The most significant tax reform legislation in over 30 years was signed into law as the Tax Cuts and Jobs Act (TCJA) in December 2017. The TCJA is a significant modification to the existing complex system, and the consensus is clear – most businesses expect their income tax expense to decrease, including dealerships.
Though there are many moving parts in the new tax law with the potential to affect businesses and individuals to varying degrees, this article highlights what we consider the top 10 most significant changes for dealerships.
1 Individual tax rates and corporate tax rates
The final law maintains that there are seven individual tax brackets established prior to the TCJA. However, the new tax law reduces individual income tax rates to 10, 12, 22, 24, 32, 35 and 37 percent, raising the income levels subject to each tax rate. These rates apply to tax years beginning after December 31, 2017, and beginning before January 1, 2026, unless subsequently extended by future legislation.
On the corporate side, the current graduated tax rate was removed in favor of a flat 21 percent rate for tax years beginning after December 31, 2017.
2 Alternative minimum tax
The original goal was to repeal the alternative minimum tax (AMT) for both individuals and corporations. Unfortunately, while the final law removes the proposed full repeal of AMT for individuals, it was replaced with an increased exemption for 2018 from $86,200 to $109,400, and the phase-out threshold increased for 2018 from $164,100 to $1,000,000 for married filing joint taxpayers. The exemption amount for single taxpayers increased for 2018 from $55,400 to $70,300, and the phase-out threshold increased for 2018 from $123,500 to $500,000.
On the other hand, corporate AMT is fully repealed under the final law for tax years beginning after December 31, 2017, which is beneficial to dealerships taxed as a C corporation. Any AMT tax credit carryforwards will offset the taxpayer's regular tax liability and is refundable, within limits, starting in 2018.
3 Pass-through income deduction
Aligning with a reduced corporate tax rate, Congress provided pass-through entities with a deduction for a percentage of their taxable income. Beginning for the 2018 taxable year, a deduction is allowed for taxpayers who have qualified business income (QBI) from a partnership, S corporation or sole proprietorship, subject to limitations. The 20 percent deduction is limited to the lesser of (1) 20 percent of their pass-through business income; or (2) the greater of (a) 50 percent of the W-2 wages paid in the qualified trade or business, or (b) the sum of 25 percent of W-2 wages, plus 2.5 percent of the unadjusted basis of all qualified property. This deduction applies for tax years beginning after December 31, 2017, and beginning before January 1, 2026.
4 Standard deduction, charitable contributions, and the Pease limitation
Personal exemptions are removed in the law in favor of a higher standard deduction effective for tax years beginning after December 31, 2017, and beginning before January 1, 2026. The new standard deduction amounts for 2018 will be $24,000 for married filing joint or surviving spouse, $18,000 for an unmarried individual with at least one qualifying child and $12,000 for single filers. Charitable contributions – which under prior law were limited to 50 percent of a taxpayer's AGI – will now be limited to 60 percent of AGI effective for tax years beginning after December 31, 2017, and beginning before January 1, 2026. The law also repealed the 80 percent deduction for certain contributions to universities made in connection with athletic seating rights.
5 State and local tax deduction
One of the TCJA's most impacting features is the limiting of the deduction available for sales, income or property taxes paid to state or local tax authority to $10,000 ($5,000 for a married taxpayer filing a separate return) for tax years beginning after December 31, 2017, and beginning before January 1, 2026. This limitation does not apply to any of the aforementioned taxes paid or accrued by a trade or business in connection with carrying on a trade or business. For example, a real estate entity that pays real estate taxes assessed on a building that is leased to a dealership would still be allowed to take a deduction within the entity for the real estate taxes paid without the deduction being subject to the new limitation, which applies at an individual taxpayer level.
The law specifically includes a provision that disallows prepaying state or local income tax for a taxable year beginning after December 31, 2017. Any amount paid in a taxable year beginning before January 1, 2018, is treated as being paid on the last day of the tax year for which the tax applies.
6 Depreciation changes
The law includes a provision that allows for 100 percent expensing through bonus depreciation of certain business assets placed in service after September 27, 2017, through December 31, 2022. The amount of bonus depreciation allowed is then phased down over four years as follows: 80 percent in 2023, 60 percent in 2024, 40 percent in 2025 and 20 percent in 2026. The requirement that the property be new is replaced with a requirement that the property simply be new to the taxpayer – an impactful distinction. Property acquired from a related party is generally not eligible for bonus depreciation.
