WEDA Legal Notes
With all of the social media noise and constant barrage of political advertising, it becomes easy to tune out conversations relating to the upcoming federal elections. But despite all of the “bombshell” news stories and constant “breaking news,” it is important that dealers start thinking now about the potential impact of the election on their personal and business planning considerations… the consequences of an election resulting in a Biden presidency and a Democratic-controlled Congress will truly be a breaking news story with real-life consequences to your financial picture.
Trying to predict what will happen can be a fool’s errand in most situations, but the contrast between the two choices in the election is too stark to ignore. If a change is coming, giving some advance thought to what might happen is not a wasted exercise this year because making moves to react to a change can take some significant time and planning.
We have no idea what would ultimately come out of the sausage-making legislative process, but if there is a sweeping change in the government, 2021 will likely see several proposed tax code changes that will include the following concepts:
- a dramatic reduction in the amount of assets that can be gifted to your family without estate tax,
- increases in capital gains tax rates to match ordinary income tax rates,
- increases in payroll taxes and ordinary income tax rates on individual compensation over $400,000 (this appears to be the current magic cutoff number), and
- increases in C corporation tax rates, changes in dividend tax rates, and elimination/reduction of S corporation income deductions.
The hard question for you will be what to do in light of these changes? While the answer won’t be the same for everyone, there are a number of potential reactions to these changes that can be considered as part of a strategy to minimize their impact. As I look into an admittedly foggy crystal ball, here are some of the things that I would recommend considering:
Getting Assets Out of Your Name
Our tax code is set up to tax the value of assets passed from one generation to another (whether gifted during life or at death) at a very high rate (40% federal tax rate). The consequences of this high tax rate are limited by two very important concepts in our tax code.
First, the government sets an “exemption limit,” which is an amount of assets that you can give away without triggering estate or gift tax. The current cap is $11,580,000 per person (currently increasing each year with inflation), but as recently as 2008 it was $2,000,000 and in 2017 it was $5,490,000. Second, if you transferred assets at your death, the next generation would see the tax basis in that asset “stepped up” to match its fair market value at the date of your death. What this means in its simplest terms is that your kids could turn around and sell that asset and not pay any income taxes on the sale. This concept ONLY applies to transfers at your death and is one of the most significant advantages of transferring at death vs. gifting to your family while you are alive.
If there is a change resulting from the election, we expect to see proposals to dramatically reduce the exemption amount AND to eliminate the “stepped up” basis. The combination of the two create a powerful incentive for you to consider moving as many assets as possible out of your name while the exemption amount is at this all-time high through gifts to family members or to irrevocable trusts to maximize the amount of assets that can be passed at your death without estate or gift taxes. If the exemption amount is reduced after 2020, your gifts made in 2020 will not be affected.
In other words, this year’s exemption amount is a “use it or lose it” benefit if the exemption is later reduced. Dealership stock is a great asset to consider for this purpose because it is also an asset that will likely appreciate in value over time, resulting in more potential estate tax savings by moving it now. The power of this from a tax-savings standpoint is illustrated with this simple chart:
10 Years Later (Appreciation)
Dealership Stock Value
Estate Tax/Potential Savings
While there are some potentially powerful tax incentives, there are a couple of other important factors that might also make this type of change attractive:
- Voting vs. Non-Voting Stock – If you are ready to transfer assets, but you are not yet ready to transfer control, you should consider creating voting and non-voting stock classes so that you can effectively split dealership decision-making from the asset value.
- Manufacturer Approval – Most ownership transfers will require manufacturer approval. The benefit of making a transfer now is that it is much easier to gain manufacturer approval of a current transfer to the next generation than to ask a manufacturer to approve a transfer that may not occur until your death.
Adjustments to Exit Strategy?
A second important change that will cause many dealers to rethink their business plans is the potential increase in the capital gains tax rate to match the ordinary income tax rate.
