Buy-here, pay-here (BHPH) dealers are accustomed to taking a tax deduction when they sell contracts to their related finance companies (RFCs). This deduction is permitted by the IRS and it helps make up for the loss the dealer takes on the sale. I have noticed that some dealers apply the same deduction to the sale of their lease-here, pay-here (LHPH) receivables. I would advise against that, and I’ll explain why.

The Internal Revenue Code has a general rule that covers losses on transactions between related parties, including BHPH dealers and their RFCs. The rule states that losses are disallowed until the property is transferred outside of the related party controlled group. Fortunately for dealers, the Deficit Reduction Act of 1984 carved out an exception to that rule.

The so-called “factoring exception” basically says that if one corporation acquires a receivable from the sale of goods or services to an unrelated person, and sells that receivable to a related corporation at a discounted amount representing its true, fair market value, the loss (a.k.a. discount expense) is fully deductible — as long as it didn’t exceed the gain created from the original sale to that outside person.

That is why discounted sales from a BHPH to an RFC are allowed to work. They are protected by the factoring exception. However, it doesn’t work the same way for LHPH paper. When a dealer acting as a lessor immediately sells the lease contract to their related corporate finance entity, the transaction runs into trouble. Having booked the full cap cost as a sale on his books, the dealer then tries to arbitrarily extend the discounting exception to the lease contract and allows a deep discount.

The problem is there is no substantiation for doing so in the tax laws. A tax lease — as in a typical LHPH contract where the lessor is entitled to take depreciation — is not a “sale of goods or services.” That, according to the UCC in section 2A on leases, is a deal breaker.

Fact Checking

I decided to do some research to determine what the Senate and House Finance Committee had in mind when they wrote the Deficit Reduction Act almost 30 years ago. I turned to the conference report, a resource often used by tax professionals, to look at what the House and Senate were after before they were forced to compromise to finalize each new point of law.

On Page 158 of the report, titled “Sec 123 Treatment of Related Person Factoring Income,” it defines “trade or business receivable” as “… any account receivable or evidence of indebtedness arising out of … the disposition by a related person of” property in the nature of stock in trade. Stock in trade-type property would certainly cover the vehicles on your lot, but it requires there be a “disposition” of the property — which still sounds more hopeful than the word “sale.”

Unfortunately, leasing is not a disposition, because the lessor retains title. Unless the title transfers — and it never will as an LHPH lease contract — the factoring exception does not apply. And remember, the sale requirement is between the dealership corporation and the customer, not the dealership corporation and its related leasing corporation (RLC) when it transfers the lease.

Additionally, the rules state that losses (or discounts, in this case) between related parties are not allowed as a deduction until the item involved is transferred outside the controlled group of companies. If and when the discount on the lease gets disallowed in an IRS exam, it would probably end up deferred or suspended on the dealer’s tax balance sheet until the lease terminates for one reason or another. Examples could include anything from a total loss or a vehicle that was returned and sent to auction once the term was up. Only then would the discount be deducted for taxes by the dealer.

After reading the conference report, I spoke informally with an IRS attorney whose job is to provide counsel on letter rulings and requests from the field. He agreed that a lease is not a sale of goods or services.

To this point, there has been no litigation challenging the discounting of the sale of leases from a dealer to his or her related leasing company. It’s possible that the sale of LHPH contracts could eventually be categorized alongside BHPH contracts. But to continue lease discounting without consulting a qualified accountant or tax attorney is extremely aggressive and risky.