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Tax Info for the Automotive Industry Business Types-I

Laws and Regulations

Automotive Tax Center

 

Avoiding Problems - Automotive
This section contains important information on recordkeeping, misclassification of employees and warns you of fraudulent automotive schemes.

Recordkeeping
Unless you are a professional bookkeeper, you probably don't like to spend valuable business time keeping records. But keeping good records can actually help you save money.

 

Why should I keep records?
Good records will help you monitor the progress of your business, prepare your financial statements, identify source of receipts, keep track of deductible expenses, prepare your tax returns, and support items reported on tax returns.

Everyone in business must keep records.  Keeping good records is very important to your business.  Good records will help you do the following:

  • Monitor the progress of your business
  • Prepare your financial statements
  • Identify source of receipts
  • Keep track of deductible expenses
  • Prepare your tax returns
  • Support items reported on tax returns

Monitor the progress of your business
You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make.  Good records can increase the likelihood of business success. 

Prepare your financial statements
You need good records to prepare accurate financial statements.  These include income (profit and loss) statements and balance sheets.  These statements can help you in dealing with your bank or creditors and help you manage your business. 

  • An income statement shows the income and expenses of the business for a given period of time.
  • A balance sheet shows the assets, liabilities, and your equity in the business on a given date. 

Identify source of receipts
You will receive money or property from many sources.  Your records can identify the source of your receipts.  You need this information to separate business from nonbusiness receipts and taxable from nontaxable income. 

Keep track of deductible expenses
You may forget expenses when you prepare your tax return, unless you record them when they occur.

Prepare your tax return
You need good records to prepare your tax returns.  These records must support the income, expenses, and credits you report.  Generally, these are the same records you use to monitor your business and prepare your financial statement. 

Support items reported on tax returns
You must keep your business records available at all times for inspection by the IRS.  If the IRS examines any of your tax returns, you may be asked to explain the items reported.  A complete set of records will speed up the examination.

What kinds of records should I keep?

You may choose any recordkeeping system suited to your business that clearly shows your income and expenses. Except in a few cases, the law does not require any special kind of records. However, the business you are in affects the type of records you need to keep for federal tax purposes. Your recordkeeping system should also include a summary of your business transactions. This summary is ordinarily made in your business books (for example, accounting journals and ledgers). Your books must show your gross income, as well as your deductions and credits. For most small businesses, the business checkbook is the main source for entries in the business books.

Supporting Business Documents

Purchases, sales, payroll, and other transactions you have in your business will generate supporting documents such as invoices and receipts. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain the information you need to record in your books. It is important to keep these documents because they support the entries in your books and on your tax return. You should keep them in an orderly fashion and in a safe place. For instance, organize them by year and type of income or expense. For more detailed information refer to Publication 583,  Starting a Business and Keeping Records.

The following are some of the types of records you should keep:

  • Gross receipts are the income you receive from your business. You should keep supporting documents that show the amounts and sources of your gross receipts. Documents for gross receipts include the following:

    • Cash register tapes
    • Bank deposit slips
    • Receipt books
    • Invoices
    • Credit card charge slips
    • Forms 1099-MISC

  • Purchases are the items you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following:

    • Canceled checks
    • Cash register tape receipts
    • Credit card sales slips
    • Invoices

  • Expenses are the costs you incur (other than purchases) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following:

    • Canceled checks
    • Cash register tapes
    • Account statements
    • Credit card sales slips
    • Invoices
    • Petty cash slips for small cash payments

    Travel, Transportation, Entertainment, and Gift Expenses
    If you deduct travel, entertainment, gift or transportation expenses, you must be able to prove (substantiate) certain elements of expenses.  For additional information on how to prove certain business expenses, refer to Publication 463, Travel, Entertainment, Gift, and Car Expenses.


    • When and how you acquired the assets.
    • Purchase price
    • Cost of any improvements.
    • Section 179 deduction taken.
    • Deductions taken for depreciation.
    • Deductions taken for casualty losses, such as losses resulting from fires or storms.
    • How you used the asset.
      When and how you disposed of the asset.
    • Selling price.
    • Expenses of sale.

    The following documents may show this information.

    • Purchase and sales invoices.
    • Real estate closing statements.
    • Canceled checks.

