Many new and used vehicle dealerships make use of what is known as a related finance company when providing customers credit to purchase a car or truck. While many RFCs serve legitimate business and financial purposes, others do not. The IRS is savvy to the fact that some car dealerships will use RFCs to conduct “paper transactions” lacking economic substance but intended to arrange the businesses finances in such a way as to reduce or eliminate income and other taxes. When assessing an RFC, IRS agents are likely to focus on three main potential issues.
When Facing a Tax Audit, IRS Agents will Check Your RFC for These Three Problems
Generally, when an RFC is present, the auditor will assess the entities to determine whether it is being used for legitimate business purposes or fraudulently to conceal income or improperly defer reporting of income. Thus, the first area of inquiry is into the economic purpose for and use of the RFC. Valid economic reasons can include:
- To provide credit to prospective customers.
- Improve collections efforts for accounts receivables.
- Avoiding certain financial regulatory or licensing requirements for the dealership entity.
- Protect the dealership from adverse publicity generated from collection and repossession efforts.
- Protect the dealership against risks inherent in lending.
Second, the auditor will assess the structure and form of the RFC. A properly formed and structured RFC must meet or exceed all of, roughly, 13 factors used to assess its structural propriety. These factors include:
- The RFC must be a separate and distinct legal entity.
- The RFC must satisfy and maintain all financial licensing requirements in the jurisdiction.
- The RFC should have its own employees and should directly compensate the same.
- The RFC should have a distinct business address or P.O. Box.
- The RFC should maintain its own separate set of books and records.
The third and most important aspect of the inquiry is concerned with the economic substance of the RFC. Generally, to properly claim a tax benefit, an RFC must have not only a valid business purpose but also a valid economic purpose. Thus, when an RFC discounts the dealership’s accounts receivables for purchase, the discount must be reasonable and the ARs must be purchased at fair market value. Second, auditors will consider whether the arrangement shifts risks, improves cash flow, or otherwise serves an economic purpose. Finally, the auditor will assess whether all transactions are perfected.
If any of the above factors are not satisfied and the dealership has used discounts to reduce tax, there is an extremely high likelihood of facing a significant tax liability.
