Is Your RFC Safe?

At least two buy here-pay here dealers recently had the Internal Revenue Service attempt to collapse their related finance companies after audits by the service—begging the question whether this is a result of poor business and accounting practices or a change in federal temperament toward the common dealer-RFC (related finance company) business model.

Chuck Bonanno, Leedom Group executive conference moderator of buy here-pay here and automotive finance Twenty Groups, said through his Twenty Group members he’s heard of the plight of the two dealers.

“You have to ask with two occurring nearly simultaneously, ‘Is this the result of errors on their part or a change in IRS enforcement?’” Bonanno said.

Dave Wiggins, a CPA with the Top 20 national accounting firm of Larson Allen LLP and buy here-pay here accounting expert, said though he has not been involved or consulted on attacks of his dealer-RFC arrangements, he has recently had informal discussions with IRS automotive industry personnel.

He said he doesn’t believe there has been any change in the way IRS approaches its oversight of RFCs and buy here-pay here dealers. That being said, however, there are still plenty of pitfalls dealers and their RFCs can fall into with the potential of huge tax liabilities.

“There are always key issues in an audit situation that can put the RFC into non-compliance with IRS guidance,” Wiggins said.

One of the key problems he sees is dealers using CPAs who do not fully understand the nature of the buy here-pay here and RFC business model. This leads to errors, omissions and poor advice.

First off, the companies must be set up properly, Wiggins said. The entities (the dealership and RFC) have to ultimately be treated as corporations. They can either be S or C corporations.

“You can have an LLC, but it must have made the elections to be treated as an S or C corporation,” he said. “LLCs can also be sole proprietorships or partnerships, but such entities cannot sell notes at a discount to an RFC. The regulations that allow for the discounting between companies are corporate statutes, so that is why the entities have to be corporate in struc-

ture.”

Another important issue that frequently concerns dealers is what type of accounting methodology should be used.

“The dealership will always be on the accrual method,” Wiggins said. “We generally review the RFC to determine what type of entity it should be. Normally, we make it a cash-basis taxpayer.”

Wiggins said the IRS has issued the Independent Used Car Dealer Industry Audit Guide, which provides agents with guidance in auditing used dealers and RFCs. It references the IRS 26-point check list for setting up and operating an RFC.

“Many CPAs don’t even know this exists,” Wiggins said.

Simply defined, an RFC is the finance company set up to purchase retail installment contracts, usually at a discount, from a dealership, which has already funded the consumer transaction.

The key tax advantage for the dealer is not having to pay taxes on as yet unrealized gross profit, but rather having the RFC pay its tax on the transaction as the payments are received. There are a number of areas in the rules and regulations governing the creation and on-going operation of

an RFC that can be challenged; it is impossible to be “bullet-proof,” Wiggins

said.

“There are some things the IRS can always challenge regardless of how you structure your RFC,” Wiggins said. “Determination of the ‘fair market value’ for the discounting of your notes is not black and white, therefore the IRS can always challenge that determination.”

Valuation reports are by nature subjective, and it is to the RFC’s favor to get portfolio values from an independent third-party that understands the nature of the buy here-pay here business.

“It makes sense to get a quote from a third-party that buys notes, however, they’ll not be so likely to run through the exercise again next year when you don’t sell them any notes,” he said. “They are in the note-buying business and not the portfolio-pricing business.”

Bonanno regularly analyzes and evaluates portfolios for just that reason. “Each year I provide a few dozen valuations, so that dealers have a sense of what their portfolio is really worth relative to market,” Bonanno said. “By taking this approach dealers have an independent third-party assessment of their notes.”

One concern with getting a portfolio valuation from a note buyer is they will never buy 100 percent of the paper, choosing to buy only more seasoned notes, for instance, where there is at least a 60- or 90-day track record and the customer has made a payment in the last week. The note buyer may place a value of 80 cents on the dollar on the portfolio, but that 20 percent discount does not reflect the full portfolio, nor the full risk.

Wiggins said one alternative to place a value on a buy here-pay here portfolio is to use a “build up rate” that incorporates static-pool analysis. A “build up rate” determines the discount rate using loss analysis and other factors present relative to collection costs and investment returns to arrive at a fair value discount. The data input must be accurate and timely and you want to use this to adjust your discount annually or quarterly.

“That is where many dealers get caught up,” Wiggins said. “They run their numbers but never bother to change their discounts to reflect real-world conditions or changes that occur in underwriting and economic factors.”

The second most important factor, said Wiggins, is adequate capital or financing of the RFC.

For instance, an “at-risk” RFC might have capital of $50,000 and a $1 million line of credit with a $5 million loan portfolio that shows a $2 million dollar inter-company balance due back to the dealership.

“You are at risk when the bulk of the payment for the notes is represented by an inter-company balance,” Wiggins said. “The RFC must pay the dealership for notes as they are purchased. An unrelated dealership would never allow a finance company to purchase its notes and pay for them sometime later.”

He said the RFC must operate as an independent business. If there are inter-company balances, at least pay interest between the companies and make monthly payments.

Another common mistake, said Wiggins, is the way the paperwork is set up. An RFC does not initially finance the retail installment contract. The dealership enters into the retail installment contract, then sells the note to the RFC at a discount.

“Remember too, that all organizational documents and minutes of board meetings should reflect the economic and business reasons for operating the RFC,” Wiggins said. “It’s simply not enough to create an RFC because it saves you on your federal taxes. There are numerous legitimate reasons for having an RFC, including improved collections, not having the dealership serve as the collecting agent on the note and diversifying ownership. These are the primary reasons that many dealers setup RFCs; just make sure they are documented.”

Wiggins cautions dealers to be very careful in all they do with their RFC. He said to make sure and re-examine the discount rate between the dealership and RFC each year. It’s not wise to leave the discount rate unchanged as market conditions change.

“This business must reflect the real-world and not just your corner of it,” Wiggins said. “I know of one dealer who used a discount rate of 30 percent on the fair valuation of his portfolio, but indicated to the IRS in exam that 40 percent was fair market value, so he would be covered.

The IRS took the position that the discount should be disallowed since the taxpayer’s discount didn’t agree with its own market value assertion; as a result

his RFC didn’t comply with the regulations.”