Dealerships: Tax Savings Are Available with Smart Year-End Planning
As your dealership undertakes year-end tax planning, there are several critical provisions you should pay close attention to:
- How to maximize your Section 199A deduction. This results in a 20% savings to you.
- Will I use the floor plan interest expense exclusion and how will this affect my equipment bonus depreciation?
- How will LIFO affect my dealership this year and should I adopt or terminate it?
- Is the owner's salary reasonable and should I adjust it?
- What items should my controller and I review at year-end to make sure I have taken advantage of tax planning and adjusted my dealership accounting accordingly?
- If some of my businesses have losses, will I be able to use those losses for tax benefit this year?
Below is a detailed year-end review of some areas and accounts within your dealership that you should look into before or near year-end that affect nearly all dealers. We have also outlined the key tax provisions specific to dealerships that you need to understand in order to properly plan to minimize your taxes.
Tax provisions every dealer should know about
C corporation versus S corporation
Now that the tax rate for C corporations is a flat 21%, many dealers have considered changing their entity structure to a C corporation. In most cases, this isn’t a beneficial move because of the double taxation inherent in a C corporation status. C corporation earnings are taxed at both the entity level and the shareholder level, taking the overall double tax rate to approximately 40%, while the S corporation (pass-through entity) rate is approximately 29.6%.
There are some situations that the C corporation tax rate changes could provide benefit. With the new 21% tax rate, dealerships currently structured as C corporations may find it less costly than it used to be to convert to S corporation status since the tax repayment to convert last-in, first-out inventory reserves (LIFO) will be less.
If you remain as a C corporation, you may also find the benefits from LIFO increase due to the repeal of the alternative minimum tax (AMT) for C corporations. In prior years, the LIFO benefits for many C corporation dealerships were limited due to the AMT. Some dealerships will now find they have AMT credit carryforwards from past filings, which are now allowed under the new laws.
Section 199A 20% business income deduction
Owners of pass-through dealerships are now able to deduct up to 20% of the entity’s qualified business income (QBI), which includes the ordinary income of the business. W-2 wages, interest income, and capital gains received from your dealership are not eligible for the deduction. If your adjusted taxable income exceeds $157,500 for single filers or $315,000 for joint filers, the deduction can be limited based on the amount of W-2 wages paid by the dealership or the unadjusted cost of depreciable property of the entity.
Dealership real estate is also eligible for the 20% deduction but is subject to the same W-2 and depreciable asset limitations. Consult your accountant to see if you’re eligible to make an aggregation election to use wages of the dealership to claim the deduction with respect to rental income and, if not, what can be done to increase the amount of your deduction.
With the Section 199A deduction, wage planning is more important than ever before. A shareholder-employee of an S corporation dealership or related business should review W-2 wages for reasonableness. W-2 wages paid to your dealership’s owners decrease the income of the dealership, thereby reducing the amount of income eligible for the 20% business income deduction. The top federal tax rate for W-2 income is 37%, while the top rate for business income, taking into consideration the 20% deduction, is a more favorable 29.6%.
Dealerships organized as corporations must pay reasonable wages for services provided by an owner-employee. If your dealer’s wages are too high, reducing those wages will increase dealership income and result in a lower overall tax. If dealer wages are too low they should be increased, which will increase the overall tax.
Section 179 expense and bonus depreciation
For 2019, Section 179 first-year expense deduction has been increased to $1 million per year. This deduction starts to phase out dollar-for-dollar once the entity places $2.5 million of Section 179-eligible assets in service. To claim Section 179 expense, your business must have taxable income.
Bonus depreciation of 100% is now available for most new and used depreciable assets placed in service as of September 28, 2017; however, starting January 1, 2018, dealerships with floor plan financing indebtedness may be unable to utilize bonus depreciation (see next paragraph). Bonus depreciation will allow you to expense 100% of the purchase price for qualifying assets in the year of acquisition. Depending on your situation, you may be able to obtain a benefit by completing fixed-asset purchases by year-end.
