By Dave Wiggins, CliftonLarsonAllen LLP
The recent tax reform legislation is the largest tax overhaul since 1986. While there are some elements of simplification (increasing the standard deduction, removing the alternative minimum tax (AMT) for businesses, etc.), the law as passed is quite complex. It will take years for the IRS to issue rulings and interpretations and for tax court rulings to settle disputes and offer clarity.
The change most dealers are immediately curious about is the treatment of pass-through entity income (e.g., income flowing to an owner’s personal return from an S corporation or LLC). Under the new law, the top personal tax rate was reduced from 39.6 percent to 37 percent. Dealerships structured as pass-through entities are eligible for an additional 20 percent deduction against income, reducing the effective tax rate to 29.6 percent
The following discussion includes answers to many of the questions dealers are asking about the new tax law.
Since the 2017 year has ended, are there still some things I can do in light of tax reform changes?
There has been a lot of noise about various tax tricks, etc., that can be done for your 2017 year-end. Many have been generated from the tax headlines and not by actually reading the bill or making educated guesses on how the IRS will interpret the law. Some items are clear, however:
Because tax rates are going to be lower in most instances (top rate going from 39.6 percent to 37 percent or less for S corporation/partnership owners), tax deductions are worth more in 2017. If there were expenses you expected to incur in early 2018, accelerating them to 2017 will save tax. The obvious type of items are accrued expenses, prepaid items, etc.
- Consider accelerated depreciation to expense fixed asset purchases, service loaners, and rental vehicles.
- Write off obsolete parts inventories.
- Adjust used vehicles down to market value.
- Write off old uncollectible receivable.
- Accrue bonuses to employees.
Is interest still deductible?
For businesses with less than $25 million in average annual gross receipts, interest will continue to be deductible in full. For those with over $25 million in gross receipts (which includes most dealerships), non-floor plan interest is limited to 30 percent of net income before interest and depreciation. Floor plan interest is deductible in full. Since the deduction limitation is a function of income, the limitation is most likely to apply in years in which profitability is down. If you have significant non-floor plan interest, then it may be worthwhile to analyze whether you expect the interest limitation to apply for 2018 and consider whether any changes should be made to your existing capital structure in response to the limitation.
Interest (other than floor plan interest) exceeding the limitation amount can be carried forward to future years. If you elect to do so, the limitation would not apply to interest incurred in real property development or rental real estate operations. As an aside, the floor plan expense carve out in the law was very valuable because floor plan interest is not netted with floor plan assistance received from the factory for tax purposes. Had the limitation applied to floor plan interest, it is possible a dealership could break even or lose money for the year yet still owe significant tax.
Was LIFO affected?
Although repeal of LIFO was discussed at various times in the tax reform process, the final bill retains it as a viable tax-savings strategy. Because tax rates will likely be reduced for both C corporations and S corporations, dealerships on LIFO prior to 2018 will likely not only get deferral benefits from LIFO but permanent tax savings due the rate changes (based on the expected tax rates). Since the AMT has been eliminated for C corporations, this will also ensure that dealers on LIFO realize the full benefits of the related deductions.
Is the cash method now allowed for dealerships?
The new law allows for businesses with less than $25 million in gross receipts to adopt the cash method of accounting for tax purposes. Accordingly, smaller dealerships may be eligible to adopt the cash method of accounting if desired. The $25 million gross receipts threshold is applied on a combined basis for commonly-owned businesses. Your dealership’s specific situation will need to be reviewed to determine if the cash method would be of benefit.
Is full expensing allowed for fixed asset purchases?
Bonus depreciation has been enhanced with a full deduction of the cost of most new or used property acquired after September 27, 2017. Real estate will generally not be eligible for the bonus depreciation, but certain real estate improvements will qualify. Unfortunately, when dealers were allowed to exclude floor plan interest from the 30 percent interest limitation, the service included a related provision stating that businesses that use the floor plan interest exclusion are not eligible to use bonus depreciation for the year; thus, this item will have to be determined each year. All fixed asset acquisitions made between September 27, 2017, and December 31, 2017, will qualify for bonus depreciation because the interest limitation doesn’t apply until 2018.
If we don’t get bonus depreciation, can we still claim Section 179 expense?
Yes. While many dealers will not be eligible for bonus depreciation, you may be able to immediately expense the cost of certain new and used equipment purchases under Section 179. The maximum amount per year that can be expensed under Section 179 been increased from $500,000 to $1,000,000, effective for tax years beginning in 2018, subject to a phase-out beginning when the total cost of acquisitions during a year exceeds $2,500,000. You can even elect to immediately expense the cost of some building improvements, including the cost of replacing a roof or HVAC system. Now “qualified real property” for which Sec 179 can be claimed includes roofs, heating, ventilation and air-conditioning (HVAC) property, fire protection and alarm systems, and security systems.
Are entertainment expenses affected?
In the past, business-related entertainment expenses were 50 percent deductible. Under the new law, the cost of business-related entertainment is generally not deductible. Baseball tickets given to employees or customers, luxury boxes at stadiums, etc., are now non-deductible. Business-related meals continue to be deductible at 50 percent (going to dinner with the factory rep, etc.). Business meals on site for the employer’s convenience (including Saturday salesperson lunches, etc.) are 50 percent fully deductible. Holiday parties remain 100 percent deductible.
I own an S corporation. What will my tax rate be?
