Salesman Looking Out Showroom Window

Limitations on tax reform’s 20 percent deduction on QBI will determine your tax rate in the year of a sale. But limitations change as the year progresses.

Tax reform

Thinking of Selling Your Dealership? Under Tax Reform, Timing Is Everything

  • Lee Ferguson
  • 10/9/2018

If you’re thinking of selling your dealership in the near future, add tax reform to your list of considerations. The legislation’s tax-saving benefits will vary depending on what point in the year a sale occurs. Timing could determine how much tax you pay (and possibly save) on the sale of the business.

It all depends on qualified business income (QBI) limitations

The Tax Cuts and Jobs Act offers a 20 percent deduction on all qualified business income (QBI) from entities such as S corporations, partnerships, and sole proprietorships, which are how the vast majority of dealerships are structured. QBI is essentially the ordinary income earned from your dealership business, but there’s a catch. The 20 percent deduction is limited to the greater of:

  • 50 percent of your dealership’s W-2 wages, or
  • 2.5 percent of the unadjusted basis of your depreciable assets, combined with 25 percent of W-2 wages.

In a dealership sale, 50 percent of W-2 wages will always be greater than the 2.5 percent asset limit, because the 2.5 percent is based on the assets owned at the end of the year — which will be nothing in the year of sale. These limitations also apply to your business in the year you sell. Since most dealership sales are structured as asset sales, they will normally generate some amount of ordinary income from inventory, fixed assets, or LIFO recapture. If your wages are not high enough, the 20 percent QBI deduction may be limited.

If you sell your dealership early in the year, you may not have sufficient W-2 wages paid to realize the full benefit of the 20 percent deduction. In that case, you might pay a tax rate of 37 percent compared to 29.6 percent (the maximum federal tax rate, assuming a full 20 percent deduction under Section 199A). This tax rate difference could be significant on a sale with millions of dollars of income.

Examples illustrate the effect of QBI limitations on a dealership sale

Assume you’re a calendar-year taxpayer, and you sell your dealership on January 31, 2019. Year-to-date, you’ve only paid wages $75,000. With the January dealership income and the sale of your inventory (LIFO recapture) and fixed assets, the dealership will generate $1 million in QBI. In this situation, the 20 percent deduction will be limited to $37,500 ($75,000 wages x 50 percent) of QBI. Due to insufficient wages expense, $162,500 of the $200,000 (20 percent of $1 million) deduction is lost.

Now assume the same facts as above, except your dealership sells on November 30, 2019, and you’ve paid wages of $2.75 million. The entire $1 million of QBI would be eligible for the 20 percent deduction. This results in an additional $60,125 in federal income tax savings to the seller.

It’s important to note that capital gain income is specifically excluded from the QBI calculation; gain from the sale of the franchise or assets that generates capital gain will not receive this 199A deduction benefit. Such capital gains are still taxed at preferential 20 percent or less federal tax rates.

Buyers are affected, too

Tax reform not only drives the dealership seller’s transaction tax, but will also affect buyer purchase price allocations. Now that 100 percent bonus depreciation is available for used tangible depreciable asset purchases, buyers will desire the most tax-efficient purchase price allocation for them. Whether you are a seller or a buyer, transactions and tax differences will be significant.

How we can help

Tax reform has created many variables for dealerships and their owners, and planning is critical up to and through the sale of the business. CLA’s dealerships professionals can help you evaluate a variety of scenarios and their tax consequences under the new law, so you can make informed decisions about your future.