LIFO and buy-sell agreements

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided. 

Many different tax aspects must be considered when buying or selling an automobile dealership. One of the most critical items in terms of total dollars is the consideration given to a dealership’s LIFO reserve.

It can be said that a LIFO reserve is the ultimate tax deferral. Many dealers have LIFO reserves dating back to the mid 1970s and have, over the years, accumulated accounts in excess of a million dollars. As the LIFO reserves have accumulated tax deductions which have been enjoyed by the dealership and its owners, the result has generally enhanced dealership working capital. In fact, the LIFO reserve can be looked at as an interest free loan to be repaid at a point in the future. Often that point is when the ownership changes in a buy-sell.

The impact of the LIFO reserve can vary depending on how the transaction is handled. If the dealership buy-sell is an asset sale, the selling dealership entity would likely recapture the entire LIFO reserve as ordinary income in the year of sale. In this instance the actual tax liability on the LIFO reserve has been triggered in full.

Remember, the use of the LIFO inventory method is a tax deferral, not a permanent tax deduction. Regardless of a potential buy-sell, consideration should be given to saving or “earmarking” the cash flow from LIFO deductions so that funds will be available in the future to pay the tax liability upon liquidation of the LIFO reserve.

In a sale of stock of a dealership corporation, the impact of the LIFO reserve is quite different from an asset sale. When valuing the stock, the book net worth is generally increased by the LIFO reserves and decreased to compensate for an estimate of the future income tax impact on the LIFO reserves.

There is typically no triggering mechanism to recapture any of the LIFO reserves as no sale of LIFO inventories has occurred and, assuming the corporation continues to comply with IRS regulations regarding LIFO, it is possible to have corporate shares change hands an infinite number of times with no LIFO tax liability recognized.

Nevertheless, the purchase price of the stock will definitely be impacted by the LIFO reserves. In essence, the buyer is acquiring the future tax liability from the seller. Other things being equal, this feature in a stock sale generally allows the buyer to buy in for less money than an asset sale because the LIFO tax liability is yet to be realized. Of course, many other considerations play a part in the willingness to buy stock including liabilities and contingencies of the acquired corporation.

The following example compares the results on an asset versus stock sale given the same parameters:

EXAMPLE

ABC Inc. dealership buy-sell has the following key figures and assumptions:

• No contingencies considered

• Effective tax using current highest federal individual income tax rates and assuming S corporation status.

• Ordinary income rate 39.6%-LIFO reserve

• Capital gain rate 28%-Goodwill

• Stockholders equity = cost basis in stock

• No purchase considered for fixed assets, used vehicles or parts inventory.

Given the above facts in an asset sale, a seller would net $1,464,000 after federal income taxes of $536,000. By contrast, the same seller in a stock sale would net $1,294,880 after federal income taxes of $309,120. This is a function of the timing of the tax impact on LIFO reserves between the two methods. Which tax rate should be used to value the tax effect of LIFO in a stock sale? In the age of S corporations where income is primarily taxed at the shareholder level it would appear to be appropriate to use the highest individual rate for ordinary income (39.6%). However, for C corporations, the appropriate rate might be the predominant corporate rate (34%). In the end, the use of a tax rate in the calculation of the tax effect of LIFO should be a negotiated item simply because the actual rate to be paid is unknown at the time of sale.

The buyer in the stock sale has a potentially larger stock basis than the buyer in an asset sale due to the new capital requirements of the acquiring corporation.

As with any taxable transaction, the individual circumstances surrounding each particular buy-sell will influence the treatment of LIFO reserves in the structuring of a sale. Some additional considerations are as follows:

• In a stock purchase of a C corporation, what is the intent of the new owners with respect to electing S status? If the new dealer wishes to become an S corporation, the tax effect of LIFO reserves can be calculated with certainty as under IRS regulations the C corporation must recapture all LIFO amounts as ordinary income in its final tax year as a C corporation. In this situation the IRS requires the corporation pay the LIFO tax recaptured ratably over a four year period without interest.

• The dealer buying stock in a corporation using the LIFO method of accounting should inquire as to what types of LIFO elections were made and if the dealership is in current compliance with the Internal Revenue Code. Have the new procedures under Revenue Procedure 92-79 been elected and properly interpreted by the corporation?

• To the extent the purchase price of the dealership goodwill relates to a multiple of earnings, does LIFO play a role? Yes, as any dealer who has been on LIFO knows, the deductions or income attributable to LIFO which are required to be reflected on the financial statements can dramatically affect the net profit of the dealership. In order to truly determine “before LIFO earnings,” LIFO adjustments should be extracted from profit or loss, remembering for this purpose the current LIFO adjustment is the income/deduction effect of the net change in the LIFO reserve only for the financial period covered and not the entire cumulative LIFO reserve. For example, a dealership which makes $100,000 net profit after a $150,000 LIFO deduction should be considered to have earned $250,000 for the purposes of a multiple of earnings calculation.

• Are net operating losses of a C corporation available to offset future LIFO recapture under the stock ownership change rules of IRC section 382, Sometimes a net operating loss is a direct result of an accumulation of prior years’ LIFO deductions. Unfortunately, if the corporate stock is sold, under certain circumstances IRC Section 382 can severely limit the availability of the pre-ownership change net operating loss to offset future income, including LIFO recapture. This is a particularly complex tax issue which should be explored by professional tax advisors on a case by case basis.

While the ongoing use of the LIFO method generally yields favorable tax results, its benefits are often forgotten in buy-sell agreements as parties deal with its liabilities.

This article was written in 1995.