How long should I keep records?

The length of time you should keep a document depends on the action, expense, or event the document records. Generally, you must keep your records that support an item of income or deductions on a tax return until the period of limitations for that return runs out.

The period of limitations is the period of time in which you can amend your tax return to claim a credit or refund, or that the IRS can assess additional tax. The below information contains the periods of limitations that apply to income tax returns. Unless otherwise stated, the years refer to the period after the return was filed. Returns filed before the due date are treated as filed on the due date.

Note: Keep copies of your filed tax returns. They help in preparing future tax returns and making computations if you file an amended return.

  1. You owe additional tax and situations (2), (3), and (4), below, do not apply to you; keep records for 3 years.
  2. You do not report income that you should report, and it is more than 25% of the gross income shown on your return; keep records for 6 years.
  3. You file a fraudulent return; keep records indefinitely.
  4. You do not file a return; keep records indefinitely.
  5. You file a claim for credit or refund* after you file your return; keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later.
  6. You file a claim for a loss from worthless securities or bad debt deduction; keep records for 7 years.
  7. Keep all employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.

The following questions should be applied to each record as you decide whether to keep a document or throw it away.

Are the records connected to assets?
Keep records relating to property until the period of limitations expires for the year in which you dispose of the property in a taxable disposition.  You must keep these records to figure any depreciation, amortization, or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.

Generally, if you received property in a nontaxable exchange, your basis in that property is the same as the bases of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property in a taxable disposition.

What should I do with my records for nontax purposes?
When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes.  For example, your insurance company or creditors may require you to keep them longer than the IRS does.

How long should I keep employment tax records?
You must keep all of your records as long as they may be needed; however, keep all records of employment taxes for at least four years.

Internal Revenue Service (IRS)

Keep all records of employment taxes for at least four years after filing the 4th quarter for the year. These should be available for IRS review. Records should include:

  • Your employer identification number.
  • Amounts and dates of all wage, annuity, and pension payments.
  • Amounts of tips reported.
  • The fair market value of in-kind wages paid.
  • Names, addresses, social security numbers, and occupations of employees and recipients.
  • Any employee copies of Form W-2 that were returned to you as undeliverable.
  • Dates of employment.
  • Periods for which employees and recipients were paid while absent due to sickness or injury and the amount and weekly rate of payments you or third-party payers made to them.
  • Copies of employees' and recipients' income tax withholding allowance certificates (Forms W-4, W-4P, W-4S, and W-4V).
  • Dates and amounts of tax deposits you made.
  • Copies of returns filed.
  • Records of allocated tips.
  • Records of fringe benefits provided, including substantiation.

How should I record my business transactions?
Purchases, sales, payroll, and other transactions you have in your business generate supporting documents. These documents contain information you need to record in your books.

A good recordkeeping system includes a summary of your business transactions.  Business transactions are ordinarily summarized in books called journals and ledgers.  You can buy them at your local stationery or office supply store. 

A journal is a book where you record each business transaction shown on your supporting documents.  You may have to keep separate journals for transactions that occur frequently.

A ledger is a book that contains the totals from all of your journals.  It is organized into different accounts. 

Whether you keep journals and ledgers and how you keep them depends on the type of business you are in.  For example, a recordkeeping system for a small business might include the following items. 

  • Business checkbook
  • Daily summary of cash receipts
  • Monthly summary of cash receipts
  • Check disbursements journal
  • Depreciation worksheet
  • Employee compensation records

Note: The system you use to record business transactions will be more effective as you follow good recordkeeping practices.  For example, record expenses when they occur, and identify the source of recorded receipts.  Generally, it is best to record transactions on a daily basis. For additional information on how to record your business transactions, refer to Publication 583, Starting a Business and Keeping Records.

What is the burden of proof?

The responsibility to prove entries, deductions, and statements made on your tax returns is known as the burden of proof. You must be able to prove (substantiate) certain elements of expenses to deduct them. Generally, taxpayers meet their burden of proof by having the information and receipts (where needed) for the expenses. You should keep adequate records to prove your expenses or have sufficient evidence that will support your own statement. You generally must have documentary evidence, such as receipts, canceled checks, or bills, to support your expenses. Additional evidence is required for travel, entertainment, gifts, and auto expenses.

