Tax Byte

After 25 years as a commercial lender at Comerica Bank, Mr. Alvarado opened South Bay Autos, a used car business, preparing a few tax returns on the side. South Bay relied heavily on credit, both for the acquisition of inventory and for the sale of vehicles to customers. South Bay purchased vehicles at car auctions using credit with terms that required repayment in 45 days before having to pay high interest charges. Vehicles were generally sold on credit, with the contracts sold to financing companies. The finance companies would pay the face amount of a contract less a reserve and any amounts not recovered on previous (now uncollectible) contracts.

Most of the South Bay sales records were maintained on auto dealer car jackets and with an inventory system that had some partially reliable financial records. The revenue agent auditing the business used bank records and car jackets to determine both gross receipts and cost of goods sold. When the cost of a vehicle could not be traced to a specific payment, the IRS agent allowed nothing. Additionally, the IRS determined unreported income to which they did not attribute any amount for cost of goods sold. This method resulted in the IRS creating gross profit margins of over 60% each year. Not even the Tax Court believed this was plausible. Using some parts of South Bay’s inventory system and matched bank records, the Court estimated the cost of goods sold under Cohan at about 55% — not 40% as the IRS claimed.