Reminder: I am not a CPA or an attorney. None of the information in this article should be considered qualified legal or financial advice. It is your responsibility as a business owner or manager to obtain and retain licensed, qualified advisors for your business. Make sure you get the people who know your area of business. See THIS article.
A Related Finance Company (RFC) is simply a second company or corporation set up to collect receivables. It is either captive, meaning it only buys notes from the sister car dealer corporation, or it is open, which means it can and usually does buy notes from any dealer. Due to licensing requirements, it is not a Point-of-Sale finance operation, in other words, it does not directly offer loans to the public, nor does it make decisions on which loans can be offered. It can set limits on which loans will be purchased, and the dealer(s) are free to offer only loans to the public keeping those limitations in mind. But all in all, the dealer must initially finance the note, and in states where a Finance License is required for BHPH, hold the license to do so.
The big issue with car dealers is that since 1986, companies that hold an inventory for profit must use the Accrual method for income taxes. Prior to that, car dealers who did Buy Here Pay Here would simply use the Cash Method of taxation, allowing them to only pay taxes on the profits when collected. Accrual method has the dealers paying taxes on the sale price profits in the year of the sale. The idea, then, is to utilize an RFC to defer those taxes by selling the note with a loss. The dealer offsets current year profits with the loss, and the RFC will pay taxes on the profits later.
In most situations, the RFC purchases the note from the dealer at a discount. For example: a Deal with 10,000 amount financed, @28% APR, 36 Months gives a total payment stream of $ 14,891.04. The dealer would sell this account to the RFC for about 55% of the Total Balance, if Precomputed, or 80% of the Principal (10,000). The RFC writes a check to the dealer for 8190.07 (55% of 14,891.04).
- The IRS requires that such purchase agreements be in writing, reasonable, and customary for the area. Each dealer needs to get a qualified quote from at least three companies who purchase receivables. The average rate or percent paid, quoted is the basis for the RFC-Dealer purchases. A qualified quote means that the dealer shows the note purchaser his portfolio, and gets a specific quote based on his accounts.
The Discount here is the difference between actual Principal (10,000) and the RFC purchase price (8,190.07 ) — $1,809.93. The dealer declares this a loss on the sale, and the Finance Company uses this as a (potential) profit basis. Hopefully, the dealer has made a little profit on this deal, even after only collecting the 8190.07. The RFC will incur taxes on this profit later.
The RFC is now the lien holder and the customer makes payments to the RFC instead of the dealer. Most dealers simply collect the payments on behalf of the RFC.
- States typically require that the RFC file as Lien holder on the Title. If you have a captive RFC, try to do this at the time you print the title application.
Remember that the RFC *must* pay for the note. The IRS requires, among many other things, that the RFC be financially capable of conducting business, and that all transactions between the Dealer and RFC be at “arms length.” This also means that the RFC must be incorporated or otherwise registered legally as a business, have a state license where required, local business license if required, and a “presence.” Presence means existing. The RFC should have a phone number, its own bank accounts, its own files, at least one employee, and a physical place to conduct business.
The dealership should have a Contract of Sale for the Sold Notes, and make copies of the relevant contract paperwork for the RFC to have as it’s records. These records must be maintained separately from the dealership. Remember that the IRS requires the dealer to deal with the RFC on an “arm’s length” relationship. Treat the RFC the way you would treat any third-party Finance company buying your notes.
The NIADA published a guide that uses information from an IRS Field Guide the IRS Agents use to audit a car dealership with an RFC.
There are many rules and conditions to having an RFC. Loss of recognition of your RFC can lead to an assessment on the claimed losses, and potential penalties. Add to that the money already spent setting it up and maintaining it, and the dealer can be out a lot more than if he had not bothered with it in the first place.
An RFC is not a simple thing, nor is it to be entered into lightly. It *can* be used to defer taxes on profits, but should be dealt with as that. It is not a tax dodge.
Once again, consult with an experienced CPA and an attorney before taking this on.