By Don Ray, Portfolio
The most sweeping federal income tax changes since 1986 have recently become law. If you are considering purchasing a new car dealership (or as you consider your current business), you will want to understand some ways the Tax Cuts and Jobs Act could impact your decision.
While it may take months to sort out the details, one thing is obvious: the tax rates have changed for both individuals and corporations. Most high-income individuals and C corporations will see their federal tax liability decrease. An exception is those C corporations with net operating loss (NOLs) carryforwards. Generally, those C corporations will only be able to offset 80% of their current taxable income with an NOL carryforward in any given year.
A question to be considered is: How does the Tax Cuts and Jobs Act (Act) which became law on December 22, 2017 effect a car dealer’s opportunity to participate in the underwriting (and investment) earnings generated by his or her dealership? Again, while much still needs to be sorted out, high level comments are presented herein for various structures currently used by auto dealers.
Retroactive (deferred until earned) commission
The good news is that as a result in the changes in the income tax rates, retros received by the dealer’s corporation will likely pay less tax than in the past. However, the disadvantages of this structure remain in place. These include reduced profit participation, reduced investment earnings, and higher administration fees. Better tax rates on a bad structure is still a bad structure.
Non-Controlled Foreign Corporation
This structure has typically been used by very large dealer organizations. A key requirement to escape the tax issues surrounding Controlled Foreign Corporation (CFC) status was for US shareholders to own 25% or less of the foreign corporation. The Act expands the definition of a US shareholder to include not only US citizens with 10% or more voting power, but now also includes US citizens with 10% or more share value. If such foreign corporation cannot meet the requirements to be classified as a Non-Controlled Foreign Corporation (NCFC), its US owners become subject to the very complex rules contained in IRC § 952 – Subpart F.
The Act also requires that a foreign insurance company’s “insurance liabilities” must be at least 25% of its total assets to maintain its exemption from the punitive taxation rules related to a Passive Foreign Investment Company (PFIC). This provision effectively encourages excess earnings to be distributed as taxable dividends annually.
Additionally, certain US shareholders (as defined) are subject to a tax on the deemed repatriation of previously untaxed post-1986 foreign earnings. For most US taxpayers this income from deemed repatriation is included in 2017 taxable income (although the related tax may be paid over time).
Dealer Owned Warranty Company
In certain states, a Dealer Owned Warranty Company (DOWC) remains a viable option for very large dealership organizations. The key benefit of this structure has been the deferral of income taxes. The key components of this structure remain in place.
Special planning must still be enacted to deal with taxable income once any NOL carryforwards have been fully utilized.
Allied Risk Company
The use of an Allied Risk Company (ARC) continues to be the best structure for most auto dealers in the US. The Act creates a single corporate tax rate of 21% which could impact this structure and cause it (i.e. those with less than approximately $90,000 of annual investment income) to pay a higher tax rate on its investment income only. An ARC is typically a CFC that elects under IRC 953(d) to be taxed as a US taxpayer and further elects to be tax as a “small property and casualty” insurance company under the provisions of IRC 831(b). The premium received limitation increases to $2.3m in 2018 for those electing under IRC 831(b). This increase along with the increase in the estate tax exemption to approximately $11.2m (based in indexing) may decrease the number of ARCs needed by a dealer group.
As is obvious, the rules surrounding these various structures can be quite complex. Please consult with your Portfolio representative in conjunction with your tax advisor to determine what buy sell considerations or changes, if any, you should make regarding your F&I profit participation structure.
The information contained herein is provided for general information purposes only and does not constitute legal, tax or other professional advice on any subject matter. Such advice can only be properly given by qualified professionals who are fully aware of a user’s particular circumstances. You should consult a qualified CPA or tax attorney at the proper time before you make any decisions.