Tax Reform’s Impact on the Buy Here - Pay Here World
Like it or not, tax reform is here, and its impact is far-reaching. President Trump signed the Tax Cuts and Jobs Act (TCJA) into law on Dec. 22, 2017. The Act includes various provisions that Buy Here – Pay Here (BHPH) dealers should know. As we study and digest these changes, there are numerous questions and situations that the law itself does not clearly address. Technical corrections will likely be made by Congress as well as regulations issued by the IRS throughout 2018.
The following is a summary of key provisions in the new law and their implications for BHPH dealers.
Pass-Through Entity Taxation
Under the new tax law, owners will be allowed to deduct 20 percent of their qualified business income (QBI) from pass-through entities on their individual income tax return in arriving at taxable income. Under previous tax law, income from pass-through entities (i.e., sole proprietorships, partnerships, limited liabilities companies, and S corporations) was taxed as ordinary income to individual owners.
Under this provision, QBI is defined as “domestic income from a pass-through entity” but does not include investment income (e.g., dividends, capital gains, and investment interest), reasonable compensation, or guaranteed payments.
In general, the pass-through deduction would be limited by the greater of:
However, an individual taxpayer would be exempt from the above limitations if their taxable income does not exceed $315,000 for married filing jointly filers or $157,500 for single filers.
Dealers who utilize a Related Finance Company (RFC) two-entity structure will need to be mindful of the results for each company. The pass-through deduction is calculated separately for each. On the individual shareholder’s return, an operating loss in one entity will reduce the deduction generated by the other entity. It is fairly common for the RFC to show substantial profits while the dealership entity might show a break-even outcome or a loss of some magnitude. If most of the overall salaries are related to the dealership, the RFC’s pass-through deduction could be significantly reduced by the W-2 wage limitation. There will be other items of expense allocation between the two entities that take on a new significance.
Additional items dealers should revisit include the salary a dealer/principal should pay him or herself as well as the amount of rent being paid if a dealer owns the operating real estate.
Businesses with average gross receipts for the preceding three tax years of $25 million or less can elect to change their method of accounting for inventory. These taxpayers can elect to treat their inventory as non-incidental materials and supplies and take a deduction for the amount of that inventory. This election would be a change in accounting method that would generate a significant deduction in the year of change. In subsequent years, only the change in beginning and ending inventory would impact taxable income.
As part of the requirements for this election, the taxpayer must use the same accounting method on its applicable financial statements (AFS). AFS can be thought of as being audited, reviewed, or compiled financial statements. If none of those apply, the taxpayer’s books and records must be kept in accordance with this tax accounting method.
For those dealers under the $25 million threshold, this method would generate a large tax deduction equal to the cost of their vehicle inventory. The financial statement conformity requirement may present a challenge. Dealers will likely have to request permission from their lenders to present financials that deviate from Generally Accepted Accounting Principles.
Keep in mind also, that for purposes of the average annual gross receipts test, the dealership and the RFC would be aggregated so that car sale revenues and finance income would both count toward the threshold.
Businesses will be entitled to expense 100 percent of the qualified property placed in service after Sept. 27, 2017 and before Jan. 1, 2023. Beginning Jan. 1, 2023, the amount of qualified property a business will be able to expense will decrease 20 percent per year. Most used property will also qualify for this 100 percent write-off.
The overall good news is that dealers can now continue to take bonus depreciation on new capital expenditures, and the benefit is extended to the acquisition of used property. However, in determining when and how much bonus depreciation to generate, dealers will want to consider the impact the additional deductions might have on other tax-related items.
Through 2017, a business could deduct 50 percent of expenses incurred for entertainment, amusement, or recreation. The new tax law eliminates this deduction, meaning that no amount of these expenses would be deductible by a business. The new law retains the current 50 percent deduction limitation on food and beverage expenses.
Most dealers maintain one general ledger account for meals and entertainment. Beginning in 2018 it will be important to separate meals from entertainment. One simple way to do this is to create a separate general ledger account for each and code expenses correctly throughout the year. Note that meals provided for employee-related purposes have their own special limitations. These expenditures should be tracked separately as well.
Business Interest Expense
Under the new law, deductions for business interest expenses will be limited to the sum of:
Businesses with average annual gross receipts of $25 million or less will be exempt from this limitation and would be able to deduct any interest expenses in full. For this provision, adjusted taxable income is determined without regard to depreciation, amortization, or depletion deductions.
The various exemptions and allowances should eliminate this limitation for most dealers.
C Corporation Taxation
Under the current law, C corporations are taxed based on a tiered system with a top rate of 35 percent. The new tax law will eliminate the tiered system and replace it with a flat 21 percent income tax for C corporations.
The 21 percent C corporation tax rate is very inviting, however, this is a corporate-level tax and individual shareholders will be subject to a second tax on any dividend distributions received, whether in the normal course of business or upon the sale or liquidation of the corporation. For high-income taxpayers, these dividends would be subject to an income tax rate of 20 percent plus the net investment income tax of 3.8 percent. When you combine these two levels of tax, the effective rate for a C corporation scenario is significantly in excess of the maximum individual tax rate on qualified business income.
Additionally, C corporation tax returns stand alone. For dealers who utilize the RFC two-entity structure, a loss in one entity would not offset the taxable income of the other entity. The profitable entity would pay a higher tax on its reported profits and the loss entity would carry forward its losses which could only be used to offset future profits generated by that entity. This would not be an efficient tax outcome. It would take a rather unique set of circumstances for a conversion to a C corporation to make sense for a BHPH dealer.
Again, the new tax law has generated many questions and uncertainties. As we continue to sort it all out, we will provide you with updates throughout the coming year. For additional information regarding these and other key provisions found in TCJA, visit here.
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