Business interest limitations and floor plan financing indebtedness
If your dealership’s combined gross receipts are in excess of $25 million, the law limits the deduction for net business interest expense to 30% of the entity’s adjusted taxable income plus floor plan financing interest. For the purposes of the limitation, adjusted taxable income is the entity’s taxable income with adjustments for business interest income and expense, depreciation, and amortization, among other adjustments. Business interest expense that exceeds this limitation is disallowed in the current year and carried forward.
Recently issued regulations allow dealerships to claim bonus depreciation for the year as long as their interest expense does not exceed the normal 30% limit. If your dealership’s interest expense exceeds the 30% limit by even a dollar, you are prevented from using bonus depreciation for the year. You should work with your accountant to estimate the business interest limitation to understand the effect of the limitation on your tax liability and your ability to claim bonus depreciation for 2019.
Bonus depreciation for building improvements
A 15‐year straight‐line depreciation used to be allowed for most leasehold improvements incurred after a tenant had occupied a property, but this did not apply to dealership properties owned by the dealer. This is now expanded to include improvements to buildings owned by a dealership. Unfortunately, while the revised law was also intended to allow depreciation over a 15‐year period, it was not included in the final version. Until a tax technical corrections bill is enacted, qualified leasehold improvements will require a 39-year life with no bonus depreciation allowed. The good news is that qualified improvements, as well as HVAC units, roofing, and security systems may be eligible for Section 179 expensing.
Deductibility of meals and entertainment expenses
The deductibility of meals provided for the convenience of the employer (e.g., lunches or dinners provided at meetings or under certain work conditions) has decreased from 100% deductible to 50% deductible. Entertainment expenses, including charitable sporting event tickets, are now completely nondeductible. Expenses related to office parties or events continue to be 100% deductible. Meal expenses related to business meetings and business travel remain 50% deductible. If you provide entertainment to customers with the purchase of a vehicle or have customer events that include meals and other entertainment activities, these costs are still 100% deductible. Because of these changes, you will need to look at breaking out travel and entertainment expenses further and setting up more specific G/L accounts for 0%, 50%, and 100% deductible items.
Cash method of accounting and election out of Section 263A
Businesses with less than $25 million in combined gross receipts (such as smaller dealerships) are allowed to adopt the cash method of accounting for tax purposes. The $25 million gross receipts threshold is applied on a combined basis for commonly owned businesses. Under the cash method of accounting, inventory continues to be deductible only when sold. Your dealership’s specific situation will need to be reviewed to determine if the cash method would be beneficial. Dealers under the $25 million threshold may elect out of the uniform capitalization requirements under Section 263A, which requires dealers to capitalize on certain indirect inventory costs.
Year-end tax planning consideration for dealerships
New vehicle inventory planning
Dealerships that use the LIFO inventory accounting method should closely monitor the new vehicle inventory in stock at year-end with the type of vehicles they will have in stock in the coming year. Work with your advisors on estimating inventory levels to determine potential LIFO adjustments. Inventory can include in-transit vehicles as long as they are invoiced by December 31.
S corporation or partnership losses and basis issues
If you own an interest in an S corporation, you may need to increase your tax basis in the entity so you can deduct a current-year tax loss against other income. If you are reporting losses, you should review the tax basis in the stock of your dealership and the tax basis in loans to the dealership to ensure that you have sufficient tax basis to deduct the loss on this year’s personal income tax returns. Similar but more complicated rules apply to partnerships.
Used vehicle write-downs to market and LIFO
Consider writing down your used vehicle inventory to the current market value (if the market value is less than cost). To do so, you must have made the election to value your inventory at the lower of cost or market in prior years. These market value adjustments should be based on industry guidelines and market value guides. If you have not made the appropriate elections in prior years, your tax advisor should be able to prepare a Form 3115, Change of Accounting Method, to allow you to value your inventory at the lower of cost or market.
Dealers not using used inventory LIFO, or who revoked LIFO more than five years ago, may benefit by adopting it this year. LIFO generally reduces income by the rate of inflation; 5% inflation could reduce taxable income by 5% of your used vehicle inventory value. If you are on used vehicle LIFO, you are prohibited from taking used vehicle write-downs. The LIFO benefit is additive each year, while used vehicle write-downs are generally a one-time deduction that carries forward. Keep in mind, if you want to consider adopting LIFO for new or used vehicle inventory pools, it is necessary to include a reasonable LIFO estimate on your December financial statement.
