Forming and Operating a Related Finance Company

By Keith E. Whann

When the Tax Reform Act of 1986 was passed, the ability to use the installment or "cash" method of accounting was eliminated for anyone who utilized an inventory in operating a business. This change in the Tax Code impacted motor vehicle dealers who engaged in installment sales transactions because they were forced to pay taxes on income before it was received. Dealers attempted to decrease this negative tax result by selling receivables generated by retail installment sales to their own (i.e. related) finance company at a discount.

Many dealers who explore the possibility of forming a related finance company, have been lead to believe that the Internal Revenue Service’s Private Letter Ruling 9704002 creates a roadblock to the establishment of a related finance company. This Private Letter Ruling, in reality, does not in any way hinder a dealer's ability to establish a related finance company. The Private Letter Ruling merely follows the rationale set forth in the Internal Revenue Service’s Audit Technique Guide and speaks to issues concerning the discounting transactions engaged in by the dealership, not the "related" nature of the finance company to the dealership.

The issue presented in the letter ruling was whether the transfer of notes from the dealership to the related finance company constitutes a sale or other disposition of property within the meaning of Section 1001 of the Internal Revenue Code. The Service concluded that such transfers did not constitute a sale or disposition of property within the meaning of Section 1001 of the code. A quick analysis of the facts and circumstances surrounding the discounting transactions in question demonstrates why the Service reached this conclusion.

The dealership was a corporation owned by a sole shareholder and it used an accrual method of accounting to report income for federal income tax purposes. The sole shareholder owned several incorporated car dealerships which operated as used car dealerships. The majority of the dealerships' customers were people who were unable to obtain bank financing, thereby requiring the dealership to finance the sales.

The owner of the dealerships formed a finance company. The finance company was incorporated under state law and the owner was the sole shareholder. The finance company was capitalized with one thousand dollars in equity and a $24,000 loan from the sole shareholder.

From time to time during the period in question, the dealerships transferred to the finance company their installment notes from motor vehicle sales, and employees of the dealerships transferred the notes from the dealerships' books to the finance company's books. When the dealerships transferred notes to the finance company, they did not receive any cash payment for the notes at the time of the transfer. There was no fixed payment schedule for the finance company to pay the dealerships for such notes, nor had the parties entered into any written agreement concerning the transfers of the notes from the dealerships to the finance company.

Despite the fact the notes were transferred to the finance company, the vehicle buyers were not informed of the transfer and the vehicles’ certificates of title continued to show the dealerships as the lien holders. Additionally, the customers continued to make their payments to the dealerships and employees of the dealership recorded the payments and performed any and all necessary collection functions, including vehicle repossessions. Any repossessed vehicle was recorded in the individual dealership's used vehicle inventory at a value shown in the NADA Used Vehicle Guide and the transaction was treated merely as if the dealership had purchased the vehicle from the finance company. Any profit earned by the finance company was loaned by the finance company to related businesses of the finance company and to the dealerships. Since the dealerships were listed as the lien holders on the certificates of title, the finance company could not sell or otherwise transfer the notes it acquired from the dealerships.

It is well established that the economic substance of a transaction, rather than its form, will be controlling for federal tax purposes. In addition, the question of when a sale is complete for federal tax purposes is essentially one of fact. The determination of when a sale occurs depends upon the benefits and burdens of ownership rather than upon the satisfaction of the technical requirements for transferring title from one entity to another under state law.

In the case set forth in the Letter Ruling, upon the transfer of the notes, the dealerships still had the burden of ownership, including the risk associated with the credit worthiness of the notes. At the same time, the dealerships, not the finance company, continued to have all of the benefits of ownership after the transfer of the notes. Under these facts, it is fairly clear that the transactions lacked economic substance. Additionally, the form, as well as the substance of the transfers, raised questions as to whether a bona fide sale of the contracts took place. In most respects, the dealerships and the finance company did not act like an arm's length transaction had taken place as between normal buyers and sellers of installment contracts. Therefore, when taking into account the facts and circumstances surrounding the transfers of the notes by the dealerships to the finance company, the IRS ruled that the transfers did not constitute a sale or other disposition of property within the meaning of Section 1001 of the Code. The Private Letter Ruling addressed only this issue and did not speak in any way to the appropriateness of the related nature of the finance company to the dealerships.

In reality, the use of related finance companies has been a common practice in the motor vehicle industry for many years. A related finance company can serve many valid business purposes and were utilized by motor vehicle dealers before any tax advantages were possible. When setting up a related finance company, there are three major business issues which must be considered and satisfied in order to meet all of the legal requirements. The first issue involves the economic reasons for the related finance company arrangement, the second involves the validity or form of the related finance company itself, and the third and most critical issue involves the economic substance of the discounting transactions.

Given the fact that there are numerous reasons for a motor vehicle dealer to create and use a related finance company, the economic reasons for the transaction are the easiest of the three requirements to satisfy. Listed below are some of the more typical reasons that a dealer will create a related finance company. Each of these reasons can provide a significant and valid business and economic reason for creating a separate entity to finance the dealer’s receivables, even if third party receivables are not acquired. These are not the only reasons for which a related finance company can be created, there are others that can serve as an equally valid and legitimate reason for using a related finance company.