Consequences of the Misclassification of Employees
If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker (relief provisions of IRC section 530 will not apply).

If you have a reasonable basis for not treating a worker as an employee, you may be relieved from having to pay employment taxes for that worker. To get this relief, you must file all required Federal information returns on a basis consistent with your treatment of the worker. You (or your predecessor) must not have treated any worker holding a substantially similar position as an employee for any periods beginning after 1977.

If you would like the IRS to determine whether a worker is an employee, file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Withholding.

For additional information regarding worker classification, refer to:

Individuals Have Been Investigated and Recommended for Prosecution in the Automotive Industry - Don't let this happen to you.
Scams, schemes and cons are prevalent in all industries and professions. Violations of federal tax and related statutes carry serious consequences.

During the past three years, the Internal Revenue Service has seen an increase in scams and fraud involving the automotive sales industry. Some scam artists have knowingly assisted narcotics traffickers in laundering their ill-gotten gains, while others submit false loan documents to financial institutions to obtain car loans.

Special agents of IRS Criminal Investigation have investigated and recommended to the Department of Justice for prosecution numerous individuals involved in the automotive sales industry. These investigations vary from tax evasion to employment tax fraud to money laundering conspiracies to violations of the Bank Secrecy Act.

In addition, the IRS has more than 1,000 open audits of the tax returns of new and used car dealers for a variety of issues.

Automotive Sales Industry and Anti-Money Laundering

Automotive dealers are required to file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, with the IRS when they receive more than $10,000 in cash in one transaction (or two or more related transactions).

The Form 8300 is an information return that assists the government in its anti-money laundering efforts and must be filed by the 15th day after the date the cash transaction occurs.

Normally, when the Form 8300 is filed, a correlating Form 4789, Currency Transaction Report, is filed by a financial institution when the same cash is deposited with the financial institution.

For example, if an automotive dealer receives a cash payment of over $10,000 for a vehicle, the dealer must file a Form 8300 with the IRS. When the dealer deposits that cash into a financial institution, the financial institution is also required to report the $10,000 or over cash transaction to the IRS by filing a Currency Transaction Report, Form 4789.

When a discrepancy is found between the filings of Forms 8300 for cash sales and the filings of Forms 4789 for currency deposits, it.s often an indication of a possible violation of the currency reporting laws.

A scheme regarding the Form 8300 has surfaced that describes a "dumping clause" or an "IRS Form 8300 Exemption Certification" that can be filled out by the potential client to exclude the business from filing the required form. The IRS says, "There is no such clause or certificate."

Automotive Sales Industry Statistics

Tax fraud investigations are the main component of IRS efforts to foster compliance with the tax laws. Many of these investigations include white-collar financial crimes in legal industries and involve individuals from all facets of our economy. In the past three and a half years, IRS has initiated over 280 investigations involving individuals in the sales sector of the automotive industry. Fifteen percent of those cases involve violations of the currency reporting requirements of the Form 8300.

For the first half of fiscal year 2003, the United States Attorney's Office has filed indictments or informations on twice as many individuals for the same time period as fiscal year 2002, and the average sentence has jumped from 38 months to 55 months.

 

FY 2000-2002
Totals

FY 2002
(10/01- 5/31)

FY 2003
(10/01- 5/31)

Initiations

219

54

65*

Prosecution recommendations

146

22

35

Indictment/information filed

145

19

38

Convictions

136

29

18

Sentenced

155

34

22

Incarceration rate

78.9%

61.8%

72.7%

Avg. months to serve (w/prison)

37

38

55

Avg. months to serve (all sent)

32

24

40


* How to Interpret Criminal Investigation Data
Since actions on a specific investigation may cross fiscal years, the data shown in cases initiated may not always represent the same universe of cases shown in other actions within the same fiscal year. Therefore, in fiscal year 2004, the data should reflect an increase in convictions and sentenced due to the fiscal year 2003 increase in case initiations, prosecution recommendations and indictments.

Case Summaries

The following case summaries are excerpts from public record documents on file in the court in the judicial district in which the cases were prosecuted.

