We are receiving a number of questions from dealers who have heard that the Tax Cuts and Jobs Act of 2017 (The Act) contains changes to tax law which will result in “Buy Here Pay Here” or BHPH dealers no longer needing to use a related finance company (RFC). The Act, the most comprehensive tax legislation since the Reagan era, is very complicated and we expect a significant number of regulations implementing the new law to be issued in the coming months and years.

One of the items contained in The Act is an expansion of the use of the cash method of accounting for businesses. Taxpayers using the cash method of accounting recognize income when cash is received and deduct expenses when paid. In general, the accrual method recognizes revenue when it is earned and expenses as incurred regardless of when payment for those items are received or paid.

Under prior law, there have been limitations on using the cash method of accounting. One of these limitations impacts taxpayers who maintain inventories. Generally, taxpayers with inventories are required to use the accrual method of accounting. Since dealers typically maintain inventories, they are not permitted to use the cash method. This results in dealers being required to recognize all of their sales revenue as income, forcing them to pay income taxes long before the customer has paid for the vehicle. Using an often-overlooked section of the tax code, dealers created RFCs to help alleviate the tax impact of this issue. The use of an RFC, because of the discounts taken, permits dealers to spread the recognition of taxable income over the life of the loan; thereby, more closely matching the tax burden to the cash flow. If dealers could use the cash method, the creation of the RFC would have been unnecessary.

The Act has expanded the use of the cash method so that businesses with gross receipts of less than $25 million dollars may be able to file for an election to use the cash method. This sounds like good news for many BHPH dealers, right? Not necessarily.

The current tax rules relating to the use of the cash method contain a snag for BHPH dealers that they may not have considered. These rules create “cash equivalency.” Under this definition, a dealer who receives an unconditional, assignable promise to pay from the customer, must recognize this as a cash equivalent; therefore, making the entire sale, once again, subject to income tax. The courts and the IRS have both reinforced this cash equivalency theory.

The Bottom Line: The expansion of the use of the cash method under the Act may not solve BHPH dealers’ problems. Accordingly, BHPH dealers must continue the use of RFCs until the IRS issues guidance changing the current rules or dealers risk seeing a significant increase in their tax bills. Contact Rex Collins with any questions you may have about the Tax Act and how it may impact your business.

Overview

The Tax Cuts and Jobs Act (the Act) created a new Business Interest Deduction limitation, effective for tax years starting after December 31, 2017. This new provision limits the deduction for business interest for all businesses, though an exception to the limitation applies for businesses who meet the gross receipts test, discussed below.

What is the Business Interest Deduction?

Businesses are allowed to deduct any interest paid or accrued on debt that is properly allocable to a trade or business, and is not considered investment income. Historically, this interest deduction has not been subject to many limitations.

Scope: Then and Now

Internal Revenue Code (IRC) Section 163(j) is the code section that provides for a limitation on the deduction for business interest. Prior to the Act, this provision had a limited application and only applied to U.S. corporations or U.S. branches of foreign corporations to prevent businesses from stripping earnings and avoiding U.S. taxation. The Act changed this code section to apply to all taxpayers and all debt, even if the debt arises from a related-party transaction.

The Limitation

The deduction is limited to the sum of business interest income, 30 percent of adjusted taxable income (ATI), and floor plan financing interest. ATI is generally taxable income, computed without regard to:

• activity that is not allocable to the trade or business;
• business interest expense or business interest income;
• depreciation, amortization, or depletion (for tax years beginning before January 1, 2022);
• net operating losses under Section 172; or
• the new 20% qualified business income deduction under Section 199A.

Floor plan financing interest is generally defined as interest paid or accrued on debt used to finance the acquisition of motor vehicles held for sale or lease, and which is secured by the inventory acquired.

If the limitation applies, the disallowed business interest will carry forward to the succeeding taxable year.

Gross Receipts Test Exemption – Small Businesses

There is an exemption from the limitation for small businesses with average annual gross receipts for the three taxable years ending prior to the taxable year at hand that is less than $25,000,000. However, taxpayers in controlled groups and partnerships may be required to aggregate gross receipts, so this should be considered when calculating whether or not the limitation should apply.

Carve Outs

Farming, real estate businesses, dealerships and certain public utility businesses successfully lobbied to avoid the application of this limitation. For dealerships, floor plan financing is fully deductible without limitation. However, these dealerships are excluded from 100% bonus depreciation on any of their assets.

Farming and real estate businesses may elect out of the new 30% limitation, but they will be required to use the Alternative Depreciation System (“ADS”) to depreciate their depreciable assets. Businesses using ADS are not eligible for 100% bonus depreciation. If the election is made, it is irrevocable, and ADS treatment will apply to all depreciable assets that are already owned or will be purchased in the future.

