Car Dealership Tax Audit Defense
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.
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.
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.
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.
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.
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. 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.
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 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.
Common Questions About Car Dealer Tax Audits
- Can A Related Finance Company (RFC) Result in Tax Problems for a Car Dealership?
- Do I Have to Pay Income Tax on Online Sales Commission?
- Is the IRS Aware of Car Dealership’s Methods of Underreporting Taxable Income?
- What Tax Concerns Exist When a Dealership Repossesses a Vehicle?
- Does my Car Dealership Need to Account for the Value of Trade-Ins?