How tax reform will affect the auto dealer industry
Published March 15, 2018
On December 22, 2017, the President finalized historic federal income tax legislation by signing a bill known as the Tax Cuts and Jobs Acts (the “2017 Tax Act”). The 2017 Tax Act provides a host of tax law changes that significantly affect the auto dealer industry. This provides a wide range of planning and structural opportunities across the industry that will need to be considered beginning with the tax year starting January 1, 2018.
Here is a summary of key federal income tax reform changes and planning opportunities of which dealers should be aware.
Corporation tax rate
For those dealerships that operate as a C corporation, the federal corporate tax rate has dropped significantly from a maximum 35% rate to a flat 21%. Some consideration should be given to any potential benefits of converting to a C corporation on a case by case business. If a significant amount of the dealership’s earnings are distributed to the owners, the benefits of conversion are greatly diminished and could be detrimental.
Pass-through deduction – Section 199A
With many auto dealerships operating in some form of a pass-through structure, one of the greatest benefits in the new law is the Section 199A deduction (the “20% deduction”) on “qualified trade or business (QBI)” for pass-through entities for tax years beginning after December 31, 2017 and before January 1, 2026. This new deduction applies to pass-through ventures – individuals with Schedule C, S corporations, and partnerships/LLCs. It also applies to trusts, which were initially omitted, but ultimately included in the final bill. The 20% deduction excludes “specified service businesses,” where the principal asset of such trade or business is the reputation or skill of one or more employees or owners.
Overall the 20% deduction is calculated on the entity’s income, with some exclusions, and subject to two wage-based limitations – the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of qualified property. Wages include compensation paid to both non-owner and owner employees. As compensation is one of the highest dealership expenses, these limitations would normally not be a factor. Qualified property includes the original cost of all real and personal property subject to depreciation used in qualified business income producing activity. The property must be held at end of the year and not be fully depreciated prior to year-end.
This deduction will ultimately be applied at owner level, on an entity by entity basis. The wage limit does not apply if an individual’s taxable income is less than $315,000; and, phases out completely once taxable income reaches $415,000 (for married filing jointly). In addition, the exclusion of service-based businesses from the 20% deduction does not apply if an individual’s taxable income is under these thresholds. Combined with the reduction of the top individual tax rate from 39.6% to 37%, the effective top rate for business income could be reduced to 29.6%.
It remains to be seen if management companies can qualify for this deduction or if they will be considered a specified service business and, therefore, ineligible. Another consideration is how the impact of Section 179, bonus depreciation and wage limits will require careful attention for planning purposes around the application of Section 199A.
Beginning January 1, 2018, a new 30% of EBITDA interest expense limitation applies to dealerships. The 30% interest expense limit is determined at the entity level. However, entities with less than $25 million in annual sales are exempt from the new 30% interest expense limitation. Most importantly, floor plan interest is exempt from this limitation. Any business interest not currently deductible can be carried forward indefinitely.
Certain real property entities may elect to be exempt from the 30% limitation but must use the Alternative Depreciation System (ADS) for depreciation calculations. ADS requires longer depreciable lives resulting in lower annual depreciation deductions. Also, bonus depreciation is not allowed under ADS.
Capital expensing and depreciation
The tax bill has extended and modified the first-year bonus depreciation deduction through 2026. What was a 50% allowance before tax reform, has been increased to 100% expensing for property placed in service after September 27, 2017, and before January 1, 2023. It also expands the definition of qualified property to include used property. Dealerships could elect to use 50% bonus depreciation for the period after September 27 through December 31, 2017.
As a trade-off for exempting floor plan interest from the 30% limitation mentioned above, property used in a trade or business with floor plan financing is not eligible for bonus depreciation for years beginning after December 31, 2017. For this reason, most dealerships will be excluded from benefiting under the new bonus depreciation rules unless qualifying under the small business exemption for exclusion from the interest limitation rule.
The good news is that the Section 179 deduction (100% expensing) is still alive and well and has been expanded. The annual expensing limit has doubled from $500,000 to $1,000,000 and the phase-out threshold increased from $2,000,000 to $2,500,000. The bill also shortens the recovery period for qualified improvement property to 15 years. In addition, real improvement property on non-residential buildings (roofs, HVAC, systems, etc.) may also be eligible for Section 179 but not bonus.
Many of the state laws in this area have not been updated to conform to the new federal tax law, therefore modifications and planning should be considered in determining state taxable income.
Luxury auto depreciation limits have been increased as well. Under prior law, passenger autos were limited to first year depreciation of $3,160 in the first year, $5,100 in the second, $3,050 in the third and then $1,875 thereafter. The new law has increased this to $10,000, $16,000, $9,600 and $5,760, respectively.
The law has repealed the like kind exchange rules for all but real property transactions. Under the old rules dealerships could defer gains on transactions that included personal property and intangibles such as equipment and franchise rights. Unfortunately, those planning opportunities are no longer available.
Beginning January 1, 2018, the deduction for entertainment, amusement, recreation, membership dues and related expenses were fully repealed in the new tax bill. Included in this repeal is the 80% deduction for contributions made to universities for seat license. The 50% deduction for food and beverage expenses remains, but the 50% limit has been expanded to include employer expenses providing food and beverages to employees through on-premises eating facilities.
Net operating losses
For those that lived through the late 2000s, the ability to carryback net operating losses from the business to offset taxable income in previous years provided a nice cash influx at a time when many could use the liquidity. Unfortunately, the new tax bill does not do any favors in this area, which now disallows the carryback of net operating losses that previously could be carried-back up to two years. In addition, net operating losses now carried-forward will be limited to 80% of taxable income for losses created in taxable years beginning after December 31, 2017. Finally, on top of everything above, business losses for non-corporate taxpayers are limited to $250,000 per year for single, and $500,000 for married filing jointly. The ability to see any immediate influx of cash from a down year due in this area has been severely limited.
The bill includes many provisions related to insurance entities which also includes reinsurance companies. F&I reinsurance companies, including small companies with an election to be taxed on investment income and Controlled Foreign Corporations (CFC’s) are taxed at 21%.
Companies organized as Non-Controlled Foreign Corporations (NCFC’s) may now be classified as a Passive Foreign Investment Company (PFIC). PFIC rules include significant reporting requirements and changes to the exemption qualifications. This change could result in shareholders being taxed on the current earnings of the NCFC.
For more information about how these changes may affect you and your dealership business, please reach out to your MCM tax professional or Partner Mark Schmitt, CPA via e-mail or phone (502.783.2520).