Taxberg Ahead: Beware of These Hidden Deal Killers

A version of this article appeared in San Diego Dealer Magazine in August 2014.

When you’re buying or selling a dealership, it can be easy to miss critical tax problems before the sale—especially when you’re moving full steam ahead toward closing. And these tax icebergs (or “taxbergs”) can often, unfortunately, become deal killers.

Even if you’re watching carefully, taxbergs can sneak up on you, since the fog of LLCs and S corporations make it difficult to spot them without a trained eye. We’ll share some general information about hidden taxbergs that could help you change these deal killers into opportunities.

Background

Over the last 25 years LLCs and S corporations have gained popularity as a way to own dealerships and related facilities. They’re popular because they offer flexibility in structuring ownership interests and generally don’t pay federal income tax. Instead they’re pass-through entities, which pass taxable income or losses through to the ownership group. The owners then include these amounts on their personal tax returns.

Simple, right?

This flexibility has been a good way for dealers to take advantage of a number of great tax strategies (often tax deferrals) that are very beneficial in the high-tax environments common today. By deferring taxes into the future, more cash flow can be immediately reinvested into the dealership.

For example, current tax law generally allows for different ways to compute revenue and deduct expenses. In early years these tax rules often generate positive timing differences that build up and reverse over time. Since depreciation for tax purposes is generally accelerated (or taken at a faster rate) than the methods the same company would use for its financial reporting, it creates a depreciation difference between the company’s book and tax methods. By accelerating tax depreciation, the company creates a favorable short-term tax benefit, paying less income tax in early years—but the same treatment becomes unfavorable in later years. As you can see, this can get complicated.

What does this mean? Who’s keeping track? As timing differences add up over a given period, they need to be managed very carefully. What’s interesting is the IRS does not require LLCs or S corporations to report the total amount of the cumulative timing differences on their LLC or S corporation tax return. Therefore, most owners of LLCs and S corporations don’t focus on whether they owe a future tax liability or own a future tax asset at any given time. These taxbergs, favorable or unfavorable, are usually lurking hidden under the water and don’t become an issue until the dealership is sold or an interest is transferred. And by then it’s too late. For example, if you were purchasing a company where the timing differences were reversing, you wouldn’t be getting the benefits of the accelerated deductions as the new owner—which would be unfavorable. But if you purchased a company where the accelerated depreciation was not reversing, you’d be getting additional deductions after you purchased the company, a favorable situation.

This is important to note, because when you’re selling your interest (or transferring it via a gift), you may be passing this liability or asset on along with it. A well-informed investor will want to understand the amount of tax assets or liabilities they’re purchasing as part of the transaction. This doesn’t come into play when you’re purchasing the assets of the dealership, but it may affect you if you’re directly buying an interest in an LLC or an S corporation.

Common Taxbergs

LIFO

Last in, first out inventory management (LIFO) is a common example of a taxberg. Although LIFO is recorded on most dealerships’ balance sheets, its tax effect is not. If you’re acquiring a partial interest in an LLC (though there are planning exceptions available in these cases) or S corporation that has significant LIFO reserves, then you’ll be the proud owner of those reserves. This means you’ll be paying the tax on the portion of the reserve you purchase and the seller will not. However, if you’re aware of the situation before you enter into the purchase, it might be possible to negotiate.

LIFO is also tricky because if you purchase a controlling interest in the store, you may inadvertently create a tax event whereby the entire LIFO reserve becomes taxable at the time of transfer. Keep this in mind when you’re selling as well.

Accelerated Depreciation

Accelerated tax methods are often used when depreciating assets, and the bonus depreciation offered in the past several years has made the tax savings especially rich. Over time accelerated depreciation builds up and then reverses.

Used Car Write-Downs

Some dealerships write down used car inventory on their books using approved (and sometimes not approved) methods. This write-down is an annual computation that accelerates deductions into the current year and reduces taxable income in the current year. This onetime benefit reverses in the next year. In many cases these write-downs are done on the tax return only, and they’re accounted for as a timing difference in the current year. Unfortunately, only the change between last year’s write-down and this year’s write-down flows through the tax return. The cumulative write-down is not reported anywhere. This makes the tax burden especially difficult to see coming, and it means that—in many cases—this taxberg is going to be yours if you’re buying into the entity.

Factory Incentives

The tax treatment of advertising credits, interest credits, and other incentives may also create similar types of tax timing differences.

Accruals

Owners’ bonuses, vacation payable, and various other reserves can sneak up on you when they reverse.

Buyer Beware

These common examples of taxbergs are just the beginning, and they’re why so many sellers want to sell an interest in their entity rather than make an asset sale. Additionally, most entity sales qualify for capital gains treatment. Most buyers are keenly aware of the tax benefits and detriments of buying assets versus buying the entity. However, when the buyer is computing the net tax effect to the seller, these hidden taxbergs are often missed.

Understanding the true value of the taxbergs transferred to you at closing will make you a savvy buyer—and should give you more power to negotiate. To learn more about how buying and selling dealership ownership interests may impact your taxes, contact a tax professional with dealership experience.