Real Property Business – Election Comparison

So, How does it Work?

Let’s use a hypothetical company, ABC Corporation, and assume it exceeds the small business exemption. ABC Corporation is in the business of residential rental property and, for illustration purposes, will not elect out of the business interest limitation. For the taxable year, ABC Corporation has the following income statement:

ABC Corporation can only deduct $30,000,000 of its $49,000,000 of net interest expense. The remaining $19,000,000 of disallowed interest expense will carry forward until used in a future year. The $19,000,000 disallowance is calculated as follows:

$50,000,000 interest expense – $1,000,000 interest income = $49,000,000 net interest expense

$49,000,000 net interest expense – $30,000,000 interest expense limitation = $19,000,000 disallowance

ABC Corporation will have taxable income of $45,500,000 if they do not elect out, but will have taxable income of $25,500,000 if they do elect out. Therefore, the election out is most beneficial in the current year where there is high business interest expense. However, electing out will likely decrease the depreciation deduction for the current year and future years, thus slightly increasing taxable income. The decision of whether or not an election out should be made should therefore take into account the impact on current and future depreciation.

Effect of Depreciation, Amortization, and Depletion on ATI and the Deduction

The larger the ATI, the larger the deduction. Starting in 2022, ATI will be reduced by depreciation, amortization, and depletion. Therefore, the deduction will likely decrease for many businesses at that point. Looking at our example above, if depreciation and amortization were included in the calculation of ATI, ABC corporation would have $52,150,000 of taxable income. The following shows this calculation:

ATI would be $74,500,000 because depreciation and amortization amount are not added back. ATI of $74,500,000 is then multiplied by 30%, which results in a limitation for business interest in the amount of $22,350,000. Taxable income ($74,500,000) is then reduced by the limitation amount ($22,350,000) to equal $52,150,000 of taxable income.

Conclusion

The new business interest expense limitation can be complicated, depending on the type of business and the business’s average gross receipts. For businesses that qualify to elect out of the limitation, it is important to compare the effects of the deduction limitation and the depreciation adjustments on overall taxable income for the current and future years. For businesses that will be subject to the limitation, planning should focus on the method of providing future financing since the limitation may restrict cash flow.

Please consult your tax advisor or a member of the HBK Tax Advisory Group to determine whether or not this limitation applies to your business.

A look at the Supreme Court case that could mean major taxation changes for many business owners.

History of the Case

In 1992, the Supreme Court made a decision that has, so far, stood the test of time and shaped how states impose sales tax on businesses. Quill v. North Dakota involved Quill Corp., a company distributing ads, catalogs, flyers, and floppy disks into North Dakota, and North Dakota’s attempt to impose sales tax on Quill Corp. for their “regular or systematic solicitation” of consumers within the state. The Supreme Court’s decision in Quill cemented what we now know as the “physical presence test,” which requires a physical presence, or a tangible connection, between a state and a business in order for that state to impose taxing obligations. For more than twenty years, states have modeled their taxing systems around the limitations imposed under Quill, and anyone engaged in e-commerce knows that understanding where their physical presence or “nexus” lies is critical in determining their tax collection and filing requirements within a state.

Since Quill, many states have attempted to broaden their taxing authority while still meeting the requirements set forth under Quill’s physical presence test. Quill was decided before the boom of e-commerce and large internet retailers, in a time when mail order catalogs were often used for interstate sales. An e-commerce business without physical presence in a state cannot be required to charge sales tax on purchases within it since they lack sufficient nexus. Arguably, this has created a large deficit in a state’s taxing ability and the revenue that states are able to generate as e-commerce continues to grow and deepen in the marketplace. South Dakota, intent on challenging Quill, has now forced the Court’s hand into making a determination as to whether Quill should be overturned now that e-commerce is common.

In March of 2016, South Dakota passed S.B. 106, which imposed sales tax registration and collection obligations on sellers that lacked physical presence within a state if the seller in the current or previous calendar year had gross revenue from sales of tangible personal property (TPP) and services delivered within the state exceeding $100,000, or sold TPP and services for delivery into the state in 200 or more separate transactions. Following this bill, South Dakota sued four out-of-state retailers seeking to affirm the validity of S.B. 106. One of the retailers registered and chose to collect sales tax, and the remaining three moved for summary judgment, which was granted by the Supreme Court of South Dakota under the restrictions imposed by Quill. The U.S. Supreme Court granted certiorari of this case in January of 2017, agreeing to look at whether the precedent set under Quill should be called into question, or even potentially overturned.

