Janet Gearhead is the new owner of Gearhead Cars, Inc. (an accrual-based corporate taxpayer). Janet has come to your firm with a proposed transaction and wants your advice regarding how the transaction will be treated for federal income tax purposes. The transaction that Janet is proposing is as follows: When Gearhead Cars sells an automobile, the dealership will also attempt to sell the car buyer an auto service warranty contract separately from the purchase of the car. Amounts received for these warranty contracts will be placed into an escrow account. The warranty agreements will grant the buyer the right to have parts or components covered by the contract repaired or replaced whenever the covered parts experience a mechanical difficulty during the three-, four-, or five-year warranty period. Gearheads auto repair center will either provide the services or reimburse the car buyer for the reasonable cost of repair or replacement. Normally, the buyer will likely return the vehicle to the dealer for repair, but this is not required. In either case, the repairs or replacements must be authorized in advance by a third-party administrator hired by Gearhead Cars. Fees to the administrator of the contracts to pay for the repair, as well as the administrators fee, are paid out of the escrow account. For tax and legal purposes, Gearhead is considered the owner of the escrow account.

What is the appropriate tax treatment for the income from the service warranty contracts (i.e., when is gross income recognized on the sale of the contract for federal income tax purposes)? When are the payments to the administrator deductible? Assuming Gearhead Cars objective is to defer income and accelerate deductions, could the warranty arrangements be restructured. to provide a better tax result?

prepare a memo with citations.