Don’t Forget About Demo Use and Income Exclusions

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Almost two decades ago, the Internal Revenue Service (IRS) released Revenue Procedure 2001-56, which outlines simplified methods for auto dealers to determine the income inclusion or exclusion amount for employees who are provided vehicles by the dealership. While the guidance is not new, and also not mandatory, it’s still important for dealers to understand the significance, especially if you hope to avoid hefty penalties from a potential IRS examination.

Original guidance from the IRS was issued so full-time automobile salespersons were not taxed on the value of a qualified automobile for demonstration (demo) purposes. Certain restrictions apply, including that the vehicle must be in current inventory and available for test drives, must be used in the sales area of the dealership and must be subject to significant restrictions on personal use, such as mileage limits and when the vehicle can be used (i.e., not on personal vacations or for storage of personal items). The optional methods include the following:

  • Simplified method for full exclusion of qualified automobile demo use, or the Simplified Out/In Method. Per the guidance, this method is only available to qualified salespersons (employed full-time by an automobile dealer, derives at least 25 percent of gross income from sales activity, spends at least half of their time as a floor salesperson or manager and directly engages in the promotion and negotiation of sales of vehicles to customers) and requires a qualified written policy. Personal use is limited to commuting plus an average of 10 miles per day, and the salesperson must maintain a mileage log.
  • Simplified partial exclusion method. As with the Simplified Out/In Method, the partial exclusion applies only to qualified salespersons and requires a qualified written policy; this method allows for some personal use and does not need a mileage log. However, the value of the use of the vehicle must be included in the salesperson’s income no less often than monthly.
  • Simplified full inclusion method. This method is for salespersons who do not meet qualifications for the other exclusions as well as for all other employees. The value of the use of the vehicle must be included in the employee’s income no less than monthly, without the need to consider actual business use of the vehicle.

When these methods are not applied, there is also a general rule stating that the amount required to be included in an employee’s income should be the fair market value of the use of the demo vehicle. Under the partial exclusion or full inclusion method, the value of provided demo vehicles can be determined by using the annual average look back method, which is based on the average sales price and number of vehicles sold in the previous year. There are tables available for each method which provide for the daily inclusion amount dependent on the value of the demo automobile. These tables can be found in Revenue Procedure 2001-56.

Generally, dealers may wish to use the partial exclusion for fulltime salespersons and the full inclusion method for all other employees, but it is strongly recommended that dealers discuss the methods with a tax advisor to determine which would best suit their needs, especially as we prepare to head into a new year. In addition, there are several advantages to using the optional methods, including:

  • Ability to provide a good response to the IRS in the course of an examination;
  • No need to keep mileage logs, unless using the full exclusion method;
  • Personal use is allowed, with varying degrees depending on which method is chosen;
  • Methods may be selected on an employee-by-employee basis. While these methods may act as a safe-harbor for dealers who choose to adopt them, the rules are still complex and may require the help of a tax advisor, so now is the time to check demo use policies and make certain they maintain proper compliance.
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