South Dakota’s Argument

While it wouldn’t be unprecedented to see the Supreme Court overturn Quill, this is not an easy argument for South Dakota to win. Under the principle of stare decisis, overturning a prior precedent set by the Court requires a demonstration of “special justifications.” The Court will consider whether their prior decision is inconsistent with other decisions, and whether the holding in Quill was harmful, important, or detrimental to the doctrine at issue. The court will also determine whether Quill should be overturned due to a change in circumstance, and will analyze the distinguishing factors between Wayfair and Quill, focusing on any statutory or constitutional interpretations that may factor into the facts of these cases.

On Tuesday, April 17, 2018, the Supreme Court began hearing oral arguments in South Dakota v. Wayfair. Among some of the more frequent concerns raised by the Justices is the concern over the immense administrative burden that making such a “binary” decision to overturn Quill would have on both states and small businesses. Immediately, the Attorney General for South Dakota was met with questions from the Justices voicing these concerns. Justice Sonia Sotomayor, stating she was “concerned about the many unanswered questions that overturning precedents will create,” indicated that this would ensure an influx of lawsuits surrounding such a massive change. Justice Sotomayor also vocalized concerns over retroactive liability for sellers if the Court were to change the physical presence standard, which would only increase the administrative burden on small businesses.

While these administrative concerns are immense, South Dakota also has a strong argument that states could lose billions in revenue over the next decade if they are unable to fully tax retailers within the e-commerce marketplace. Chief Justice John Roberts noted that, as a country we may be past the point in our history where major e-commerce-based retailers are refusing to collect and remit sales tax. He noted that the major five players in this field already comply across the board (Amazon, for instance, has long charged sales tax appropriately throughout the country). His statements highlighted the fact that these large retailers are still successful, even while complying with varying state taxing liabilities. Chief Justice Roberts noted that large e-commerce retailers no longer refuse to collect sales tax in order to enjoy a price advantage over brick and mortar stores. He said, “…if it is, in fact, a problem that is diminishing rather than expanding, why doesn’t that suggest that there [is] greater significance to the arguments that we should leave Quill in place?” The Justices noted that these larger players in the marketplace that are not of any state’s primary concern at present nor will they will necessarily feel an increased burden if Quill is overturned. Rather, small businesses will feel the impact first.

Many of the arguments have come down to whether the Supreme Court should be deciding this issue, or whether action by Congress would be more appropriate. While South Dakota argued that Congress has had more than twenty years to act, thus allowing the Court to step in, the Justices were prompt to point out that “this is something [Congress is] going to leave the way it has been for, whatever it is, 25 years.” The Court also noted that “it would be very strange for [the Supreme Court] to tell Congress it ought to do something in any particular area.” Chief Justice Roberts brought up the possibility that this is an area that Congress has simply decided to avoid. On the other hand, Justice Elena Kagan cautioned that Congress’s inaction is reason enough to proceed carefully in overturning Quill. This inaction may have the effect of raising the bar as to what would be necessary to overturn another such monumental case.

Decision Expected this Summer

While it is unclear what the fate of Quill and Wayfair will be, it is certain that no decision from this Court will be entered into lightly. The Justices are rightly concerned with the practical impact that such a massive decision would have on small retailers, specifically the increased procedural burden e-commerce vendors would face if states were permitted to impose tax on businesses lacking physical presence. Many states are struggling to increase revenue and balance their budgets, especially after the passage of the Tax Cuts and Jobs Act (TCJA). The impact of TCJA makes it clear why South Dakota is attempting to broaden its taxing authority. However, it is wise to keep in mind what overturning Quill could mean for all sides. We are in an age where the law and technology are in a constant race against each other. If Quill remains, the Wayfair case could spark a flood of new laws from states attempting to define and re-define what digital touches to a state are consistent with Quill.

A decision from this case is expected around the end of June. HBK will continue to monitor this case and its potential affect on our clients, associates and colleagues. Please contact Cassandra Baubie at cbaubie@hbkcpa.com or 330-758-8613 with any questions.

The Tax Cuts and Jobs Act (TCJA) means several changes in the depreciation and expensing of vehicles used in a taxpayer’s trade or business.

Vehicles not subject to these limitations are detailed below, as are other types of property that are subject to general provisions also explained below. Under the TCJA, §179 expensing has increased to $1 million and the phase-out threshold has increased to $2.5 million for qualified assets placed in service during tax years beginning on or after January 1, 2018. Previously, taxpayers were limited to $500,000 in §179 expensing and the phase-out threshold was $2 million.

