I hands after they made the payment to the insurance subsidiary. - PDF document

C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting BY JAMES E. SALLES reported as income only the “commission” left in their n this month’s column: I hands after they made the payment to the insurance subsidiary. In Private Letter Ruling 9218004, however, • The T ax Court takes another stab at the thorny prob- the IRS concluded that under the common form con- lem of auto dealers’ warranty contracts, T oyota tracts, the car owners were not contracting with the T own, Inc. v. Comm’r , 79 T .C.M. (CCH) 1457 (2000); insurance subsidiary. Instead the dealers were obligat- • A teacher’s travails illuminate the perils of construc- ing themselves to their customers as principals and tive receipt in legal disputes, Visco v. Comm’r , T .C. then paying the insurance company to assume what Memo. 2000-77); and was now their risk. This meant the dealers were imme- diately taxable on the whole receipt under Schlude v. • The IRS issues yet another ruling in its ongoing Commissioner , 372 U.S. 128 (1963), although under attempt to grapple with capitalization issues. Rev. normal capitalization principles they could only deduct Rul. 2000-7, 2000-9 I.R.B. 712. their payments to the insurance company over the life- AUTO DEALERS’ WARRANTY time of the contracts, generally several years. CONTRACTS Revenue Procedure 92-98 A T ax Court decision issued in February upholds the Widespread criticism of the whipsaw imposed by conditions the IRS imposes on auto dealers’ use of the Private Letter Ruling 9218004 prompted administrative “service warranty income method” to report income concessions. Revenue Procedure 92-98, 1992-2 C.B. under warranty agreements. T oyota T own, Inc. v. 512, since superseded by Revenue Procedure 97-38, Comm’r , 79 T .C.M. (CCH) 1457 (2000). 1997-2 C.B. 479, permitted dealers in automobiles and other durable consumer goods to elect the service war- Background ranty income method of accounting. T axpayers electing Dealers’ accounting for automobile warranty con- under the procedure could recognize the “nonprofit” tracts, which frequently span several years, has been a portion of their customers’ up-front payments over the life sore spot since at least 1992, when the IRS National of the contract rather than take the whole amount into Office ruled against the taxpayer in Private Letter Ruling account all at once. In exchange, electing taxpayers 9218004 (Jan. 23, 1992), which involved “extended had to agree to include “phantom” income to compen- service plan contracts” sponsored by automobile man- sate the IRS for the time value of money. For example, if ufacturers. Dealers sold the contracts to their cus- the “applicable interest rate” (based on the applicable tomers along with the cars, were paid up front, and federal rate) was 6 percent, a dealer deferring $1,000 immediately turned over most of their receipts to a spe- under a five-year contract would report $224 per year for cial-purpose subsidiary of the manufacturer. That sub- five years. T axpayers also had to amortize their corre- sidiary operated the actual “insurance program,” pay- sponding payments to the insurer over the lifetime of the ing the dealers (or others) as they made repairs under contracts. 1 the warranties. Thus, taxpayers could in effect pay—by accepting For tax purposes, the dealers generally treated them- the inclusion of phantom income—to eliminate the whip- selves as if they were sales agents for the policies, and saw otherwise imposed by Schlude . More accurately, they could eliminate most of the whipsaw, but not quite all of it. For simplicity, Revenue Procedure 92-98 James E. Salles is a member of Caplin & Drysdale, Chartered, in Washington, DC. required that payments received at any time during the M A Y 2 0 0 0 1

C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y taxable year be treated as having been received on the The issue was whether the conditions the revenue pro- first day of the year, so that in each year of the contract cedures imposed on the taxpayers’ election were rea- term there was a full year’s inclusion; however, Revenue sonable, and the court held that they were. Ruling 92-97, 1992-2 C.B. 510, permits amortization of Lessons from Johnson ? the deduction only over the actual contract term. The T oyota T own court was notably unreceptive to the Dealer A, a calendar-year taxpayer, Example. taxpayers’ argument that their method more clearly defers $1,000 under a five-year contract beginning reflected income because it provided a superior match- July 1, 2000. The applicable interest rate is 6 per- ing of income to deductions, remarking that “matching cent. Dealer A must include $224 in warranty of income and related expense does not necessarily income in each of 2000, 2001, 2002, 2003, and result in a clear reflection of income for tax purposes.” 2004. On the other hand, it is only permitted to 79 T .C.M. (CCH) at 1463, citing Thor Power T ool Co. v. deduct insurance expense of $100 in 2000, $200 in Comm’r, 439 U.S. 522 (1979). With some luck, howev- each of the years 2001 through 2004, and a final er, the taxpayers may find a more hospitable reception $100 in 2005. to their matching argument on appeal. T oyota T own bears more than a passing resemblance to Johnson v. It was this disparity that produced the issue in T oyota Commissioner , 184 F .3d 786 (8th Cir. 1999), aff’g in part T own . and rev’g in part, 108 T .C. 448 (1997), discussed in this Toyota Town column in the November 1999 issue. Johnson involved vehicle service contracts that were The taxpayers in T oyota T own were several related similar to the warranty contracts in T own except auto dealerships that sought to use the same conven- oyota T tion on the deduction side as Revenue Ruling 92-98 that the dealerships retained primary responsibility for imposed on the income side. That is, they calculated vehicle repairs, and most of the proceeds were trans- their deductions as if all the policies had been issued on ferred to an escrow account rather than paid over to the the first day of the taxable year rather than by using the insurer. Notwithstanding the escrow account, the IRS actual policy term. and both courts agreed that the dealers had a receipt, that what was received was an advance payment, and Example. The facts are the same as those in the therefore the dealers were immediately taxable under preceding example. Under the method used by the Schlude . The Eighth Circuit, however, reversing the T ax T oyota T own taxpayers, in each of the years 2000 Court on this point, held that the expenses associated through 2004 Dealer A would report $224 in warran- with the escrow account should be immediately deduct- ty income and deduct $200 of insurance expense. ed. The court stated that “both income and deduction must be considered” in determining whether a method 79 T .C.M. (CCH) at 1460. In the notice of deficiency, the IRS of accounting “clearly reflects income,” and basically imposed adjustments calculated to conform the taxpayers’ held that it was unreasonable to require amortization of accounting to the terms of the revenue procedures. a deduction when Schlude required all the associated The IRS cannot change a taxpayer’s accounting income to be reported “up front.” 184 F .3d at 789. method unless it does not “clearly reflect income.” See own is complicated by the fact that the tax- T oyota T I.R.C. § 446(b). Even then, the new method the IRS imposes must clearly reflect income itself. 2 The taxpay- payers made an express election and then tried to wig- gle out of its terms. Purely on matching grounds, how- ers argued that their method clearly reflected income ever, the taxpayers in T oyota T own would seem to have and that the method in the revenue procedures did not. a stronger case than Johnson , because they paid all the The court, however, reasoned that had the taxpayers amounts that they sought to defer over to the insurance not elected under Revenue Procedure 92-98, they company, whereas the escrow administration expenses would have had to include the full receipt up front under in Johnson accounted for only a small fraction of the Schlude , and the deduction would have had to be receipts at issue. An appeals court might shortcut the amortized over the contract term anyway. 79 T .C.M. (CCH) at 1463. Nobody forced the taxpayers to elect. election issue by holding that, regardless of whether it 2 2 M A Y 2 0 0 0