The most recent changes to the federal tax code certainly generated plenty of attention. But Steven Carstens — a partner at Shilson, Goldberg, Cheung & Associates, which is an accounting firm that specializes in the buy-here, pay-here industry — thinks the windfall for independent dealers might not be as fruitful as some lawmakers hailed.
Furthermore, along with describing the impact of the federal tax code changes, Carstens also elaborated about an accounting change coming that’s connected with operator facilities and could have a “long-term effect on dealers.”
During a conversation with BHPH Report, Carstens began by stating, “Right off the bat, the new tax rules do lower the overall tax rates for businesses, so that is a good thing.
“However, for all flowed-through businesses, which are S corporations, LLCs and partnerships, you actually have to jump through certain loopholes and meet certain requirements in order to enjoy the lower tax rates,” he continued. “So, many businesses will actually have to work closely with their accountants to make sure their business is hitting the requirements of what we call the 199-A deduction in order to enjoy the lowest tax rate.
“Now C corporations get a flat, 21-percent tax rate, which is the lowest corporate taxes have ever been,” Carstens went on to say. “However, most dealers are not set up as C corporations because in the past, corporations were generally for large businesses.”
Carstens shared that conversations this past year with clients and accounting contemporaries included debate over whether wide swaths of BHPH operators should change their organizational structure to secure this tax possibility. But Carstens pointed out a possible significant ramification if dealers made what might initially seem as simple as switching to a vehicle with an automatic transmission from one that has a manual gearbox.
“The answer, on the face of it, it seems simple. Convert and get a lower tax rate. But C corporations have some tricks to them that dealers aren’t thinking carefully about,” Carstens said. “And the biggest trick with the C corporation is that it is subject to what we call double taxation.
“An owner when he takes the profits out of a C corporation, gets taxed as second time at up to 24 percent. So the business paid 21 percent, and then if the owner takes the money out of the business, he pays the second tax of up to 24 percent. So if not done right, you could be paying taxes of maybe 45 percent on a C coorperation because you didn’t think the whole situation through,” he continued.
“It has a lot to do with whether the dealer is in growth mode, where there’s not going to be a lot of distributions out of the company or whether the company is a mature company where the owners are starting to reap their profits back out of the business. And if they are, then that double taxation will make the C corporation far less attractive than what has traditionally been used, which is an S corporation,” Carstens went on to say.
New tax law impacting losses
Carstens also explained how federal tax law impacted how dealerships can use losses to their benefit. He indicated operators no longer can carry back losses.
“In the past, you were allowed to amend your prior tax return and push your loss backwards and claim back the taxes you paid in prior years. You may no longer do that. Losses can only be carried forward. So you will just have to hold onto a loss until a future year when you have a profit, and you can use your loss in the future. You cannot carry it back anymore,” Carstens said.
Carstens also touched on how a rule change also was associated with operators who use the cash basis of accounting, rather than leveraging a related finance company.
“One of the other changes is that companies up to $25 million in revenue may use the cash basis of accounting. If a dealer can use the cash basis of accounting, then there would be no need to run a separate related finance company in order to get a good tax answer,” Carsten said.
“However, unfortunately there are many other rules in tax code that kind of take away the benefit for someone who has long-term receivables like a buy-here, pay-here dealer does,” he continued. “Those rules effectively cancel out any benefit that switching to a cash basis could generate for a dealer.
“After some research, the talk on switching to cash basis has fallen away and dealers are still best served using accrual basis with a separate related finance company,” Carstens went on to say. “The cash basis really is not of any use to a dealer because of some old tax rules that were never changed and still exist related to long-term receivables.”
Big changes from FASB
To recap, the Financial Accounting Standards Board (FASB) is looking to ensure that BHPH dealers and other financial institutions have solid measures in place to ensure they have appropriate reserves for any future losses based on the life of each auto loan. As a result, the board has instituted its new Current Expected Credit Loss model (CECL).