Prior to the TCJA, taxpayers were permitted a deduction of 50% the cost of certain types of new tangible property the year it was placed in service. One hundred percent bonus deprecation is now allowed for qualified property acquired and placed in service after September 27, 2017, but before January 1, 2023. If property was acquired prior to September 28, 2017, but not placed in service until after September 27, 2017, then prior year rules will continue to apply. After 2022, the rate of bonus depreciation decreases over the next four (4) years:

• 80% for property placed in service in 2023
• 60% for property placed in service in 2024
• 40% for property placed in service in 2025
• 20% for property placed in service in 2026

With regard to passenger automobiles, §280F(a) provides dollar limitations on depreciation and §179 expense deductions that a taxpayer may take for “luxury automobiles.” Any vehicle of 6,000 pounds of gross vehicle weight or less is considered a “luxury automobile.” Vehicles under this weight limitation are subject to the 280F limitations, which limit the available depreciation and §179 deductions.

Limitations on “Luxury Automobiles”

“Luxury automobiles” that are placed into service after December 31, 2017, will be able to take advantage of the increased dollar limitations on deprecation and expensing under the TCJA. For 2018, the amount of depreciation and expensing deductions for a passenger car or light duty truck or van shall not exceed:

• $10,000 for the first taxable year in the recovery period,
• $16,000 for the second taxable year in the recovery period,
• $9,600 for the third taxable year in the recovery period, and
• $5,760 for each succeeding taxable year in the recovery period.

These numbers will be adjusted for inflation after the 2018 tax year. The TCJA retained the $8,000 limit for additional first-year depreciation for passenger automobiles. Therefore, in 2018, the maximum amount a taxpayer can deduct in the first year is $18,000.

§179 Limitations on SUV’s

§280F limits §179 deductions to $11,160 for vehicles up to 6,000 lbs. in 2017 and $18,000 in 2018 and beyond. Those SUVs with a gross vehicle weight above 6,000 lbs. (but not above 14,000 lbs.), are limited to a $25,000 §179 deduction. Vehicles that are above 6,000 lbs. but not more than 14,000 lbs. are not subject to the §179 $25,000 limit if any of the following exceptions apply:

• The vehicle is designed to have a seating capacity of more than nine persons behind the driver’s seat,
• The vehicle is equipped with a cargo area of at least 6 feet in length that is considered an open area or is designed for use as an open area but is enclosed by a cap and is not readily accessible directly from the passenger compartment or,
• The vehicle has an integral enclosure, fully enclosing the driver compartment and load-carrying device, but does not have seating behind the driver’s seat, and has no body section protruding more than 30 inches ahead of the leading edge of the windshield.

SUVs purchased after September 27, 2017 remain subject to the $25,000 §179 limit, however, both new and used vehicles are eligible for 100% bonus depreciation if they are above 6,000 lbs. For a taxpayer’s first taxable year ending after Sept. 27, 2017, that taxpayer may elect to apply a 50% allowance instead of the 100% allowance. To make this election, the taxpayer must attach a statement to their timely filed return indicating that they are electing to claim a 50% special depreciation allowance for all qualified property. Once made, the election cannot be revoked without consent of the IRS. Taxpayers may also elect out of bonus entirely for any class of property by filing an election on a timely filed return. Once filed, this election too cannot be revoked without consent of the IRS.

Please note that all of these deductions will be further limited by the business use percentage of the vehicle in question. Furthermore, if business use of the vehicle is below 50% use of the accelerated method is not permitted.

Comparison
The following is a comparison of the tax treatment of vehicles prior to and under the TCJA. Both of these comparisons assume $8,000 of bonus depreciation.

For automobiles subject to the 280F limitations that were placed in service prior to September 28, 2017, bonus depreciation is not available. Furthermore, bonus depreciation is not available on used vehicles placed in service prior to September 28, 2017. The following limitations will apply to vehicles placed in service in 2017 for which bonus depreciation does not apply:

• First Tax Year: $3,160
• Second Tax Year: $5,100
• Third Tax Year: $3,050
• Each Succeeding Year: $1,875

Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers were permitted to deduct interest on home equity debt. That was true specifically for those debts which were secured by the taxpayer’s home and were not an “acquisition indebtedness” (such as those incurred acquiring, constructing or improving a home).

Through Code §163(h)(3)(F), the TCJA eliminated the deduction for interest on home equity debt for tax years beginning after December 31, 2017 and before January 1, 2026. This was applicable regardless of when the home equity debt had occurred.