S corporation owner’s health insurance deduction
It is important that the corporation pay the health insurance premiums of an S corporation shareholder or reimburse the shareholder for premiums paid personally, in accordance with a corporate plan. Furthermore, those premium payments must be added to the owner’s Form W-2 as taxable wages. This allows the individual owner to claim a deduction for the health insurance costs. The income added on Forms W-2 is not subject to FICA or Medicare. Shareholder-employees on Medicare may be reimbursed by the corporation, which may allow them to deduct the premiums as an above-the-line deduction. Failure to set up this reimbursement arrangement for Medicare or other health insurance premiums paid by the shareholder-employee may prevent that individual from realizing a tax benefit for paying out-of-pocket premiums. Similar rules exist for partners in partnerships.
Cost segregation of buildings or improvements
Any building acquisition, construction project, or renovation greater than $500,000 can usually defer tax liabilities and provide a cash flow benefit through a cost segregation study. These studies separate the various costs of the structures and land improvements into different depreciation methods and shorten the depreciable life categories, which accelerate your tax deduction for depreciation. The tax depreciation may be greater than the book depreciation methods used for your financial statements.
With 100% bonus depreciation and the increase in Section 179 benefits, the benefit of expensing a cost segregation study performed on your facility could be greater than ever.
Capitalize or expense dealership repairs
Dealerships should consider making the de minimis safe harbor election to write off small asset purchases. You can write off the safe harbor of up to $5,000 per item or invoice if you have an audited financial statement, or up to $2,500 if you do not.
Parts inventory adjustments
Make sure to reconcile the parts inventory balances on your books with your parts inventory counter pad. This is normally done if you take a physical parts inventory when it is not required. Reconciling the two inventory balances often results in decreased taxable income. Consider writing off obsolete inventories before year-end.
Review customer accounts receivable to determine which past-due accounts are uncollectible. You will be able to claim deductions for bad debt expense. Remember that uncollectible factory incentives, rebates, and other receivables can also be written off.
Officer note payable repayments
If your dealership or another business has generated taxable losses in the past, review current-year loan repayments made to shareholders. If prior-year losses have been taken based on money loaned by shareholders, repayment of these loans may create taxable income to the shareholder in the year of repayment. Review your loan activity in 2019 and consult with a tax advisor to determine if proper planning can avoid this problem.
Make sure you are properly treating manufacturer discounts, such as floor plan interest assistance, as a reduction of the cost of goods sold, and not a reduction of interest expense. Many dealers are still improperly recognizing the discounts into income when the funds are received from the manufacturer, or worse yet, when the vehicle is stocked into inventory. If you’ve been treating these discounts improperly for tax purposes, your tax advisor may be able to file a Form 3115, Change in Accounting Method, to defer the related income until the vehicles are sold. It’s also important to note that since the proper treatment of these discounts is a reduction of your dealership’s cost of goods sold, the interest assistance should not offset interest expense in determining your business interest limitation.
Payables, accruals, and related party expenses
Review invoices received after year-end to see if these expenses should be recorded as payables or accruals on your December financials. Make sure you also accrued all wages, commissions, vacation time, income, and other tax expenses on your December financials. Finance chargebacks related to 2019 sales can also be recorded in December’s financial statements. Many accrued expenses must be paid no later than March 15, 2020, in order to be deductible in 2019. Accruals for most related-party expenses, such as accrued interest on shareholder loans or accrued shareholder wages or commissions, should be paid before year-end to be deductible.
Accelerating the deduction for prepaid expenses under the 12-month rule
Certain prepaid expenses where the benefit will lapse within the next 12 months, such as insurance coverage, may be deductible in full for tax purposes in the year paid. An election must be made in order to accelerate the deduction of these expenses. Discuss your prepaid expenses with your tax advisor to determine if they are eligible to be deducted in 2019.
Charitable contributions and advertising
Review charitable contributions paid by the dealership to determine if they should be reported as advertising expenses rather than charitable contributions to avoid the income limitations applicable to charitable contributions. In some instances, amounts paid for sponsorships, chamber of commerce activities, and other promotional events can be reported as advertising rather than charity.
