Potential IRS Audit Issues for an Auto Dealer


By Kathleen Myers

With the IRS’s recent hiring surge, the number of small business audits will likely increase over the coming months. In light of the increased activity, we thought this was the perfect time to discuss various hot topics that the IRS will likely hit on when auditing an automobile dealership. Below is a list of six such issues.

ISSUE: Substantiation of Used Vehicle Write-down
The Lower of Cost or Market “LCM” method is the most common method used by automobile dealers in valuing their used vehicle inventory. Under the LCM method, dealers can write-down a decline in the value of a vehicle in the year the decline occurs. If the market value of the vehicle at the end of the year is lower than its cost, the dealer can write-down the basis of the vehicle to the lower market value, thereby reducing gross income.

In order to prevent IRS scrutiny on this issue, dealers must maintain adequate, detailed records, including an item-by-item comparison of cost-to-market, to substantiate any write-downs taken. The IRS and courts have acknowledged the use of official valuation guides, such as Kelley Blue Book or Black Book, for valuing market. In order to make a proper comparison of cost-to-market, the following items are required:

  • Make, model and year of the vehicle
  • Vehicle condition, mileage and optional equipment

In addition to the above items, the IRS and the tax courts emphasize that the official guide selected must be used on a consistent basis and must be the correct guide for the dealer’s location and for the correct time period. Any change in the official guide used is considered a change in accounting method.

The bottom line on used vehicle write-downs is that 1) you have to calculate the write-down on an item-by-item basis and not use group estimates or reserves, 2) you have to consider all of the items listed above to make a proper comparison of cost to market using an official guide (be sure not to arbitrarily classify all vehicle conditions as “average”), and 3) you have to have documentation of 1) and 2) to substantiate the write-down to the IRS.

ISSUE: Shareholder Compensation
The too-high issue: For C corporations, the IRS will look for indications that shareholder compensation is unreasonably excessive. If the IRS believes that compensation is too high, some of the compensation will be recast as a dividend. The dividend is not a deduction item; rather it is taxable to the shareholder.

The too-low issue: For S corporations, the IRS doesn’t generally worry that compensation is too high, but instead looks for compensation that is too low. If the IRS believes that an owner is not being adequately compensated, it can reclass other payments, such as distributions, as compensation thereby subjecting the corporation and owner to additional payroll taxes and possible penalties.

To avoid either issue, dealers must carefully lay out and document (in the corporate minutes) the justification for any shareholder compensation. 

ISSUE: Demos
Revenue Procedure 2001-56, provides guidance for the taxation of personal use of a Demo Vehicle. In addition to computing a W-2 inclusion amount per the guidance provided in the revenue procedure, dealers also need to have and retain a written demonstrator policy that includes the following information:

  • documentation of communication to employees
  • payroll records, including Forms W-2 and payroll journals
  • list of employees with demos
  • valuation of the demos

Upon an IRS audit, the agent will review the demo policy and calculations for all open tax years and will assess additional payroll taxes and penalties for all years if a deficiency is found.

ISSUE: Miscellaneous Transactions with Owners
Health and accident insurance premiums paid to a more then a 2% shareholder of an S corporation: These payments must be included as taxable wages to the shareholder. The shareholder in turn is able to deduct these premiums as a self-employed health insurance deduction on Page one of his or her individual Form 1040.

Shareholder loans: The main issue the IRS will address is whether or not the loan is a bona fide debt between the shareholder and corporation. Depending on the type of entity and amount of the debt, the IRS will look at many factors to make that determination. At a minimum, the debt should have an interest calculation and should have all of the other elements of an arms-length debt transaction. The IRS will also carefully scrutinize any debt between an S corporation and its shareholder if the debt is used as debt basis for losses. There are complex tax rules for this type of debt, so dealers should talk to their tax advisors well in advance of any structured transaction.

ISSUE: Meals and Entertainment
The deductibility of meals and entertainment expenses is a hot topic in any IRS audit. Meals and entertainment expenses can only be deducted as a business expense if they are directly related to the trade or business. If there is a valid business purposes for the item, the expense is either 50% deductible or 100% deductible. Some examples of each are provided below.

50% deductible:

  • Meals provided for business meetings of employees, officers and shareholders. Business must be discussed during the meal for this to be deductible. If there is no business purpose, then it is fully nondeductible for tax purposes
  • Meals provided during business travel or during a convention or seminar
  • Meals with persons related to the business, such as clients, customers or vendors, as long as there is a business purpose

100% deductible:

  • Meal expenses for a company picnic or holiday party
  • Snacks provided in the office including coffee, soft drinks and water
  • Food provided to the public as part of a promotion
  • Meals provided on the employer’s premises to more than half of the employees for the convenience of the employer
  • Meals that are includable as taxable compensation to an employee and are included on the employee’s Form W-2

Dealers should be sure to have documentation and support for any meal and entertainment expense as the IRS is sure to review and test this area heavily.

Retailers, including auto dealers, are required to capitalize certain costs (both direct and indirect) related to inventory. For tax year 2010, auto dealers were able to elect new UNICAP safe harbor methods: the retail facility safe harbor method; and the reseller without production activities safe harbor method.

This was a hot issue in past years due to a 2007 Technical Advice Memorandum (TAM) that was very unfavorable to dealers. Recently, the IRS stepped-down its audit activity, waiting for the release of the safe harbor methods. However, since the new guidelines are now out, UNICAP will most likely be back on the list of IRS hot issues for tax years 2010 and later.

In order to avoid the harsh consequences outlined by the IRS in the 2007 TAM, dealers should file a change of accounting method on Form 3115 to elect the safe harbor method. Once the election is properly filed, the dealer will have audit protection on this issue for all open tax years. You should contact your tax service provider to file this form.


There are many other issues that the IRS might look at during an audit, but these are just some of the major areas that we have seen them address. If you are selected for audit, we advise that you contact your tax service provider to help you through the audit.

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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person any tax-related matter.

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