Through Informational Release IR 2018-32, the IRS clarifies that, although restricted by the TCJA, taxpayers can still deduct interest on many home equity loans, home equity lines of credit, or second mortgages. The IRS states that TCJA suspends the deduction for interest paid on home equity loans and lines of credit when they are used for something other than the purchase of, building of or substantial improvement of that taxpayers home that secures the loan.

This Informational Release also clarifies the new dollar limitations on total qualified residence loans for those taxpayers considering taking out a mortgage. The TCJA imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. For tax years after December 31, 2017, taxpayers may only deduct interest on $750,000 of qualified residence loans. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home, as well as a second home.

In order to qualify for this deduction, the home equity loan must be considered “acquisition indebtedness,” which is essential debt secured by a home and used to acquire, construct, or substantially improve the home. If the home equity line qualifies as acquisition indebtedness, the interest should be deductible, subject to the new principal balance limitations ($750,000 for debts incurred after December 15, 2017). If the principal balance of the mortgage and the equity line combined is in excess of this limitation, the interest deduction will be limited.

The following examples illustrate these updates.

Example 1: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home with a fair market value of $800,000. In February 2018, the taxpayer takes out a $250,000 home equity loan to put an addition on the main home and both loans are secured and the total does not exceed the cost of the home. Because the total amount of both loans does not exceed $750,000, all of the interest paid on the loans is deductible. However, if the taxpayer used the home equity loan proceeds for personal expenses, such as paying off student loan and/or credit card debt, then the interest on the home equity loan would not be deductible.

Example 2: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home and the loan is secured. In February 2018, the taxpayer takes out a $250,000 loan to purchase a vacation home and the loan is secured. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. However, if the taxpayer took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible.

Example 3: In January 2018, a taxpayer takes out a $500,000 mortgage to purchase a main home and the loan is secured. In February 2018, the taxpayer takes out a $500,000 loan to purchase a vacation home and the loan is secured. Because the total amount of both mortgages exceeds $750,000, not all of the interest paid on the mortgages is deductible.

For questions on this or any other provision of the Tax Cuts and Jobs Act please contact a member of the HBK Tax Advisory Group.

The Tax Cuts and Jobs Act contains several provisions that impact farmers and agricultural cooperatives. The most significant changes for both include the elimination of the Domestic Production Activities Deduction (DPAD) and creation of a new Section 199A deduction.

How It Impacts Farmers and Agricultural Co-Ops

Essentially, under this new provision, the deduction is calculated as the lesser of 20% of gross income less distributions to patrons, or 50% of the cooperative’s W-2 wages, however it cannot exceed taxable income. The Tax Cuts and Jobs Act also reduced the cooperative’s corporate income tax to 21 percent.

The changes to Section 199A would permit a deduction beginning after December 31, 2017 for the lesser of:

1. 20 percent of the excess of gross income of the specified agricultural or horticultural cooperative over the qualified cooperative dividends of the taxpayer during the tax ear for the tax year or
2. The greater of 50 percent the W-2 wages of the cooperative relating to the qualified trade or business or the sum of 25 percent of the W-2 wages relating to the qualified trade or business and 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property by the cooperative.

In Summary

Basically, the new provision provides a significantly larger deduction to certain farmers marketing their products through a cooperative organization than it offers to independent farmers. Agricultural trade groups and federal officials are now working to change this provision. Such a change would need to occur quickly because it is still unclear how and if the Tax Cuts and Jobs Act will be altered by Congress or through regulations.

Lawmakers and Federal Groups Weigh In on the Issue

On January 11, 2018 Republican Senators John Thune of South Dakota and John Hoeven of North Dakota, sponsors of the cooperative provisions, stated that there was no intention to “unfairly tip the scales in favor of marketing to one type of business entity or another.” Both Senators vowed to find a solution, jointly commenting, “…right now, in terms of the technical fixes, this is the one (issue) that probably needs to get fixed the most.”

The United States Department of Agriculture (USDA) also recently issued a press release on the matter stating, “The aim of the Tax Cuts and Jobs Act was to spur economic growth across the entire American economy, including in the agricultural sector. While the goal was to preserve benefits in Section 199A for cooperatives and their patrons, the unintended consequences of the current language disadvantage the independent operators in the same industry. The federal tax code should not pick winners and losers in the marketplace. We applaud Congress for acknowledging and moving to correct the disparity, and our expectation is that a solution is forthcoming. USDA stands ready to assist in any way necessary.”

We will provide updates on this provision as they become available. If you have questions about this or other aspects of the Tax Cuts and Jobs Act please contact Cassandra Baubie at cbaubie@hbkcpa.com or 330-758-8613.