By Kenneth R. Rosenfield, CPA
These days, most dealership acquisitions are via the purchase of assets. Even back in the “glory days” of the first consolidations, many of the institutional and publicly-traded dealership groups would acquire dealerships by purchasing the stock of the corporations that the assets were owned by, but it was very rare for a closely-held dealership to acquire another dealership by anything other than an asset purchase.
Stock purchase deals do occur, however. We have been involved in a few deals in which purchasing the stock of a corporation made sense just to make the deal happen. There are few if any tax advantages and the legal issues could be significant, but in some cases it may be the only option if you really desire to acquire that point.
The typical scenario is an older dealership in a strategic market for your footprint. The dealership may be so “old school” that they are “trapped” in a taxable corporation environment and could never elect to be treated for tax purposes as a pass through type entity. In most cases, it is due to a very high LIFO reserve or extremely low basis in the Blue Sky of the Franchise.
From the legal aspect, most of the corporate and legal protection will come from indemnification clauses in the contract and it is always advisable to escrow a good portion of funds for such potential cash flow requirements such as Finance and Insurance chargebacks, Service Comebacks, We-owes, Customer Retention/Satisfaction payments or credits, underpaid tag fees or loan payoffs; or more serious liabilities such as warranty and incentive chargebacks, sales/use tax audits, unclaimed property audits, payroll tax problems or any other unforeseen issues.
We strongly recommend some intensive due diligence procedures prior to closing to detect and possibly estimate the potential for such liabilities. Other items to consider could be the cost to ensure that all technicians are up to par for their certifications and that all the required special tools are in stock.
We recently spent time in the due diligence process on the acquisition of a C Corporation target. As part of the negotiation for the transaction, we computed the estimated amount of the Built in Gains (BIG Tax) which is inherent in the transaction, and determined methods to mitigate the amount of tax that would arise on the stock sale. This potential tax is a type of exposure that could substantially reduce the acquisition price.
The built-in gain tax is the amount of “double taxation penalty” that would be incurred if the dealership were sold again within a 10 year period. The tax would be computed on a number of items, most significantly the difference between the fair market value of the blue sky over its basis.
Another sleeper BIG tax would be on the sale of the inventory items i.e. vehicles and parts. And if the real estate is an asset of the corporation, there is an inherent gain which could create a BIG tax as well.
There are a number of tax planning strategies to mitigate the built-in gains tax. Minimizing the BIG tax on the Blue Sky may require some advance planning prior to closing the acquisition. Researching the sales and service agreements and tax rulings, you may be able to have some of if not all of the Goodwill allocated as personal goodwill outside of the corporation.
For the inventory aspect, planning well in advance, the inventory levels can be substantially reduced prior to the closing, which would mitigate a double taxation on the inventory when it is sold.
If the dealership is on the LIFO method of accounting, planning years in advance to reduce the LIFO layers or electing out may be of some benefit. Changing to a pass through entity later on will cause a collapse of the LIFO layers and income and the tax laws will essentially make you start over for this method.
If the acquired dealership has a high figure of retained earnings, this could also be problematic for future distributions from a tax standpoint. If a pass through entity is chosen afterwards, distributions in excess of current earnings and profits will need to be well thought out in advance as they could be subject to double taxation as well.
There are a myriad of other issues lurking out there. A well-planned due diligence checklist to review all the potential issues in a non-asset acquisition is essential to a successful transaction. But they can work out well if properly planned and the issues negotiated well in advance prior to closing.
Ken Rosenfield is the managing partner of Rosenfield & Company PLLC, a full service CPA firm with one of the largest automotive practices in the U.S.. The firm currently has offices in Orlando, Florida, Florham Park, NJ and in Manhattan. He can be reached at ken@rosenfieldandco.com