Allstate Auto Sales West, Inc.
On Aug. 6, 2003, Harry F. Zanko, owner of Ohio-based Allstate Auto Sales West, Inc., was sentenced to four years probation, with the first twelve months in electronically monitored home confinement, for attempting to evade his income taxes for 1996, in violation of Title 26, 7201 of the United States Code. As a condition of his probation Zanko was also ordered to perform 300 hours of community service, refrain from gambling and attending gambling establishments, attend mental health counseling for his gambling addiction, follow doctor's instructions regarding his treatment of diabetes, and cooperate with the IRS in determination and payment of his civil tax liabilities.

According to court documents, Zanko.s source of income from 1996 through 1998 was from owning and operating used car lots, initially with a partner in Cleveland, Ohio, under the name of Allstate Auto Sales. Then in 1998 he moved to a new location in Parma, Ohio, where he operated a dealership alone under the name of Allstate Auto Sales West, Inc.

Zanko acknowledged that he diverted receipts and funds for his personal use consisting of: (1) currency payments by customers, (2) four check payments from customers, and (3) various checks written on the corporate checking account, which he recorded on the corporate disbursements records as being for business purposes. Zanko attempted to evade income taxes of approximately $249,669 for the years 1996 through 1998, by willfully understating his income for those years by approximately $1,151,636 on his personal income tax returns and amended 1996 return.

Raley-Vaughan Motor Company, Inc.
On April 7, 2003, four family members who operated an automobile dealership in Rogersville, Tenn. were sentenced to prison terms ranging from 22 to 30 months for conspiring to commit various schemes to fraudulently obtain money, according to court documents.

The family ran the Raley-Vaughan Motor Company, Inc. (RVMC) with Terry Vaughan as Vice President and general manager. His mother, Wanda Vaughan, was Secretary/Treasurer and a co-owner, and his father, Edward Vaughan, was President and a co-owner. His sister, Sheree Vaughan Kelso, was employed by the dealership handling accounting, sales and other duties.

During the course of the conspiracy, the Vaughan family, through RVMC, (1) fraudulently obtained money, funds and credit by making false applications, installment contracts, promissory notes and other documents to banks and lending institutions; (2) engaged in a scheme to defraud General Motors Acceptance Corporation (GMAC); (3) deposited non-sufficient funds to RVMC accounts to fraudulently inflate the balances, and (4) used the money unlawfully obtained from banks, lending institutions and GMAC to promote the fraudulent schemes.

Terry E. Vaughan was sentenced to a prison term of 30 months. Edward K. Vaughan, Wanda R. Vaughan and Sherree Vaughan Kelso were sentenced to prison terms of 22 months. All prison terms are to be followed by 36-months of supervised release and the four were ordered to pay restitution totaling $572,250.

Car Outlet
On Nov. 15, 2002, Andrew S. Holloway, owner of Car Outlet in Blue Springs, Mo. was sentenced to 30 months in prison for laundering the proceeds of another person's cocaine trafficking, according to court records. In August 2002, Holloway pleaded guilty to charges that he conducted a financial transaction that involved the proceeds of an unlawful activity, knowing that the transaction was designed to avoid a federal transaction-reporting requirement.

According to court records, Holloway sold a 1999 Chevy Tahoe to a cocaine dealer for $21,000, which he knew represented the proceeds from unlawful drug sales. Holloway admitted that he assisted the cocaine dealer in concealing his use of substantial amounts of cash by creating false sales documents, which understated the purchase price of the vehicle. Those false sales documents were created to avoid filing Form 8300 with the IRS, and to conceal the method of payment.

Relevant Criminal Statutes

There are many United States Code Statutes for which IRS has jurisdiction with which to recommend prosecution. The ones most commonly associated with persons involved in the automotive industry are the following.

  • Title 26 USC Section 7201, attempt to evade or defeat tax;
  • Title 26 USC Section 7203, Willful failure to file return, supply information, or pay tax;
  • Title 18 USC Section1956, Laundering of monetary instruments;
  • Title 18 USC Section 1957, Engaging in monetary transactions in property derived from specified unlawful activity;
  • Title 31 USC Section 5324, Structuring transactions to evade reporting requirement.

All except the Title 26, 7203 charge are felony criminal statutes, some of which carry a possible maximum sentence of 20 years.