The new model will require higher levels of loan loss reserves and lead to changes in lending practices and portfolio management. It will also require a significant amount of data capture, analysis and modeling to meet the implementation.
Carstens pointed out that private, independent dealerships won’t have to comply with these new standards until 2021.
“Honestly, dealers have not put a lot of effort into this standard. Things like accounting standards dealers are very much, ‘I’ll put off until tomorrow what I don’t absolutely have to do today.’ They have inquired, but very few are doing any actual work on it because it’s very much going to be a one-time, catch-up adjustment. Dealers haven’t worried about it too much because in the year it goes into effect, they will make the catch up, they will notify their bank and they will move forward beyond it,” Carstens said.
“It shouldn’t have much of a loss. Once you’ve made the catch up and you’ve dealt with the effect on your financials, it shouldn’t have too much of a lasting effect,” he continued.
“The calculation is much more complicated, and we’ll have to put in procedures on how to calculate it going forward. But I think most dealers just assume their accountants will tell them what they have to do, make the necessary calculations, make the one-time adjustment and move forward,” he went on to say.
Another rule from the FASB won’t go into effect until 2020, but Carstens suspects the impact on BHPH dealerships could be much more significant. The FASB said a property lease an operator signs for his showroom, lot and other facilities will be counted as debt.
“So if a dealer signs up a 10-year lease for his dealership, those 10 years of payments are actually listed as debt on your financials the second you sign that lease, which totally changes your debt-to-equity ratios and your entire financial statement,” Carstens said.
“Signing a 10-year lease, that might be $1 million of total payments that you suddenly have to call debt on your books because you’ve signed a contract to pay someone. The new accounting rules say, ‘Well, that sounds like debt,’ so they call it debt,” he continued.
“Now conversely, they do get to show an asset on their books because now they have control of that piece of land for 10 years,” Carstens went on to say. “So the accounting rules will say, ‘Well, you have this debt, but you also sort of have an asset, which is the use of this property.’ But for certain covenants like debt-to-equity, you’ve added debt without changing your equity and you will definitely blow some of your banking covenants because of this rule. It will definitely make your debt situation look a lot worse on your just because you might have four or five property leases that are now debt.”
Carstens noted that he’s notified all of his dealer clients about this change even though it’s five years away from being enacted.
“I think this could have a long-term effect on dealers,” he said.
And with regard to the lease matter, Carstens added a caveat.
“Small dealers whose financials are prepared under what we call the income tax basis of accounting — meaning they just do the financials just so that they can file their taxes — are not impacted by either of these rules, because the IRS isn’t changing anything,” he said. “This is for larger dealers who report to banks and have to follow generally accepted accounting principles. They have to follow these new rules.
Smaller dealers who simply do the books just to file taxes and follow what we call the income tax basis of accounting, these rules have no effect. You’d have to follow the tax rules, not accounting rules,” Carstens added.
More emphasis on accounting
With all of the complicated matters, Carstens highlighted that dealers of all size are turning to accounting specialists to manage their books.
“I will give dealers some props for improving their accounting practices. Dealers years ago, they really did not put any emphasis on accounting. But now they are becoming more sophisticated and placing more emphasis on accounting for couple of major reasons,” Carstens said.
“This business has become much more competitive, and the profit margins have dropped a lot, and so dealers are watching every expense and trying to run slim operations,” he continued. “The only way to do that is to have good accounting records and to monitor things. Dealers have become far more interested in the financial statements over the last few years in order to stay competitive.
“Secondly, most buy-here, pay-here dealers have bank loans, and the bankers are under increased pressure for any loans that they made to the subprime industries such as the buy-here, pay-here industry,” Carstens went on to say. “They have far more stringent reporting regulations after the crash, and that puts more pressure on dealers to report more frequently and more in depth. The bank has had put a lot more pressure on dealers and the type of reporting they do in addition to the frequency of the reporting they do. Dealers have had no choice but to improve their accounting department to meet that.”