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Auto dealers: extended service contracts.

Auto dealers frequently sell their new car customers extended service contracts as add-ons to the manufacturer's warranty. For a new vehicle with a three-year warranty, the dealer might sell the buyer an additional two-year extended service contract for $800. Often, the dealership then passes off the risk of this warranty by purchasing coverage from the manufacturer or an insurer, say for a fee of $600.

The Internal Revenue Service ruled that an accrual basis car dealer must report the full customer warranty payment in income but only can deduct the amount paid by amortization over the term of the extended service contract (technical advice memorandum 921-8004).

In the example above, the IRS position would require the dealership to report $800 of income during the first year at the time of sale to the customer but to claim only the $600 as amortization deductions of $300 in the fourth year and $300 in the fifth year.

The IRS position is the dealership's purchase of the service contract coverage from either the manufacturer or an insurance company creates an asset with a useful life extending substantially beyond the tax year, therefore requiring amortization. Internal Revenue Code section 461 supports this, and recent regulations say prepaid expenditures are deductible only when the goods or services are received within three and one-half months.

Observation: Had the auto dealership been treated as an agent in this arrangement, so that it had received a commission, it would have been in a position to report only the difference between the contract and the warranty as net income in the year of sale. However, in this ruling the customer had a separate contract with the auto dealership, which in turn had a separate service contract insurance arrangement with a subsidiary of the manufacturer.

Because of the extended period of the service contract, it was not possible for the auto dealership to defer the remittance from the customer for that contract. Payments received by an accrual basis taxpayer under an agreement for the performance of future services may be deferred only if the services are to be performed before the end of the succeeding tax year (revenue procedure 71-21, 1971-2 CB 549).
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Publication:Journal of Accountancy
Article Type:Brief Article
Date:Jul 1, 1992
Words:363
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