Additionally, there are provisions under the federal statutes that allow for the seizure of vehicles and/or funds from auto dealerships that knowingly engage in transactions which involve proceeds derived from a specified unlawful activity (Title 18 USC Section 981 & Title 18 USC 982).

Understanding Your IRS Notice
We realize that receiving a notice from the IRS can be unnerving, but if you follow these simple steps, the process to resolving the discrepancy should be straight forward.

Do you need to see what an IRS notice or letter says, but don't have it in front of you? If you know the notice number, you can look up its purpose, basic message, possible enclosures, and other useful details. And if you have the tear-off stub from the last page, you can use the information printed on it to see some of the variable content included in that notice.

How To Identify Your Notice
The notice number prints on the top of the first page of all our notices and on the lower left-hand side of the tear-off stub included with most of them. That number identifies the message we deliver in every notice. While the contents may vary somewhat, every notice with the same number has the same basic purpose.

Understanding Your Notice or Letter

CP or Letter Number Title
CP 11 Changes to Tax Return, Balance Due
CP 11A Changes to Tax Return and Earned Income Credit, Balance Due
CP 12 Changes to Tax Return, Overpayment
CP 14 Balance Due
CP 21B Data Processing Adjustment Notice, Overpayment of $1 or more
CP 22A Data Processing Adjustment Notice, Bal Due of $5 or more, Balance Due
CP 22E Examination Adjustment Notice, Balance Due
CP 23 Estimated Tax Discrepancy, Balance Due
CP 49 Overpaid Tax Applied to Other Taxes You Owe
CP 57 Notice of Insufficient Funds
CP 88 Delinquent Return Refund Hold
CP 90/CP 297 Final Notice - Notice of Intent to Levy and Notice of Your Right to a Hearing
CP 297A Notice of Levy and Notice of Your Right to a Hearing
CP 91/CP 298 Final Notice Before Levy on Social Security Benefits
CP 161 Request for Payment or Notice of Unpaid Balance, Balance Due
CP 501 Reminder Notice - Balance Due
CP 503 Second Request Notice - Balance Due
CP 504 Final Notice - Balance Due
CP 521 Installment Agreement Reminder Notice
CP 523 Notice of Default on Installment Agreement
CP 2000 Notice of Proposed Adjustment for Underpayment/Overpayment
Letter 0484C Collection Information Statement Requested (Form 433F/433D); Inability to Pay/Transfer
Letter 0549C Balance Due on Account is Paid
Letter 668D(LP 68) We released the taxpayer's levy.
Letter 0681C Proposal to Pay Accepted
Letter 0757C Installment Privilege Terminated
Letter 1058 (LT 11) Final Notice prior to levy; your right to a hearing
Letter 1615 (LT 18) Mail us your overdue tax returns.
Letter 1731 (LP 64) Please help us locate a taxpayer.
Letter 1737 (LT 27) Please complete and site Form 433F, Collection Information Statement.
Letter 1961C Installment Agreement for Direct Debit 433-G
Letter 1962C Installment Agreement Reply to Taxpayer
Letter 2050 (LT 16) Please call us about your overdue taxes or tax return.
Letter 2257C Balance Due Total to Taxpayer
Letter 2271C Installment Agreement for Direct Debit Revisions
Letter 2272C Installment Agreement Cannot be Considered
Letter 2273C Installment Agreement Accepted: Terms Explained
Letter 2318C Installment Agreement: Payroll Deduction (F2159) Incomplete
Letter 2357C Abatement of Penalties and Interest
Letter 2603C Installment Agreement Accepted - Notice of Federal Tax Lien Will be Filed
Letter 2604C Pre-assessed Installment Agreement
Letter 2761C Request for Combat Zone Service Dates
Letter 2789C Taxpayer Response to Reminder of Balance Due
Letter 2822C VRU Acceptance of Proposal to Pay (30,60,90, 120 days)
Letter 2823C VRU Monthly Payment Plan Confirmation
Letter 2840C CC IAPND Installment Agreement Confirmation
Letter 3030C Balance Due Explained:Tax/Interest Not Paid
Letter 3127C Revision to Installment Agreement
Letter 3217C Installment Agreement Accepted: Terms Explained
Letter 3228 (LT 39) Reminder notice.
Letter 4903 (LT 26) We have no record of receiving your tax returns.
Letter LP 47 Address Information Request
Letter LP 59 Please contact us about the taxpayer levy.

