By Rex A. Collins CPA, CVA
Most of what we’ve been hearing about tax reform is about reducing rates for businesses and individuals. But while the framework of the legislation is just that – nothing yet has been fleshed out, so all we’re hearing and reading, including this article, is conjecture – there are several proposed items that deserve dealers’ attention.
There are four in particular. Let’s take a look at each relative to their potential positive or negative impact on our business:
Item #1: Tax rate reductions. A tax rate reduction for C corporations is clearly a good thing for those businesses, including dealerships. And a reduction to a 25 percent rate for flow-through entities likes S corporations, partnerships and LLCs is also happy news. However, the lower rate could come at a cost: potentially greater scrutiny by the IRS. Business owners might be tempted to convert wages subject to taxation at higher rates to flow-through income taxed at the lower rate. But the IRS is certain to be watching. Dealers will need to be sure that their compensation in terms of wages is reasonable and appropriate for their positions, job duties and experience.
Item#2: Advertising expense. The proposal would limit deductions for advertising expenses, which are currently fully deductible in the tax year the expense is incurred, to half that amount for that year. The remaining 50 percent could be written off in equal amounts each of the subsequent 10 years, that is, 5 percent of the expense each year. Consider a dealership that spends a million dollars in a year for advertising, but can deduct just half that amount; even at a 25 percent tax rate, that’s $125,000 increase in taxes for that year.
Item #3: LIFO options. There are currently numerous proposals being floated relative to LIFO reserves with of two of these proposals receiving the most attention, though it is not certain either will fly. Currently dealers get a non-cash tax deduction for inflation on their inventory, which can amount to substantial tax savings over the years. One proposal entirely revokes LIFO; it is being presented as a way to generate tax revenues that could offset some of impact of the rate reductions. Under the complete repeal, a dealer –or any business that holds inventory – would absorb those dollars as income over eight tax years in equal amounts each year. A second option would allow the dealer to recover 80 percent of the LIFO reserve tax-free, then take the remaining 20 percent into income in the subsequent four years: 10 percent in year one, 15 percent in year two, 25 percent in year three, and the remaining half of the 20 percent taken into income in the fourth year. Clearly, the second option would be a much better alternative.
Item #4: Interest expense. Given the amount dealers typically spend each year on interest, this item is clearly the most damaging in the proposal. The framework proposal would eliminate interest deductions. That is, it would disallow deductions based on gross interest cost, not net of any credit or interest support payments from the manufacturer. While details are sketchy, like other proposal provisions, it is likely that any reform bill will limit the deductibility of interest in some form or fashion. Dealers should consider renegotiating debt agreements now: renew floorplan agreements, mortgage agreements and lines of credit since it is possible that the elimination of the deductibility of interest may only apply to debt incurred after enactment of the legislation.
Tax reform proposals are just that at this point, and there will be plenty of lobbying and debate before we have definitive provisions. Consider, for example, how unimpressed bankers will be with any move to eliminate interest rate deductions. Still, preparation is key; dealers will be well served by keeping a close watch on the developments relative to tax reform and taking steps in advance of legislation that could protect their bottom lines.
Rex Collins is a Principal at HBK CPAs and Consultants. He directs HBK’s National Dealership Industry Group, which provides tax, accounting, transactional and operational consulting exclusively to dealers. Rex can be reached by email at firstname.lastname@example.org; or by phone at 317-504-7900.