The effective rate on your pass-through income will vary each year based on your circumstances. Instead of establishing a pass-through tax rate (like was the case with C corporations), Congress settled on pass-through entities being taxed at ordinary rates but with a deduction of up to 20 percent of qualifying income.
Determining what “qualifying income” is will be tricky enough, but Congress added several limitations on the deduction as well. They include a limitation of the greater of:
- 50 percent of the W-2 wages paid by the business, or
- the sum of 25 percent of the W-2 wages paid plus 2.5 percent of the unadjusted basis of all depreciable property used in the qualified business
In the end, the blended federal tax rate for many dealerships with pass-through income will end up at about 29.6 percent.
Because the C corporation rate is lowered to 21 percent, should a dealership switch from an S corporation to a C corporation?
The earnings of a C corporation are generally subject to a lower tax rate than the earnings of a pass-through entity (21 percent vs. 29.6 percent). However, the earnings of a C corporation are subject to a second level of tax of up to 23.8 percent when the corporation pays a dividend or is liquidated or sold. The second level of tax means the owners of a C corporation keep about $0.60 for every $1.00 in corporate earnings, compared to about $0.70 for a pass-through entity, making a pass-through entity the entity of choice for a business that distributes most or all of its earnings.
If you are looking to reinvest your earnings in the dealership, the lower current cash tax expense in a C corporation environment may make a C corporation the preferred entity. Each dealer’s situation is unique, and there are other factors to consider as well, including whether the business owns appreciating assets (like real estate), the impact of state taxes on cash flow, and the business exit strategy and timeline. Modeling after-tax cash flow on a present-value basis is a great way to evaluate different structures for your business.
If I plan to sell my dealership in the near future, does a C corporation now make sense more than an S corporation?
Generally no. Buyers typically prefer to structure the purchase of a business as an asset purchase so that they can amortize purchased goodwill and take a fair market value cost basis in acquired inventory. If the C corporation sells its assets and then liquidates, two levels of tax will generally apply — a 21 percent corporate-level income tax and a 23.8 percent shareholder-level tax. The second level of tax results in an overall federal tax rate of about 40 percent for C corporations versus 29.6 percent for flow-through entities. Each taxpayer’s situation is different, and we encourage you to consult your tax advisor to discuss your entity structure to help you plan for the potential sale of your business.
What about state income tax?
As you may have heard, the deduction for state income tax and real estate tax paid by individuals will be limited to $10,000 per year, starting in 2018. Thus, state income tax paid by dealers on pass-through dealership income will generally not be deductible.
For example, an S corporation dealer making $2 million a year in a state that has a 6 percent tax rate will lose about $110,000 in state tax deductions ($120,000 state tax, $10,000 deduction limitation). Business property taxes continue to be fully deductible.
Is my home mortgage interest still deductible?
The deduction for interest on up to $1.0 million of mortgage debt incurred on or before December 15, 2017, continues to be deductible. Interest on home equity indebtedness will not be deductible, starting in 2018. For debt incurred after December 15, 2017, the interest on up to $750,000 of mortgage debt will be deductible. Some taxpayers will no longer itemize their deductions as a result of the increased standard deduction and the repeal or limitation of certain itemized deductions (e.g., the $10,000 limit on the deduction for taxes). Taxpayers that no longer itemize their deductions will not receive a benefit for their mortgage interest going forward.
Does the estate tax still exist?
The estate tax remains in the tax law at the current rates, but the lifetime estate exemption is doubled from $5.60 million per spouse to $11.20 million per spouse. As of now, a married couple could pass an estate of up to $22.4 million without estate tax kicking in.
If my dealership loses money, can I still claim refunds of prior year tax?
Starting in 2018, net operating losses for C corporations and individuals with dealership pass-through losses can no longer be carried back. In prior years, such losses could be carried back two years.
Does this mean estate tax planning is no longer needed if my estate is less than $22 million?
Perhaps, if both you and your spouse plan on going to the afterlife before the political winds blow in a different direction. The estate tax provisions can be changed by another Congress and administration. In addition, your estate value may increase in the future, causing you to be subject to the estate tax. Even if you’re not subject to estate tax, wealth succession planning extends beyond minimizing estate taxes.
One strategy that will emerge in the near term will be gifting estate value to heirs using up the increased lifetime exemptions while those higher exemptions exist. There is no one-size-fits-all plan when dealing with estate tax and succession, so continue to engage your advisors on the subject despite the relaxed tax law.
Did Obamacare go away?
No. The 3.8 percent net investment tax on certain portfolio income is still in place. Many of the requirements related to health care reform are still in place. However, the penalty imposed on individual taxpayers that do not carry adequate health insurance is repealed beginning in 2019.
How we can help
It will take some time for the dust to settle on this law. The IRS interpretations are just starting to come out and will continue for years. They will be followed up by tax court decisions. CLA’s dealerships professionals can work with you to assess your current structure and any future business transactions and understand the impact of the new tax law on your business and your family.
CliftonLarsonAllen LLP offers wealth advisory, outsourcing, and public accounting services to help clients succeed personally and professionally.
Dave Wiggins, CPA, principal with CLA’s dealership practice, specializes in federal and state taxation with the unique perspective of those specific strategies that apply to dealerships, finance companies and their owners. He can be reached at david.wiggins@CLAconnect.com or 314-925-4316.