Providing credit to enable the purchaser to buy a car.
Many, if not most of the purchasers that utilize the services of a related finance company do so because of an inability to get credit elsewhere. In this way the related finance company serves a useful purpose in providing credit to individuals with little, no, or bad credit.
Improving the collection of accounts receivable.
A related finance company can significantly enhance the collection of accounts receivable by requiring the borrower/buyer to remit payments to a third party, even though the third party is related to the dealer. It has been the experience of some dealerships in the industry that when payment is made directly to the dealer, a bad experience with the car often leads to a default on the note for the car. This, in turn, creates a collection problem, and possibly a publicity problem for the dealership. On the other hand, if a related finance company is involved, experience shows that the customer is less likely to default on the payment. Given the general credit worthiness of the customers, this can be a significant advantage.
Avoiding the imposition of licensing and other regulatory requirements on the dealership entity.
Many states have licensing and/or regulatory requirements for finance companies. Establishing a related finance company permits the dealer to isolate itself from any liability which may arise in the event that any of the licensing or regulatory requirements are violated.
Preventing adverse publicity associated with repossessions and other collection actions.
With repossession and collection problems being a daily fact of life for this industry, creating a related finance company permits a new entity to undertake these actions, thereby insulating the dealer from any adverse publicity which can result during the collection process.
Insulating the dealership from the financial risk of default on the notes.
Much of the motor vehicle industry deals with a customer base that generally has poor or non-existent credit. The default rate on Buy Here-Pay Here notes is substantially higher than on general bank loans. This economic fact is evidenced both by the interest rates charged by the dealer or finance company and the reserves that independent finance companies generally maintain. A separate related finance company removes the financial risk of default from the dealership entity.
Diversification of ownership.
Since the financing of used cars is not inherently a part of a motor vehicle dealership, creating a related finance company permits the dealer to provide ownership in that specific business to both family and non-family members without diluting ownership in the dealership. This allows the dealer to separate the two businesses and have the flexibility to reward certain employees or other individuals with an ownership interest in a segment of the business or to utilize the related finance company for the dealer’s estate planning purposes.

While it is permissible to expand a related finance company to finance receivables from unrelated entities as well as those of a particular dealership, this is not a requirement and does not occur in most instances.

The second issue that must be addressed is to determine how a valid related finance company should be structured and operated. Since the purpose of the related finance company is to isolate liability or segregate transactions in a separate entity, the related finance company should meet, at a minimum, the majority of the following criteria to be treated as a separate, valid business entity. The related finance company should:

Be a separate, legal entity;
Meet all licensing requirements of the jurisdictions in which it operates;
Be adequately capitalized in order to pay for the contracts;
Have its own employees and compensate them directly. However, the fact that the related finance company and the dealership or other related entities may elect to use a common paymaster does not indicate that the related finance company does not have its own employees;
Obtain and maintain all appropriate licenses;
Have a separate telephone number;
Have a separate business address, which may be a post office box. Even when a separate business address is maintained, it is common for the related finance company to have an office at the dealership;
Maintain a separate set of books and records;
Comply with all title, lien, and recordation rules in the jurisdictions in which it operates;
Notify customers of the purchase of their notes;
Have a purchase contract (i.e. Dealer Agreement) for the acquisition of receivables that both complies with the appropriate state law and provides evidence of how the fair market value of the receivables will be determined;
Pay the dealer for the receivables at the time of purchase. The related finance company can generate the cash to make the payment from capitalization of the related finance company, bank or third party borrowings, borrowings from related entities or shareholders or any combination above. It should be noted that, however, borrowing from related entities or shareholders can diminish the validity of this factor;
Be operated overall in a business-like manner.

Dealers often fail to recognize that although the finance company may share common ownership or be "related" to the dealership, it must be a separate legal entity. Thus, transactions between the two entities should operate the way transactions between dealerships and finance companies customarily operate in the industry. The likelihood that a question as to the validity or form of the related finance company will arise is directly related to the absence of the foregoing criteria from the business relationship between the dealer and the related finance company.

The third and most important issue that should be addressed is the sale of the discounted receivables at fair market value (FMV). Sales of receivables must have economic substance to qualify for tax purposes, valid business reasons alone will not suffice. Purchasing receivables is not an exact science. The FMV of a receivable or group of receivables depends on a number of subjective and objective factors. The industry’s practice has been that a deep discount is warranted in nearly all transfers of receivables. In our reviews of various third-party finance company dealer agreements and related documents, we have seen finance companies offer to acquire receivables from dealers at up to a 50 percent discount. The following are some of the recognized factors that can directly influence the amount of the discount. The facts and circumstances of the individual receivable transfers will ultimately determine the importance of each factor:

The absence of a credit history or existence of a poor credit history.
The history of payments on the note.
The term of the note.
The age and mileage of the vehicle.

In conclusion, a dealer can establish and utilize a related finance company to acquire receivables from a dealership at a discount and receive the corresponding tax benefits, provided that it meets the following three requirements established by the Internal Revenue Service.

The discounting transactions must have economic substance. All of the relevant facts and circumstances must be considered. Remember that the two primary reasons for selling receivables are to obtain cash (improve cash flow) and to shift risk. If there is no shifting of benefits or burdens, the sales transaction probably lacks economic substance.
The form of the transactions and the form of the related finance company must be valid.
The receivables must be sold for fair market value. The seller and purchaser must base the discount on some reasonable factors, not on an arbitrary determination of the discount rate.