Facility image upgrade programs - IRS legal advice memorandum

On May 9, 2014, the IRS Office of Chief Counsel issued a memorandum discussing the tax treatment for payments that auto dealerships receive from manufacturers from facility image upgrade programs.

Proper treatment of payments received

The guidance says that upgrade image support payments are includable in the dealerships’ gross income.

The conclusion considered three different factual situations, all of which had the following in common:

  • Dealership participation is voluntary.
  • Payments are made to encourage dealership compliance and completion of the facility upgrade, not to encourage dealerships’ purchases or sales of vehicles.

The memo noted that previous to this guidance, dealerships have treated payments inconsistently. Often, dealerships consider the payments as nonshareholder contributions to capital under section 118 of the Internal Revenue Code (IRC) or as a way to reduce the basis of constructed assets or adjust the purchase price of vehicles from the manufacturer.

Analysis of the applicable law

Nonshareholder contributions to capital under IRC section 118

Section 118(a) provides that contribution to the capital of a corporation cannot be included in gross income, even when the contribution is made by a nonshareholder.

To determine if a transfer by a nonshareholder is a contribution of capital, the intent or motive of the transferor and the economic effect on the transferee corporation must be taken into account. Where the transfer is not made with the purpose of receiving direct service or compensation, but only for the advantage of the general community, the result is contribution to capital.

If the transfer is for the advantage of the general community, five factors indicate a contribution to capital. The transfer must:

  1. become a permanent part of the working capital structure
  2. not be compensation
  3. be bargained for
  4. result in a benefit to the transferee in an amount equal to its value
  5. contribute to the production of additional income

The upgrade support payments fail to be nonshareholder contributions to capital as described above as they are a direct benefit to the manufacturer and the intent and motive of the manufacturers is not to obtain advantage for the general community.

Basis of assets under sections 1012 and 1016 and basis reductions under section 362(c)(2)

Section 1012 states that the basis of acquired property is generally the cost of the property and is increased by the cost of capital improvements. The upgrade support payments are made with the intent of defraying dealership costs, but do not reduce the basis in the dealership’s property since dealerships own the properties and must include the full cost of construction in the basis of newly constructed property under section 1012 of the IRC. The dealership must also include the cost of capital improvements in the adjusted basis of existing property under section 1016.

Under section 362(c)(2), if money is received by a corporation as a contribution to capital by a nonshareholder, then the basis of any property acquired with such money during the 12-month period shall be reduced by the amount of the contribution.

Because upgrade support payments fail to be nonshareholder contributions to capital, they do not reduce basis of property acquired.

Gross income under section 61 versus purchase price adjustment

Section 61 defines gross income as all income (“instances of undeniable accessions to wealth, clearly realized and over which the taxpayers have complete dominion”) from whatever source derived.

Generally, when payments are made by vendors to retailers as an incentive to purchase merchandise, the payments are an adjustment to the purchase price if the purpose and intent of the parties was that the consideration given is to adjust the purchase price. Based on the contracts between the auto manufacturers and dealerships in this analysis, there is no evidence that the payments were made with any intent to reach an agreed selling price of the vehicles that the manufacturers sell to dealerships. The contracts analyzed reflected the purpose and intent of the payments as an incentive to dealerships to complete the upgrades and defray those costs.

Based on the facts and circumstances of the contracts analyzed, the upgrade image support payments are includable in the dealerships' gross income under section 61 of the code at the time the dealerships receive payment because the payments received to defray the cost of construction of, or improvements to, their property result in an access to wealth over which they have complete dominion and control.

The facts in this memorandum are similar to the facts in John B. White, Inc. v. Commissioner, a Tax Court case from 1972, in which the manufacturer paid amounts for leasehold improvements to encourage the dealer to move its dealership to another location. The Tax Court held that the payment was includable in the dealer’s income and was not excludable as a contribution to capital.

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