Year-end tax planning considerations for dealership owners
Personal tax return limitation — deductibility of excess business losses
A new provision requires individuals to combine all business losses and impose a $500,000 per-year maximum current-year deductibility limit ($250,000 per year maximum for singles). Any excess business loss that cannot be immediately deducted must be carried forward indefinitely as a net operating loss.
Many dealers have relied on carrying back net operating losses in recessionary times to generate cash flow. Now net operating losses can only be carried forward. We recommend you set aside additional cash to prepare for economic downturns.
Increased standard deduction and bunching itemized deductions
The standard deduction was increased to $24,400 for 2019. While this is good news for many, taxpayers who normally itemize but whose total deductions are under $24,400, may not realize a benefit from making charitable contributions, paying investment interest expense, incurring significant medical expenses, or paying home mortgage interest. Discuss with your tax advisor if bunching these payments in a given year to increase the amount of your total itemized deductions could be a good strategy for you.
Opportunity Zone tax incentive
If you are anticipating any significant capital gains in the near future (i.e., business, land, or stock sale) consider reinvesting any capital gains in a Qualified Opportunity Zone fund. Opportunity Zones were created under the new tax law to encourage investment in economically distressed areas. Reinvesting capital gains in a Qualified Opportunity Zone funds allows you to defer and eliminate a portion of the capital gain after being invested in the funds for at least five years. In addition, when the investment is held for at least 10 years, any post‐acquisition gains are completely excluded from gross income. Development opportunities are also available for those looking to build or renovate property in Opportunity Zones.
Charitable donations of appreciated stock
Minimize tax on capital gains by directly donating appreciated stock. This offers multiple benefits, such as being able to deduct the higher, appreciated value of the stock, as opposed to the original cost basis of the stock. In addition, there is no tax on the transaction.
Self-rental income, self-charged interest, and net investment income tax
If you lease rental real estate to your dealership, the passive activity loss rules present a significant threat. If your Form 1040 has a mix of positive and negative net income amounts among your rental activities, the passive loss risk needs to be carefully assessed. Grouping rules may allow you to offset your rental losses with your dealership profits to avoid disallowance of the losses.
The additional 3.8% tax on investment income under the Affordable Care Act is still in effect. Self-rental and self-charged interest (interest received on loans to your dealership) are not subject to this additional investment income tax. Subjecting this income to the additional tax is one of the most frequent mistakes tax preparers make. Discuss this issue with your tax advisors to make sure you’re not paying more than you should on net investment income tax. If a mistake was made in the past, an amended return may be prepared, as long as it hasn’t been more than three years from when the tax return was due.
Mortgage and home equity interest limitations
Interest expense on home mortgages originating after December 14, 2017, can be deducted on up to $750,000 of home mortgage debt. The debt limit on home mortgages originating on or before December 14, 2017, remains at $1 million, even if the debt is refinanced after December 14. Interest related to home equity loans up to $100,000 is no longer deductible unless the proceeds from the loans were used to build, buy, or improve a home.
Alimony and child support
Alimony will no longer be deductible by the payer and will not be includible in the recipient’s taxable income for divorce decrees that become final after 2018. Alimony agreements entered into in 2018 or earlier will still be deductible. Child support is given the same treatment as alimony.
Child tax credit
This credit is $2,000 for 2019. A partial $500 credit will apply to certain nonchild dependents. The phase‐out of this credit has also been significantly increased. For example, married-filing-jointly taxpayers will see an increase in the beginning point of the phase-out from $110,000 to $400,000.
Estate and gift tax exemptions
The lifetime exemption from estate and gift tax is $11.4 million in 2019. The $11.4 exemption reverts back to $5.5 million in 2025. You may want to revisit your estate plan in response to the new, higher exemption in lieu of lifetime gifts. If you are not subject to the estate tax, not making gifts may be the right strategy because assets held at death may be stepped up to fair market value.
How we can help
Our dealership industry tax practitioners can help you comply and help maximize tax savings for your business and you. We can work with you to develop a tax plan and make sense of complex regulations and rules.