108 T.C. 448 (T.C. 1997), 16038-93, Johnson v. Commissioner of Internal Revenue
|Docket Nº:||16038-93, 16039-93, 17007-93, 14430-94|
|Citation:||108 T.C. 448, 108 T.C. No. 22|
|Opinion Judge:||BEGHE, Judge.|
|Party Name:||RAMEAU A. AND PHYLLIS A. JOHNSON, ET AL.,  Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent|
|Attorney:||Kenneth G. Kolmin, Francis J. Emmons, and Aaron E. Hoffman, for petitioners. Karen J. Goheen and Elsie Hall, for respondent.|
|Case Date:||June 16, 1997|
|Court:||United States Tax Court|
Decisions will be entered under Rule 155.
Ds sold multiyear vehicle service contracts (VSC's) in connection with the sale of motor vehicles under a common program administered by A, an unrelated party. Under the terms of the program, Ds retained a portion of the contract price as their profit and remitted the remainder to A: (1) For deposit of a specified amount in escrow to fund their obligations under the VSC, and (2) for payment of A's fees and a premium for excess loss insurance provided by an unrelated insurance company. Ds currently included in gross income only the portion of the contract price that they retained as profit. Ds reported amounts held in escrow only when released to them.
1.(a) At the time Ds sold a VSC they acquired a fixed right to receive, and must currently include in gross income, the portion of the contract price deposited in escrow. The reasoning of Commissioner v. Hansen, 360 U.S. 446 (1959), controls.
(b) This amount did not constitute a purchaser deposit. Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990), distinguished.
(c) Nor did this amount constitute a trust fund for the benefit of the purchaser. Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), affd. on other grounds 407 F.2d 210 (9th Cir. 1969), and Miele v. Commissioner, 72 T.C. 284 (1979), distinguished.
2. Pursuant to secs. 671 and 677, I.R.C., Ds are treated as owners of the escrow accounts and must currently include investment income of the accounts in gross income. Effect of sec. 468B(g), I.R.C., explained.
3. Premiums are capital expenditures that must be recovered through amortization. Fees are deductible in accordance with a formula that reasonably measures A's performance of services over the life of the VSC's. Ds may not either currently deduct these payments to offset income they are required to recognize with respect to the corresponding portions of the contract price or defer recognition of income until the offsetting deductions are allowable.
4. An adjustment under sec. 481, I.R.C., is sustained.
Respondent determined deficiencies in petitioners' Federal income tax, additions to tax and penalties as follows: 
Rameau A. Johnson and Phyllis A. Johnson (the Johnsons), docket No. 16038-93.
Penalty Year Deficiency Sec. 6662(a) 1991 $ 4,097 $ 819
Thomas R. Herring and Karon S. Herring (the Herrings), docket No. 16039-93.
Penalty Year Deficiency Sec. 6662(a) 1991 $ 2,093 $ 419
DFM Investment Co., d.b.a. St. Louis Honda, docket No. 17007-93.
Addition to Tax Penalty Year Ended Deficiency Sec. 6653(a) Sec. 6662(a) Mar. 31, 1989 $ 2,285 $ 114 - 0 - Mar. 31, 1990 110,378 - 0 - $ 22,076 Mar. 31, 1992 34,686 - 0 - 6,937
David F. Mungenast and Barbara J. Mungenast (the Mungenasts) docket No. 14430-94.
