“Those who fail to plan, plan to fail.” These words apply to all sorts of things in life and, of course, when it comes to taxes. With some economic upheaval and various provisions of the Tax Cuts and Jobs Act (“TCJA”) nearing their end, here are a few things to be mindful of as we cruise into the 4th quarter of 2023.
Interest Limitations Under Section 163(j)
With record profits, reduced inventory, and favorable add-backs (depreciation and amortization until 12/31/2021), most dealerships have not had an issue with the interest limitations under Internal Revenue Code (“IRC”) §163(j). Then in 2023, interest rates began to climb and continue to do so, inventories started to get stale, manufacturers tinkered with floor plan assistance programs, and profitability dropped at stores. This is the perfect storm for 163(j) limitations on interest deductions. In 2022, the interest limitation was based on adjusted taxable income after depreciation and amortization. Therefore, even if financing strategies have not changed, if taxable income is less, so is the ability to deduct interest expense fully.
Those who are scholars in dealing with the §163(j) interest expense limitation, will be quick to point out that auto dealerships still get to deduct floor plan interest expense in full under an exception provided in the law. While this is true, it also limits the amount of tax depreciation allowed. If the §163(j) floor plan financing exception is utilized, then the taxpayer is prohibited from taking bonus depreciation. This can cause a significant increase in taxable income for dealerships with large equipment purchases in 2023, renovations put into service on the books of the dealership, etc.
Bonus Depreciation Drops to 80% of the Asset’s Cost
And speaking of bonus depreciation, unless something changes, 2023 is the year bonus depreciation starts to phase out. In 2023, bonus depreciation decreases to 80% of an asset’s cost basis. For reference, it was 100% of the asset’s cost basis for assets placed in service until 12/31/2022. This means that for a $10,000 asset that was placed in service in 2022, you’d get a $10,000 deduction utilizing bonus depreciation in 2022, assuming the IRC §163(j) floor plan financing exception was not utilized. However, in 2023 that same asset placed in service would only provide a bonus depreciation deduction of $8,000, and the remaining basis would be depreciated over the asset’s “normal” useful life, etc. Some bonus is better than no bonus, but if you have a large service loaner fleet that your dealership has been taking bonus depreciation on, and it changes over on an annual basis, you’re going to have taxable income based on the disposal of that fleet, and only 80% of the new fleet will be eligible for bonus depreciation assuming you qualify for bonus.
The step-down of the bonus amount continues annually at 20% until it is completely phased out to 0% in 2027. Until the TCJA was passed, bonus depreciation was always “supposed” to be eliminated, but it was saved annually by Congress as a last-minute addition to some year-end legislation. Has the end finally come for bonus depreciation? That depends. The House Ways and Means Committee has introduced a year-end tax bill that would preserve 100% bonus depreciation until the end of 2025. Whether Congressional leaders can show bi-partisan support for such a bill remains to be seen.
The Qualified Business Income (“QBI”) Deduction Sunsets
The QBI is a 20% “off the top” deduction on the income of qualifying businesses and lowers the effective tax rate on this income. On a basic level, if a taxpayer has $1,000,000 in a qualifying business, an immediate 200,000 QBI deduction would be provided and decrease the taxpayer’s taxable income to $800,000. The QBI deduction was adopted primarily to keep pass-through business owners on a level playing field with large corporations that are enjoying a permanent flat 21% federal tax rate.
However, unlike the reduced corporate tax rate, the QBI deduction is only temporary and no longer available after December 31, 2025. Coupled with the increased individual income tax rates that take effect after December 31, 2025, taxpayers will see an increase in their effective tax rate of 10%, going from 30% to 39.6%. The increase in effective tax rate does not include the increased taxable income that could occur due to the IRC §163(j) interest expense limitation and bonus depreciation reduction as discussed above.
U.S. Representatives Troy Balderson (R-OH) and Lloyd Smucker (R-PA) introduced a bill in July of this year to permanently extend the IRC §199A, which will allow privately owned businesses to stay competitive with large corporations.
What About Estate Planning?
Perhaps some of the most important, and possibly the most tedious, tax planning that should be done before the 2025 taxable year-end has to do with estate planning. With dealerships generating record profits over the last few years, valuations remain high, but a return to “more normal” profitability levels all but guarantees a decrease in dealership valuations which could be a good thing for gifting ownership to the next generation. For the 2023 taxable year, an individual is provided a $ 12.92 million lifetime gift and estate exemption (or $25.84 million for married couples). However, the exemption is set to return to $6 million per individual ($12,000,000 for married couples) starting in 2026. The IRS has provided favorable guidance that they generally will not claw back or limit any tax planning that took advantage of the increased $12.92 million, provided it was performed prior to the 2026 taxable year.
Owners of auto dealerships should consider gifting more of the ownership of entities in a tax-free transaction, utilizing the higher lifetime limits that are currently available. While some owners are a bit reluctant to give away a portion of their business that has taken a lifetime to build, the significant tax savings, not only related to the value transferred but also the appreciation that remains out of the owner’s estate, should be enough for them to reconsider estate tax planning.
All directions point to taxes significantly increasing over the next two years. It is imperative to work with your tax advisers to properly plan to decrease the cash impact that will occur. In addition, your state representatives also need to know how such dramatic changes in tax legislation could severely limit your ability to expand your business and remain a significant contributor to your community.
Withum helps dealerships navigate the ever-evolving tax landscape to maximize deductions and avoid unnecessary penalties. Our highly experienced dealership team remains abreast of all new tax legislation that impacts dealerships providing expert advice, tax planning, and tax preparation customized to meet a dealership’s specific needs. Contact Withum today with any questions. We are here to help.