In its effort to utilize its resources to the greatest advantage, the Internal Revenue Service created the Market Segment Specialization program to help its auditors deal with significant issues that are relevant to a particular industry. IRS examiners are then given audit technique guides to enable them to focus on key audit areas. The IRS issued its examination guide, which is available through its Website at www.irs.gov, and should be utilized by auto dealers to identify areas in which IRS examiners will focus if they are audited.
In its materials, the audit technique guide was created to achieve a high level of proficiency in the way the IRS conducts its examinations of auto dealerships. In addition, by establishing and maintaining close contact with other industry specialists, including the motor vehicle industry specialists, national office, appeals, and district counsel, the IRS can maximize its effectiveness in its auditing efforts of auto dealerships. The audit guide is divided into five parts:
Part 1
Leads the agent through the examination; from pre-audit through the books and records, concentrating on the Fulcrum concept of “financial status.”
Part 2
Illustrates inventory, concentrating on LIFO computations before and after the implementation of Revenue Procedure 97-38 IRB.
Part 3
Discusses after-sale financial products sold by auto dealerships.
Part 4
Considers “stand alone topics,” unique to auto dealerships.
Part 5
The appendix that includes comprehensive case studies, legal authorities, issue analysis, and a glossary of terms.
One area in particular that the IRS examiner will investigate is an auto dealership's building and equipment. In an auto dealership, it is common to rent the land and building from a related entity. Where this occurs, building and equipment will not be one of the larger balance sheet accounts. The main issue should be the arm's-length nature of the rent paid by the dealership to the related entity for the property. The examiner may wish to determine Fair Rental Value to disallow excessive rent and expand on a constructive dividend issue. Subsequent to a reconciliation of the building and equipment items, the examiner may wish to further look at:
- Large, unusual, or questionable items
- Like kind exchanges
- Potentially personal items
- "Imaging payments"
Manufacturers may reimburse dealers for a portion of the costs to renovate and/or relocate their stores. Taxpayers may be excluding these imaging payments from income as a contribution to capital. In John B. White, Inc., 458 F.2d 989, aff'g 55 T.C. 729, the court ruled that the payment was includable in income.
What the case says:
“A lump sum payment received by taxpayer was taxable. The Court of Appeals held that decision of Tax Court that lump sum of $59,290, which was paid by automobile manufacturer to franchise dealer for leasehold improvements and eligible premises assistance as an incentive to complete relocation of its business as a dealer to more adequate facilities in a better neighborhood, was taxable income.”
Law and Analysis
Payments by unrelated third parties to induce a business to take a certain course of action are tax-free (i.e., capital contributions) if the benefits to the payor are indirect and intangible. Thus, payments by a land developer to a department store corporation inducing the corporation to build and operate a store in the developer's new shopping center were not income.
In Federated Department Stores (footnote 35), IRS argued that payments to a corporation by nonshareholders may be treated as nontaxable contributions to the capital of a corporation under IRC s 118 only if made by a governmental unit or civic group. The Sixth Circuit disagreed, pointing to the Senate Finance Committee report (footnote 35), which expressly states that IRC s 118 also applies to contributions made by an association of nonshareholder individuals. The fact that Treas. Reg. § 1.118-1 (footnote 34) refers only to contributions by a governmental unit or civil group does not limit IRC s 118 to these payors, because Treas. Reg. § 1.118-1 lists these as an example. The court therefore concluded that this is not intended to exclude other possible applications.
The Tax Court followed Federated in an essentially similar situation where a department store received a parcel of land from a developer of a shopping center in consideration for the store's building and operating a retail outlet on the property.
In contrast, payments are taxable if the benefits to the person making the payments are so tangible as to be tantamount to payments for future services. Thus, payments by Ford Motor Co to induce a dealer agency to move to a potentially more profitable location were held to be includible in the agency's gross income.
Conclusion
Image payments by a manufacturer to a dealership to “move” are clearly taxable income. However, image payments by a manufacture to enhance the value of the dealership through renovation or expansion at the existing site of the dealership can be argued not includible in the dealership’s income because the renovation and/or expansion adds value to the present use of the real estate, but since the dealership is already present at the location the demographics do not change. Any indirect increase of market share for the manufacturer is so intangible as to be excluded from income. Here, should the Internal Revenue Service make a determination that the manufacturer’s payment was income to the dealer, the substance of the argument is flawed because they would be improperly characterizing a “relocation fee” as an “image payment.”