Addition to Tax Penalty Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) 1990 $ 355,623 $ 27,492 $ 71,125 1991 84,431 5,316 16,886
These cases were consolidated for trial, briefing, and opinion by reason of the presence of common issues regarding the methods used by certain motor vehicle dealerships to report income and expense on the sale of multiyear vehicle service contracts (VSC's). In docket Nos. 16038-93, 16039-93, and 17007-93 all the adjustments are attributable to these common issues. In docket No. 14430-94 only the adjustments related to the tax treatment of VSC's have been consolidated; the remaining adjustments were settled by the parties separately. Prior to trial, respondent revised the adjustments on the basis of more complete information, as a result of which the deficiencies now asserted are lower than those set forth in the notices of deficiency. Respondent has also conceded the Page 451 addition to tax under section 6653(a) in docket No. 17007-93 and penalties under section 6662(a) in all dockets to the extent attributable to the consolidated issues. The issues that remain for decision are: 1. Whether accrual basis motor vehicle dealerships may exclude from gross income for the year of the sale of a VSC that portion of the contract price that they were required to deposit in escrow to secure their obligations under the contract; 2. whether the dealerships may exclude from gross income the investment income earned by the funds held in escrow; and 3. whether the dealerships may exclude or deduct from gross income for the year of the sale of a VSC those portions of the contract price that they remitted to third parties as prepayments of service fees for administration of the VSC program and an insurance premium for indemnification of their losses under the program. If respondent prevails on these issues, we must further decide whether the income of one of the dealerships is subject to an additional adjustment pursuant to section 481. We hold that the dealerships' method of accounting for VSC's was not a proper application of the accrual method, and, except in regard to the treatment of the dealerships' administrative fee expenses, we sustain respondent's revised adjustments in full. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulations of fact and attached exhibits are incorporated by this reference. At the times they filed their petitions, the Johnsons, the Herrings, and the Mungenasts were residents of, and DFM Investment Co. maintained its principal place of business in, the State of Missouri. The relationships between petitioners and the dealerships whose method of accounting for VSC's is the subject of controversy in these cases (collectively, the Dealerships) are set forth below:
Tax Status During Taxable Corporate Doing Yr.(s) At Petitioners Name Business As Issue Owning Shares DFM Investment Co. St. Louis Honda Subchapter C David Mungenast corp. (at least 82%) DRK Investment Co. St. Louis Acura Subchapter S David Mungenast corp. (100%) Capco Sales, Inc. St. Louis Lexus Subchapter S David Mungenast corp. (100%) MAD Investment Co. Alton Toyota/Dodge (not in David Mungenast (prior to 1991) evidence) (not in evidence) DAR, Inc. Alton Toyota/Dodge Subchapter S David Mungenast (beginning 1991) corp. (50%), Rameau Johnson (33%), Thomas Herring (17%)
Page 452 During the years at issue, the four Dealerships offered VSC's under a common program in conjunction with the sale of new and used motor vehicles. Before October 1991 the program was administered by Mechanical Breakdown, Inc. (MBP), a corporation unrelated to petitioners. From October 1991 through March 1992, the program was administered by Automotive Professionals, Inc. (API), also unrelated to petitioners, but the structure and operation of the program remained, in all material respects, substantially unchanged.  A standard form of VSC recites that it is a contract between the issuing dealer and the motor vehicle purchaser (referred to in some contracts as the " contract holder" ). Under the terms of the VSC, the dealer agrees, for a fixed price, to
make repairs or replace any of the below listed parts or components of the Contract Holder's Vehicle covered hereunder or cause such repairs or replacement to be made by an authorized repair facility at no cost for parts or labor to the Contract Holder (but subject to applicable deductible, if any) whenever covered components or parts in the Contract Holder's said Vehicle experience a Mechanical Breakdown.
The parties agree that the full purchase price of the VSC was due and collected at the time of sale.  The VSC purchaser can select the term of coverage he desires from a range of options, each defined by reference to Page 453 a specified time or mileage limitation, whichever is reached first. Approximately three-quarters of the contracts sold by the Dealerships during the years at issue provided coverage for at least 5 years or 60,000 miles. However, the aggregate limit of a dealer's liability is fixed in some of the contracts as the value of the vehicle at the time of purchase and in the rest of the contracts as the lesser of the value of the vehicle at the time of purchase or $ 10,000. The VSC provides that
A specific amount of the Contract purchase price shall be held in escrow in accordance with and as specified in Automotive Professionals, Inc.'s Administrator Agreement, a copy of which is available from the Dealer. Said amount shall be paid directly to the escrow account established by the Administrator and Brokerage Professionals, Inc., the Escrow Trustees. * * * All amounts placed in escrow,...
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