Under the New Tax Act: Can Dealers Eliminate Their Related Finance Companies?

Date June 11, 2018

We are receiving a number of questions from dealers who have heard that the Tax Cuts and Jobs Act of 2017 (The Act) contains changes to tax law which will result in “Buy Here Pay Here” or BHPH dealers no longer needing to use a related finance company (RFC). The Act, the most comprehensive tax legislation since the Reagan era, is very complicated and we expect a significant number of regulations implementing the new law to be issued in the coming months and years.

One of the items contained in The Act is an expansion of the use of the cash method of accounting for businesses. Taxpayers using the cash method of accounting recognize income when cash is received and deduct expenses when paid. In general, the accrual method recognizes revenue when it is earned and expenses as incurred regardless of when payment for those items are received or paid.

Under prior law, there have been limitations on using the cash method of accounting. One of these limitations impacts taxpayers who maintain inventories. Generally, taxpayers with inventories are required to use the accrual method of accounting. Since dealers typically maintain inventories, they are not permitted to use the cash method. This results in dealers being required to recognize all of their sales revenue as income, forcing them to pay income taxes long before the customer has paid for the vehicle. Using an often-overlooked section of the tax code, dealers created RFCs to help alleviate the tax impact of this issue. The use of an RFC, because of the discounts taken, permits dealers to spread the recognition of taxable income over the life of the loan; thereby, more closely matching the tax burden to the cash flow. If dealers could use the cash method, the creation of the RFC would have been unnecessary.

The Act has expanded the use of the cash method so that businesses with gross receipts of less than $25 million dollars may be able to file for an election to use the cash method. This sounds like good news for many BHPH dealers, right? Not necessarily.

The current tax rules relating to the use of the cash method contain a snag for BHPH dealers that they may not have considered. These rules create “cash equivalency.” Under this definition, a dealer who receives an unconditional, assignable promise to pay from the customer, must recognize this as a cash equivalent; therefore, making the entire sale, once again, subject to income tax. The courts and the IRS have both reinforced this cash equivalency theory.

The Bottom Line: The expansion of the use of the cash method under the Act may not solve BHPH dealers’ problems. Accordingly, BHPH dealers must continue the use of RFCs until the IRS issues guidance changing the current rules or dealers risk seeing a significant increase in their tax bills. Contact Rex Collins with any questions you may have about the Tax Act and how it may impact your business.

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