By Terri Harris, DHG Dealerships
From compliance to operational matters and beyond, the better condition a “for sale” dealership is in, the higher the chances of a smooth transaction. Tax law non-compliance in particular can be a deal breaker in a buy/sell.
While there are many elements that play into overall tax compliance, demonstrating adherence to IRS guidance can help a seller in his/her mission to present a well-run dealership to a potential buyer.
Demonstration vehicles and used vehicles are accounting areas fraught with danger. Familiarizing yourself with the way to account for vehicles that dealerships provide to qualified workers for valid business purposes can not only allow you to have compliant books for a potential buyer to examine. It can also help you proactively identify problem areas in your dealership.
You should also be familiar with IRS guidance related to used vehicle valuation and write-downs. If you adopt the proper accounting method, you may be able to write down used vehicles’ inventory value.
On another note, while the assumption that “It won’t be me” lingers among many dealers in relation to an Internal Revenue Service (IRS) audit, it could happen. While the odds of undergoing an IRS audit may be slim industry-wide, it’s completely situational from dealership to dealership. Properly accounting for demonstrator vehicles and used vehicles can make an audit much less painful.
Demonstrator Vehicles
Despite present IRS guidance, demonstrator vehicles – which dealerships provide to qualified employees for valid business purposes and receive favorable tax treatment under Treasury Regulation § 1.132-5(o)(3) – can be an auditing exam issue.
In order to be treated as a qualified demo vehicle, it must be:
- Currently in the dealership’s inventory; and
- Available for test drives by customers during the qualified employee’s normal business hours.
In addition to the vehicle meeting the above standards, the employee using the vehicle must:
- Be full-time;
- Spend at least half of a normal business day performing the functions of a floor salesperson or sales manager;
- Directly engage in substantial promotion and negotiation of customer sales; and
- Derive at least 25% of gross income from sales activities
Revenue Procedure 2001-56 provided several safe harbors and optional methods that simplified the demo vehicle compliance process.
Ultimately, examiners still commonly find demo vehicle issues. The following are the most prevalent based upon my experience and should be seriously considered by dealerships to avoid potential IRS issues:
- No accounting for the demo vehicles whatsoever
- Vehicles treated as demos provided to non-salespersons
- Vehicles not in inventory
- No demo vehicle policy in place at the dealership
- Demo policy in place, but not strictly enforced or followed by employees
Used Vehicle Valuation & Write Downs
This issue primarily concerns adopting a lower of cost or market method of accounting for used vehicles. Dealerships that properly adopt the method for used vehicles may be able to write down the vehicles’ ending inventory value.
First, vehicles must be properly valued when acquired. According to Revenue Ruling 67-107, used cars taken in trade by dealerships as partial payment on the sale of cars may, for inventory purposes, be valued comparably to those listed in an official used car guide as the average wholesale prices, including required adjustments (this ruling applies to vehicles taken in trade; purchased vehicles must be valued at purchase price).
Then, at year end, the dealership may write down the vehicles’ inventory value using an official used vehicle guide if the market value, average wholesale price as of year-end, is lower than cost.
Questions dealerships can ask themselves to help prepare and protect themselves against common exam issues include:
Acquisition of the vehicle:
- Are vehicles accounted for properly when taken in on trade (and not valued at what you gave the customer in the purchase transaction)?
- Are purchased vehicles accounted for properly when acquired?
Year-end write-downs:
- Are write downs done on a vehicle by vehicle basis (no estimates)?
- Is there a flat write down percentage or amount applied across inventory? If so, the vehicles are likely improperly valued.
- Is the used car guide used properly (i.e. adjusted for mileage, condition, etc. as necessary)?
- Is the same guide from last year used this year? If the answer is “no”, the dealership is using an impermissible method of accounting. Changing from one guide to another is considered a change in method of accounting, meaning formal procedures (filing Form 3115) must be employed to make to the change.
- Are write downs properly documented and is inventory recorded legibly, properly computed, summarized and kept as a part of my accounting records as a taxpayer?
Other areas to be familiar with going into an IRS exam are factory facility programs and cash reporting. Those will be explored in future columns.
Even if you’re not under IRS examination, areas for improvement within your dealership likely exist. Take this as an opportunity for proactivity and address any uncertainty you may have with respect to these IRS compliance areas. You, and a potential buyer, will be glad you did.
Terri Harris is National Tax Liaison with DHG Dealerships. She can be reached at 1-901-259-3629 or terri.harris@dhgllp.com .
