According to a recent IRS publication on the practice of auditing car dealers, there are three main categories that should be examined when looking at an RFC: Economic Reasons, Validity, and Economic Substance.
ECONOMIC REASONS
Provide a credit source for customers. Many customers have little or bad credit and need an alternate finance source. An affiliated loan company can answer this need while focusing the collection function away from the dealership itself, which relieves the sales personnel from a task that is often time consuming. Another valuable reason for forming a finance company is credibility. If a posting to a credit report about a borrower lists a credit record from a buy here/pay here dealer, it lacks a certain flavor of respect in the eyes of those who read it. But, if it lists a finance company, even an RFC, it looks better in the eyes of other lending institutions who may lend money to your customer in the future. Your customer should be made aware of the value of this service to him and let him know that you will report his good payment patterns to the credit service (or bad payment patterns).
Improve the collection of accounts receivable. Payment schedules may often be on a weekly or bi-weekly basis coinciding with the borrower's pay-day and many ordinary finance sources will not permit such payment schedules. An RFC can significantly enhance the collection of accounts receivable by permitting convenient pay dates as a convenience to the customer. And, by requiring the borrower/buyer to remit payments to a third party, even though the third party is related to the dealer, it improves collections. It has been the industrys experience that when payment is made directly to the dealer, a bad experience with the car often leads to a default on the note for the car. This, in turn, creates a collection problem, and possibly a publicity problem for the dealership. On the other hand, if an RFC is involved, experience shows that the customer is less likely to default on the payment.
Prevent adverse publicity on repossessions. Repossession and collection problems are a daily fact of life for buy here/pay here dealers. Creation of an RFC permits a new entity to undertake these actions, and thereby insulates the dealer from bad publicity. The customer, and most of his friends, would probably shy away from a dealership who took "poor old John's" car just when he lost his job and needed it most. Maybe you don't want John's business again anyway, but you probably don't want to lose all his friends too. Let the RFC take the heat for repossession or collection activities and let the dealership stay away from ill-will.
Remove the financial risk of default. The industry deals with a customer base that generally has poor or non-existent credit. The default rate on buy here/pay here notes is substantially higher than on general bank loans. A separate RFC removes the financial risk from the dealership entity and transfers it to the finance company where it can more adequately be handled and allowed for through reserves and other accounting practices.
Diversification of ownership. Since the financing of used cars is not inherently a part of a dealership, an RFC permits the dealer to begin another company and allow ownership in that specific company to both family and non-family members without diluting ownership in the dealership. This allows the dealer to separate the two businesses and reward certain employees or other individuals with an ownership interest in a segment of the business.
Finance other dealer's customers. An RFC can be expanded, if desired, to finance unrelated receivables from other dealers as well as those of your own dealership. There is nothing stopping an RFC from functioning like any other normal finance company.
VALIDITY
It is extremely important as to how an RFC is structured and operated. Since the purpose of the RFC is to isolate liability or segregate transactions in a separate entity, the RFC should meet reasonable criteria that identifies it as a separate, valid business. Thinking of the RFC as simply a collection mechanism for the dealership is a grave mistake and should not be taken lightly.
The RFC should be a separate, legal entity. A separate business entity should exist for each of the two companies. They may or may not have the same ownership and officers.
The RFC should meet all licensing requirements. As said before, both need a finance license under Florida Statute 520. The dealership needs a "Retail installment Seller's License" and the finance company needs a "Sales Finance License".
The RFC should be adequately capitalized. Each deal (loan) should be treated separately and should be sold (assigned) from the dealership to the finance company. IRS will pay special attention to this activity and if the sale of the loan contract is nothing more than a Journal Entry in the General Ledger at the end of the month, there may be problems. Write a check to satisfy the purchase and show a trail of activity.
The RFC should have its own employees. The RFC should have its own employee(s) and compensate them directly. However, the fact that the RFC and the dealership may elect to use a common paymaster does not indicate, in any way, that the RFC does not have its own employees. Just be sure that at the end of the month money changes hands to compensate the "paymaster" company for any pay checks issued to RFC employees.
The RFC should obtain and maintain all appropriate local business and similar licenses. Be sure to get a separate occupational license for the RFC along with the appropriate finance license. Likewise, state and federal tax forms should be filed separately for the two entities.
The RFC should have a separate Address and telephone number. Both companies may occupy the same office space, but common sense says that there should be separate identification of the two businesses. Separate phones are a good start. A separate mailing address or PO box should be maintained. It is common for the RFC to have an office at the dealership but some separation of work space should be attempted. Even though the two entities are separate, certain office equipment such as faxes and copy machines may be shared. But, even here, it is wise to allocate some sharing of expenses in your ledger.
The RFC should maintain a separate set of books and records. Generally an accountant will help you with this. Normally, the dealership is setup on an "accrual" method of accounting and the finance company on a "cash" method. This can lead to one of the more obvious benefits to an RFC, so don't treat it lightly. Get some knowledgeable help from an accountant.
The RFC should comply with all title, lien, and recordation rules. The RFC should be named as the lienholder of titles, and the sales agreements should indicate that the vehicle was sold in the name of the dealership. The Retail installment contract should be entered into in the name of the dealer and then assigned by the dealer to the finance company. Any liens applied to the contract should be in the name of the RFC. An agreement should exist between the dealership and the RFC listing all terms and rights of each party.
The RFC should notify customers of the purchase of their notes. Be sure to automatically send a notice to your customers informing them that the loan has been reassigned to the finance company. It just makes good sense to advise the customer that his account is now owned by a finance company instead of your dealership. Once more, we want to establish that the two companies are separate.
The RFC and the dealership should have a purchase contract for the receivables. The agreement must comply with the appropriate state laws and provide evidence of how the Fair Market Value of the receivables was determined.
ECONOMIC SUBSTANCE
Sales of receivables must have economic substance. To qualify for tax purposes, valid business reasons alone are not sufficient. Fair Market Value (FMV) must exist to show that the values dealt with are representative of what occurs in the industry in a competitive market. If you just arbitrarily set a price, you are probably not going to be able to show FMV and may find that your RFC is denied. The FMV of a receivable or group of receivables will depend on a number of factors, the facts and circumstances of each receivable determining the importance of each factor. A little research (phone calls and inquiries) will tell you what kind of rates are being quoted by other companies who specialize in "buying paper" from car dealers. You do a similar activity, and you should be able to pretty well defend yourself if challenged.
Depending on the facts and circumstances of each dealership, the RFC could be a valid business and should be respected as a separate entity. The issue will be resolved based on the particular facts and circumstances of each taxpayer. A dealer can use an RFC to discount its receivables and have it accepted for tax purposes. Accordingly, the importance of fully developing your RFC carefully cannot be overstated.
This information was lifted from the IRS and slightly modified to fit my style of writing. If you follow this outline, you stand a reasonable chance of passing the IRS examinations. But, Your own accountant is more knowledgeable about your circumstances, ask his advice. Keep in mind that I am neither an accountant nor an attorney. Consult yours.