If your dealership provides vehicle financing and/or extended service contracts, warranties, or other insurance to its customers, you should be aware of a few important tax issues.

Limitation on deductions of RFC-related losses

A "Related Finance Company," or RFC, is a financing company owned by an automobile dealership. It provides financing for customers that cannot obtain financing through normal channels. The customer is usually required to make payments at the dealership's location. This type of arrangement is typically advertised as a "buy here, pay here" plan.

Dealerships involved in this practice establish a financing entity, typically an S corporation, which acts as the financial institution in the dealership’s selling arrangement. When a vehicle is sold to a customer needing special credit assistance, the dealership writes the note at term (high interest rate) with recourse as the lender. Then the note is sold at significant discount to the entity substantiating the discount by citing high risk.

If you own two entities (regardless of the type of entity) and you own more than 50 percent of each entity, be aware that any loss from the exchange of property between these entities may not be deductible.

Tax considerations for extended service contracts

Motor vehicle dealers sell two basic types of extended service contracts (also known as mechanical breakdown contracts or multiyear service warranty contracts) for used cars and as a supplement to the standard manufacturers’ warranty for new cars.

The first type is between the customer and an unrelated underwriter. The dealer is merely an agent for the underwriter and keeps as profit the difference between the retail price of the contract and the wholesale cost paid to the underwriter.

The second type is a contract between the customer and the dealer. For this type, the dealer may buy insurance covering his or her risk or be self-insured. If the dealer buys insurance, the income and expenses should be reported in the year of receipt; any prepaid insurance must be amortized over the life of the policy. The dealer can elect to mitigate this situation by filing Form 3115 to request changes in accounting methods.

For more information, please contact your nearest Wipfli office.