Death, we’re told, and taxes are the only sure things in life. The big difference, of course, is that no one is debating revisions to the laws of death. But tax reform is a common theme when political administrations change. The Trump administration, assisted by Republican majorities in both houses of Congress, has promised tax reform. Some sort of change is likely this year. What kind of changes should we expect? And what kind of changes should dealers support?
From the myriad of possibilities, this article will focus on three: corporate tax rate, capital investment deductibility, and estate taxes.
With a few publicly traded exceptions, car dealerships are small businesses. Per NADA, the average dealership has around 70 employees. Since the Great Recession, small businesses created 67% of all new jobs in the U.S. So what’s good for small businesses (read: “dealerships”) should be good for the U.S. economy as a whole.
And what do small businesses need most? According to Business.com, cash flow and access to capital are two of the greatest needs. Publicly traded dealer groups have, by definition, access to capital through the stock markets. The majority of dealers do not. Access to capital, in itself, softens cash flow constipation and fuels growth.
Here (drum roll, please …) is where tax policy comes into play. Every dollar a dealership has to pay in taxes is one less dollar the dealer can use to manage cash flow or invest back into the business, creating jobs and generating profit. And right now, the American corporate tax rate is wholly noncompetitive.
The chart on this page isn’t entirely accurate. The United States does not have the highest corporate tax rate in the world. We have the third highest tax rate in the world, just behind Puerto Rico (39%) and the United Arab Emirates (55%). Still wondering why IT and healthcare companies want to relocate to Ireland (12%)?
President Trump has proposed a corporate tax rate of 15%, which would move the U.S. from the worst corporate tax rate of any major country (no offense, Puerto Rico and UAE), to one of the more favorable. (The worldwide average corporate tax rate is 22.5%.) To put this in more concrete terms, would Apple really have moved 6,000 jobs to Ireland if the tax differential were only 3% instead of 26%?
In even more concrete terms, the average domestic franchised new car dealership had pre-tax earnings of $1,235,709 in 2016 (thank you, NADA). For those dealerships that are C-corporations, a 38% tax rate creates a tax bill of $469,569. A 15% tax rate would result in a tax bill of $185,356. Know any dealers who could profitably invest an extra $284,213?
Capital Investment Deductibility
Lowering the corporate tax rate will make America a more attractive place to do business, but that’s only one piece of the puzzle. Another important piece is the deductibility of capital investments.
Currently, businesses are allowed to depreciate the cost of capital investments. Depreciation is the deduction of a portion of the cost of an asset over time. The period of time depends on the type of investment, and there are various methods of calculating depreciation (straight-line, sum-of-the-year’s digits, double-declining balance, and so on). It’s complicated, but the preference for business owners is to depreciate the expense as quickly as possible.
Then there’s expensing. Expensing an asset means to write off its entire cost in the year the investment was made. This has the effect of lowering your tax liability. Expensing incentivizes investment and improvement.
For example, say an OEM wants Average Dealership (the one with taxable income of $1,235,709) to invest $1,000,000 in showroom enhancements. Average Dealer agrees and makes the investment. Let’s say that under current depreciation rules, Average Dealer may deduct 20% of that investment every year for five years. (Again, the actual depreciation schedule varies according to the nature of the asset, so I’m making this up.) That means Average Dealer may reduce her taxable income from $1,235,709 to $1,035,709, and her tax bill from $469,569 to $393,569 — a $76,000 savings.
If Average Dealer could have expensed the entire $1,000,000 cost in the year it was incurred, however, her taxable income would have dropped to $235,709 and her tax bill to $89,569 — a savings of $380,000. Under which scenario is Average Dealer more likely to make the investment? And by making the investment, employing architects, carpenters, masons, concrete finishers, electricians, painters and the occasional lawyer, all of whom will pay tax on their incomes arising from that investment?
While all of this sounds great, please note that this change to depreciation rules is not an announced part of the Trump tax plan as of the date I write this. But the funny thing about the tax policy genie is that, once he’s out of the bottle, no one can predict where he’ll go. All dealers can do is hope … and write their congressmen.
Trump wishes to repeal the “death tax,” as estate taxes are commonly called by their opponents. There is something vile about the very concept of estate taxes. A dealer can work hard all his life, pay taxes on every dime of income he ever earns, and upon his death it all gets taxed again — just because he died.
The reality is a little more nuanced. Under today’s estate tax rules, when a dealer (or anyone else, for that matter) dies, he may leave an unlimited amount to his spouse or a charity. This provides for the widow — a good thing — and kicks the estate tax can down the road until the widow dies.
As soon as the Grim Reaper leaves, the Tax Man cometh. Under current estate tax law, any asset that is part of your estate receives a new “stepped-up basis.” That means that, for capital gains purposes, the value of the asset is not what the decedent (the legal term for “dead guy”) paid for it, but its value on the date of the decedent’s death. Thus, a share of stock that cost $1 when the decedent bought it and is worth $10 when he dies, goes to any beneficiary — not just a spouse — with a $10 basis. This can take a big chunk out of any tax bill if and when that stock is sold for more than $10.
In any event, the first $5,490,000 (adjusted annually for inflation) of the estate is exempt, and the widow has an additional $5,490,000 exemption. In plain English, this means that — with appropriate planning — a couple can exempt the first $10,980,000 from taxation. The rest will be assessed estate tax at the rate of 40%.
In other words, my kids will not need to worry about estate taxes. In fact, the Tax Policy Center states that only 0.019% of all decedents pay any estate tax. That’s one in 517 decedents, for those of you without a calculator. But with current dealership valuations, reinsurance accounts, and the price of real estate, it is not unlikely for many Average Dealers to leave estates above the exempt amount. Plus, there’s Warren Buffett and Roger Penske. Just sayin’.
How likely is the type of reform we discussed above? If reason rules, very likely. This is because, at least with respect to the corporate tax rate, the Trump proposal may wind up looking very much like what his predecessor’s proposed revision to the corporate tax rate looked like. Recall that Obama proposed a reduction of the corporate tax rate to 28%, and a tax on American manufacturers of 25%. Even as I write this, the rhetoric out of the West Wing suggests the actual tax rate may fall in the 15% to 20% range, which, in Beltway-ese, means “somewhere north of 20%.”
Why the upward tendency? For Trump’s tax reform to be “revenue-neutral,” and therefore able to be passed with a simple majority in the Senate, a repeal of Obamacare will be necessary. If that is not fully repealed, revenue-neutrality of the corporate tax rate at 15% simply isn’t possible. There are a lot of ingredients in play at the sausage factory.
Still, with a Republican-controlled House, Senate, and White House, there is every reason to believe the federal tax code will change in 2017. Whether or not those changes will include the three we discussed here remains to be seen. But regardless of which changes actually get made, they are likely to benefit small businesses — like dealerships — and their owners.
James S. Ganther Esq. is the co-founder and CEO of Mosaic Compliance Services. He is a dealer compliance expert and a prolific writer and speaker. Email him at [email protected].