What If My Notice Isn't Listed

You'll find useful information here about many of the notices we send, including the purpose of the notice, the reason we send it, and a list of enclosures we might include with it. There's also sample content for each. Since parts of our notices vary depending on account conditions, the samples may not exactly match the notices we mail. The basic message, though, will be the same.
  • Individual Filer Notices
    Notices we send about Form 1040, 1040A, or 1040EZ, or any schedules, forms, or attachments included with it are Individual Filer Notice.
  • Business Filer Notices
    Notices we send about business-related tax forms such as Forms 941, 1065, and 1120, are Business Filer Notices.

What To Do When You Disagree
If your notice or letter is listed above, follow the link for advice on handling disagreements with the notice. In general though, you need to contact IRS at the contact number provided on the notice to explain why you disagree. If that doesn't result in your satisfaction, the Taxpayer Advocate may be able to assist.

Related Links - Automotive
This page provides you links to sites that have specific information dealing with the automotive industry.

Tax Laws and Regulations - Automotive
This page provides revenue rulings and court cases related to the Automotive industry.

Court Cases, Revenue Rulings, Internal Revenue Codes, and Treasury Regulations

New tax laws and regulations may affect your tax situation. View important rulings related to the following topics:

Revenue Procedure 2001-56 (PDF), provides simplified methods auto dealerships can use to determine the dollar amount to be included in, or excluded from, the income of employees provided with vehicles by dealerships.

Tax Tips - Automotive
This section provides general information on subjects such as installment sales and how to value inventory.

Helpful Tips - Automotive Tax Tips
Important information to keep in mind.

Form 8300

Who must file?

Each person engaged in a trade or business who, in the course of conducting that trade or business, receives more than $10,000 in cash in one transaction or in two or more related transactions must file a Form 8300 (PDF). Any transactions conducted between a payer (or its agent) and the recipient in a 24-hour period are related transactions.  Transactions are considered related even if they occur over a period of more than 24-hours if the recipient knows, or has reason to know, that each transaction is one of a series of connected transactions.  Form 8300 may be filed voluntarily for any suspicious transaction, even if the total amount is less than $10,000.  You, as the filer, should keep a copy of each Form 8300 for 5 years from the date you file it.

When to file?

File Form 8300 by the 15th day after the date that the cash was received.  If that date falls on a Saturday, Sunday, or legal holiday, file the form on the next business day.

Provide a written statement

You, as the filer, must give a written statement to each person named on a required Form 8300 on or before January 31 of the year following the calendar year in which the cash is received.  The statement must show the name, telephone number, and address of the information contact for the business, the aggregate amount of reportable cash received, and that the information was furnished to the IRS.  Keep a copy of this statement for your records.

Changing Accounting Methods

Changing your accounting method generally requires IRS approval. To get approval, you must file Form 3115, Application for Change in Accounting Method (PDF).  A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment of any material item.  A material item is one that affects the proper time for inclusion of income or allowance of a deduction.

Installment Method

If you finance the purchase of your property, instead of having the buyer get a loan or mortgage from a third party, you probably have an installment sale.  It is not an installment sale if the buyer borrows the money from a third party and then pays you the total selling price.  Read more about installment sales in the Installment Methods Tax Tip.

Inventory - Automotive Tax Tips
How do I value my inventory?
An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales.

Automobile dealerships have a great deal of discretion in what accounting methods they will employ for various classes of their inventoried items. Whatever method the taxpayer chooses, it must clearly reflect income. Dealerships typically maintain distinct inventories and tend to account for them differently. Among the types of inventoried items are:

  • New vehicles
  • Used vehicles
  • Parts and Accessories

The methods used for valuing and accounting for these classes of items do differ from dealership to dealership, but once a method is chosen, it must be adhered to. If a taxpayer elects to change his/her inventory method, Form 3115, Application for Change in Accounting Method must be submitted (PDF).

