchase and sales journal, you should enter the details of the source of purchase, date, description, and cost of each vehicle reflecting each purchase. The date of sale, name of customer, and selling price are recorded at the time of sale. When using this method, it is not uncommon to purchase a vehicle in one period and sell it in a later period. You should be sure to reconcile all purchases and sales each period to make sure sales are reported in the appropriate period. You will also have a report of sales books obtained from the DMV. These forms must be maintained in numerical sequence, including copies returned to the DMV or voided.

    What Should I do When My Dealership Is Under Audit?

    The complex finances and numerous risk factors present at car dealerships often means that agents from the IRS and California tax agencies will take a rigorous approach to an audit. In fact, depending on your approach to the proceedings and records, you can inadvertently open the door to a broader audit concerning additional aspects of your business finances. Therefore, it is essential to set ground rules for the audit from the outset and approach all aspects of the matter professionally but aggressively.

    The tax lawyers at the Tax Law Offices of David W. Klasing can assist new and used car and truck dealerships that have come under audit by the IRS, California Franchise Tax Board, Employment Development Division, or Board of Equalization. Mr. Klasing is a dually certified tax attorney and CPA who is a former public auditor. As such, he can often anticipate the approach auditors will take and can craft a strategy to meet this challenge. To schedule a confidential, reduced-rate initial consultation, call our Irvine or Los Angeles law firm at 800-681-1295 or online today.

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