However, in order to preserve full deductibility of floor plan interest expense, dealers receive a trade-off. The ability to exclude floor plan interest expense from the interest expense limitation (discussed below) also means that qualified property for bonus depreciation purposes now excludes any property used in a trade or business that has had floor plan financing indebtedness and does not subject the floor plan financing interest to the interest expense deduction limitation.
On December 20, 2018, the Joint Committee on Taxation issued their general explanation the TCJA referred to as a Blue Book. Included in this report were two examples that seek to further explain the interaction between the bonus depreciation changes and the new interest expense limitation rules, the latter of which are effective for tax years beginning on or after January 1, 2018.
While this report is not authoritative in nature, it can be referenced by the Treasury in connection with drafting proposed and eventually final regulations. The two examples appear to provide the trade or business an option as to whether or not to take floor plan interest financing into account in connection with increasing their interest expense limitation. If the option is not made, it would appear that the trade or business would continue to be able to take advantage of bonus depreciation.
Nonetheless, the law includes some additional changes that have the potential to benefit many dealers. For example, Section 179, another asset expensing provision for qualifying property, states that expensing limits are increased for 2018 to $1,000,000, with the phase-out threshold increased to $2,500,000 with both thresholds subject to inflation increases for tax years beginning after December 31, 2017. Furthermore, the definition of qualified property was expanded to include improvements to roofs, heating, ventilation and air-conditioning property, fire protection and alarm systems, and security systems made to nonresidential real property if placed in service after the date such real property was first placed in service.
7 Interest expense deduction limitation
The law also includes a provision that limits the deduction for business interest expense incurred by a trade or business to the sum of interest income, 30 percent of the adjusted taxable income and the floor plan financing interest expense of a taxpayer for the year. For tax years beginning before January 1, 2022, adjusted taxable income will be computed without regard to depreciation, amortization or depletion expense. Adjusted taxable income is otherwise generally defined as a taxpayer's taxable income without regard to any income, gain, deduction or loss not properly allocable to the trade or business, any business interest expense or business interest income and any net operating loss.
Real property trades or businesses, including rental property activities that qualify as a trade or business, may elect out of the interest deduction limitation if that trade or business uses the alternative depreciation system, which generally results in longer, slower depreciation deductions. This election is not available in cases where at least 80 percent of the business's real property based on its fair market value is leased to a trade or business under common control. Any interest not deductible for any tax year is carried forward indefinitely, therefore treated as business interest paid or accrued in the succeeding tax year.
8 S corporation conversion to C corporation
Regarding the reduced corporate rates, Congress anticipated the possibility of S corporations looking to convert to C corporations. To simplify this conversion, an S corporation that qualifies as an eligible terminated S corporation that pays distributions after the post-termination transition period is treated as having paid such distributions proportionately from any remaining S corporation accumulated adjustment account and any accumulated earnings and profits of the new C corporation. An eligible terminated S corporation is one that revokes its S corporation election within two years of the law's enactment date, and has the same shareholders with identical ownership percentages as of the date of the law's enactment.
9 Like-kind exchanges
Under the law, like-kind exchanges are limited to exchanges involving real property that is not primarily held for sale. This new limitation applies to exchanges completed after December 31, 2017; however, a transition rule allows likekind exchange treatment for any property disposed of in an exchange on or before December 31, 2017, or for any property received by a taxpayer in an exchange on or before the same date. This exception generally allows for like-kind exchanges already in process in 2017 to still take advantage of the current like-kind exchange rules.
For dealers, this means that like-kind exchanges involving franchise rights are no longer available.
10 Estate and gift taxes and generation-skipping transfer tax
The law doubles the base estate and gift tax unified credit exclusion to $10 million, effective for decedents dying and gifts made after 2017 and before 2026. The law also increases the generation skipping transfer tax (GSTT) exemption to $10 million. This effectively increases the inflation-adjusted exclusion and exemption amounts to $11.2 million ($22.4 million for a married couple) for 2018.
These increased exclusion and exemption amounts can provide planning opportunities for dealers looking to transition their estate in the coming years.
As there are far more elements to the tax reform than covered here, dealers may consider familiarizing themselves with the finer details of the changes. Looping in a trusted advisor and CPA is strongly recommended to ensure dealers are prepared for the oncoming effects – both favorable and complex – to their financial posture.
Adam M. Neporadny, CPA
Senior Manager, DHG Dealerships