Buy Here Pay Here (BHPH) Accounting And Tax Review

If you have a BHPH dealership and a Related Finance Company (RFC), then you are probably selling your notes to your RFC and recognizing a discount loss on the dealership. There are various IRS rules and conditions you must comply with to be able to sell the notes at a loss to your RFC.

In order to deduct a discount loss on your dealership, your company should be setup as a C or S corporation. Your RFC should also be setup as a C or S corporation. The IRS regulations that let you sell your notes at a loss to your RFC are found in corporation tax law. This means if your dealership and or RFC are a LLC or partnership taxed as a partnership, you need to file federal form 8832 with the IRS to elect to be treated as a C corporation for income tax purposes. If you instead want to be treated as an S corporation, you will also need to file federal form 2553. Generally this can be done without any tax consequences.

If you are a sole proprietorship, then you should form a corporation and contribute the assets and liabilities of the dealership to the newly formed C corporation. Again, if you want to be an S corporation, you will also need to file a federal form 2553.

As there are various IRS regulations and rules governing the above elections, you should consult with a tax advisor before considering any change in your income tax status.

Fair Market Value (FMV) Purchase of Installment Notes

When selling your BHPH notes receivable to your RFC and recognizing a loss, you should insure you are selling the notes at “Fair Market Value”. To do this, you should seek purchase quotes from various third party note purchasers. This means that your loss on sale of notes to your RFC should not exceed what an unrelated third party vendor would pay you for the notes. IRS Regulations also state that your loss cannot exceed the total gross profit you realized from the vehicle sale. This gross profit test should be performed on each vehicle separately.

Some dealerships sell some notes to unrelated third parties and may keep others to sell to their RFC. Third party sales are good documentation to keep with your income tax records to substantiate the loss you are deducting when selling the notes to your RFC. If you normally sell all of your notes receivable to your RFC, then you should obtain quotes on your entire note portfolio. Some vendors will only bid and purchase seasoned notes, normally paying a higher price. For example, if you sell your seasoned notes to an unrelated party at 75 cents on the dollar, you are probably left with notes that may not bring a bid from anyone or a bid below 50 cents on the dollar. This is due to the lack of payment history and the high repossession rate of these unseasoned notes. Therefore, based on the aging of your portfolio and the average length of your notes, the FMV of your entire portfolio may only be 60 to 70 cents on the dollar. Again, these unrelated third party portfolio bids and any sales of notes to unrelated third parties should be retained in your income tax files and discussed with your tax advisor.

Proper Financing For Your RFC

Your RFC should have adequate capitalization and debt loans from you, other individuals and/or financial institutions to operate your businesses successfully. Failure to do so can greatly inhibit your growth, your income potential and the ability to pay your vendors on a timely basis.

When setting up or reviewing your current RFC status, your RFC should have the ability to purchase the notes from your dealership with cash, much like an unrelated third party purchaser would do. If your RFC is unable to do this, you may not be able to maximize the purchase of all the notes your dealership generates. This is supposed to be similar to an unrelated third party transaction. You wouldn’t normally sell your notes to a third party vendor without receiving cash back for the discounted amount. If the RFC doesn’t have the ability to purchase the notes without conducting an intercompany loan transaction, chances are higher that the IRS will not respect the RFC as a separate company, and will therefore, consider disallowing the loss on the sale of the notes.

Income Tax Basis

If your dealership has elected to be taxed as an S corporation, has negative retained earnings (accumulated deficit), and incurs additional losses in the current year, then the stockholders may not be able to deduct the loss that flows through to them on the federal form K-1 they receive at year end. The stockholders may deduct the prior and current losses if they have established income tax basis in other ways, such as incurring profits, loaning the corporation funds or having enough stock and or additional paid in capital value to exceed the cumulative losses. If you are repaying shareholders loans due to you from the company, for which you have previously deducted losses, have your tax advisor determine if such loan repayments may create taxable income.

An S corporation stockholder may distribute prior earnings as distributions or C corporation dividends. Be careful in making distributions or dividend payments until you have determined that doing so will not create taxable income to you. A regular C corporation stockholder does not have to be concerned with income tax basis since no income flows through to stockholders.

Partnerships and LLC’s have different tax rules than corporations. Partners and members may be able to deduct losses that an S corporation stockholder can’t. This is because a partner or member may also use some partnership debt (other than shareholder debt) in determining basis. The rules can be complex, so consult your advisor if you have a partnership in a loss position.

Cash Method Of Accounting

A dealership that carries inventory for resale cannot elect or use the cash method of accounting for recognizing income and expense. The dealership must be on the accrual basis of accounting. The dealership must recognize income (also referred to as sales and gross profit) when the transaction occurs, even if no money changes hands until the next accounting period (month or year). The dealership does get to accrue expenses incurred for the production of the income, even if the expense is paid in a future period.

Accounting

You should maintain separate accounting records for the dealership and the RFC. Your dealership should operate under the pretense that you are selling the notes to an unrelated third party who is either renting space in your facility or has their own collection location. You should separate the paperwork generated by each company in separate file cabinets, have separate software installed for each company and generate separate financial statements monthly and annually.

You can prepare combined financial statements if required for banking or other purposes without jeopardizing your RFC sale transaction. Combined financial statements may require you to eliminate intercompany transactions in order to comply with Generally Accepted Accounting Principles (GAAP). Frequently your financial institution may require GAAP statements for year-end financial presentation. Intercompany dealership loss and RFC discount income should be reconciled to assure they are correctly recorded at year-end.

An asset purchase agreement should be signed by both the Dealership and the RFC to evidence the legal sale and purchase of the BHPH notes and the discount rate that will be used. This agreement is similar to what your dealership would sign with a lender when selling retail contracts to an outside financial institution. You should update your corporate minutes for both companies to recognize this contract and the transactions that will occur.

Summary

We have covered some of the more important items regarding BHPH and RFC tax and accounting issues. There are other IRS regulations and rules governing these types of companies and transactions. You should consult your tax advisor as you attempt to implement the items discussed above. They will assure that you try to meet the rules specific to your situation.

By annually reviewing your compliance with financial loan covenants of your bank and the requirements of the IRS, you will make your life much easier and worry free.