Lower of Cost or Market (LCM)

Most taxpayers use the Lower of Cost or Market Method (LCM). The LCM method is the same as the cost method (which simply requires inventory to be valued at its acquisition cost), except when the fair market value of the merchandise drops below cost. If the dealer is unable to recover its cost on the merchandise because the "market" has fallen below cost, the dealer is allowed to recognize the difference even though the loss has not been realized.

With the LCM method, the "market" generally refers to replacement cost for the same goods in the same quantities that the taxpayer would normally acquire. For auto dealers, the "market" will often be the retail sales price after markdowns and discounts. It is important to remember that the market value cannot be estimated. The taxpayer must actually offer (or be offered) those goods for sale at that price in order to call it market.

When you offer merchandise for sale at a price lower than market, you can value the inventory at the lower price, less the direct cost of disposition. These prices are figured from the actual sales for a reasonable period before and after the date of your inventory. Prices significantly different from the actual prices are not acceptable.

If no market exists, or if quotations are given without reference to actual conditions because of an inactive market, you must use the available evidence of fair market price on the dates nearest your inventory date. This evidence could include specific purchases or sales you or others made in reasonable volume and in good faith or compensation amounts paid for cancellation of contracts for purchase commitments.

You MUST use the FIFO or LIFO methods, explained below, if:

  • You cannot specifically identify items with their costs
  • The same type of goods are intermingled in your inventory and they cannot be identified with specific invoices

First In, First Out (FIFO)

The First In, First Out method assumes the items you have purchased or produced first are the first items you sold, consumed, or otherwise disposed of. The items in inventory at the end of the tax year are matched with the costs of items of the same type that you most recently purchased or produced.

Last In, First Out (LIFO)

The Last In, First Out method assumes the items of inventory you purchased or produced last are sold or removed from inventory first. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and acquired in that tax year.

The rules for using the LIFO method are very complex. Two common methods are used to price LIFO inventories, the Dollar-value method and the Simplified dollar-value method. To adopt the LIFO method file Form 970, Application To Use LIFO Inventory Method (PDF).

Dollar-value method - Under the dollar-value method of pricing LIFO inventories, goods and products must be grouped into one or more pools (classes of items), depending on the kinds of goods or products in the inventories.

Simplified dollar-value method - Under this method, you establish multiple inventory pools in general categories from appropriate government price indexes. You then use changes in the price index to estimate the annual change in price for inventory items in the pools. An eligible small business (average annual gross receipts of $5 million dollars or less for the 3 preceding tax years) can elect this method.

For additional information on the LIFO method, see Internal Revenue Code sections 472 through 474.

Differences Between FIFO and LIFO

FIFO

LIFO

Periods of Rising Prices (Inflation)

(+) Higher value of inventory
(-) Lower cost of goods sold

(-) Lower value of inventory
(+) Higher cost of goods sold

Periods of Falling Prices (Deflation)

(-) Lower value of inventory
(+) Higher cost of goods sold

(-) Higher value on inventory
(+) Lower cost on goods sold

Replacement Costs / Loss of Inventory

Regardless of which inventory method you use, you must take a physical inventory at reasonable intervals and the book figure for inventory must be adjusted to agree with the actual inventory. Precise inventory records will assist you if you were ever to incur a loss. There are several ways to claim a casualty or theft loss of inventory.

You can claim a casualty or theft loss of inventory, including items you hold for sale to customers, through the increase in the cost of goods sold by properly reporting your opening and closing inventories. If you choose to report the loss this way, you cannot claim the loss again as a casualty or theft loss. Any insurance or other reimbursement you receive for the loss is taxable.

You can also choose to take the loss separately as a casualty or theft loss. If you take the loss separately, adjust opening inventory or purchases to eliminate the loss items and avoid counting the loss twice. Also, reduce the loss by the reimbursement you receive or expect to receive. If you do not receive the reimbursement by the end of the year, you cannot claim a loss for any amounts you reasonably expect to recover.

If your inventory loss is due to a disaster in an area determined by the President of the United States to be eligible for federal assistance, you can choose to deduct the loss on your return for the immediately preceding year. However, you must also decrease your opening inventory for the year of the loss so the loss will not show up again in the inventory.

If your creditors forgive part of what you owe them because of your inventory loss, this amount is treated as income and is taxable.


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