In many dealership transactions, the primary tax paid is capital gains tax. As a result, if there is a change in rate, many dealers will be looking at paying twice as many taxes on sale proceeds. If this situation occurs and you are planning for an exit from the business in the relatively near term, this change may have two important consequences as we look at the dealership merger and acquisition market in 2021:
- Accelerating Sales – Selling dealers may be more interested in moving up timelines to sell the dealership to avoid the increased tax rate, especially since any tax rate will have a pretty good chance of remaining in place for at least four years. In addition, for dealers that sell during a higher tax rate climate, deferring receipt of a portion of the purchase price (and the related taxes) may also become a more attractive option for a seller even though it also comes with some obvious risks.
- Merger Flexibility – Mergers may become a more attractive option for dealers looking for an exit strategy. These structures can be used to structure a partial buy-out of some owners wanting out now (incurring taxes at capital gains tax rates) while allowing other owners to retain the flexibility to retain ownership in a dealership business for a longer-term. Another benefit of a merger is that if there are manufacturer approval issues that limit a dealer’s long-term options, a merger in which that dealer becomes a minority owner in a larger organization may allow a dealer the opportunity to remain in the business longer and defer a complete exit from the business (and the related tax consequences) until the timing is better.
Compensation/Corporate Structure Issues
Other likely changes in our tax code that could come with a change in administration involve increases in taxes on your individual income as well as changes in the tax rates for S corporation owners and C corporations. These proposals could have significant consequences but I view them as different because they have an impact on continuing operations (vs. single event business or asset transitions).
As a result, I would caution dealers to not make too many decisions in anticipation of changes in this area simply because they could still go in a lot of different directions and I think it would be best to maintain flexibility to react when there is more certainty.
With that said, I do think there are a couple of important considerations for dealers that tie into potential tax rate changes for ongoing business operations and may result in near-term changes in strategy:
- Income-Shifting – If you decide to implement a strategy of gifting dealership ownership to the next generation, one impact is that you may also want to structure the transaction so that ongoing income from the ownership interests flows through to the next generation. This decision should not be taken lightly since it also needs to consider your family’s perspective relating to the amount of wealth the next generation should receive immediately, but from a pure tax standpoint, a shift of ongoing income from one generation to the next will likely result in a lower tax rate. This could result either because of the splitting of income into multiple family “buckets” or simply because the next generation has lower income levels overall.
- Deferred Expenses – Your dealership expenses are usually deductible. Those deductions are valuable because they can reduce taxable income. As a result, the value of those deductions will change as the tax rate changes. This dynamic should make you think about the timing of large expenses that you may be contemplating for your dealership. Depending on the situation, it may make sense to defer significant business expenses until you have a better idea of potential tax rate changes so that you can maximize the related tax benefit.
Another challenging issue with potential tax changes is that it can also be difficult to determine when action must be taken to avoid changes. There is no guarantee that changes enacted in 2021 will only apply to actions taken after 2021 or even after the date the legislation is adopted in 2021.
Our best guess is that income tax changes passed in 2021 will apply to the entire 2021 tax year while changes to the estate and gift tax are more likely to apply only after the date the legislation passes. However, this is only a guess and the safe approach from an estate and gift tax standpoint would be to make moves in the near term (prior to 12/31/20) if you have concerns about the overall estate and gift tax exemption levels.
Any changes coming out of the upcoming election are tough to predict and will obviously be different depending on the outcome of the election. But with the potential magnitude of change and the election upon us, it is definitely not too early to be thinking about what might be coming and how it might impact your dealership and your goals for your family.
This article is intended to provide general recommendations and is not intended to be legal advice. You should always consult your attorney for advice unique to you and your business. Please note that any estimates of tax consequences are based on the current tax code and could change based on future changes in the law or regulations.
Article Written By Lance Formwalt
LANCE FORMWALT is the leader of the Equipment Dealer Group at Seigfreid Bingham, P.C. The firm also serves as legal counsel to the Western Equipment Dealers Association (WEDA). Lance may be contacted at firstname.lastname@example.org or 816-265-4106. Also see www.sb-kc.com.