NOTE: The following article is from the collection of our Automobile Dealership Buy/Sell Newsletter. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because 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.
There are a number of potential advantages of operating an automobile dealership as a Limited Liability Company (“LLC”), all states have enacted LLC statutes, and the use of LLCs has been gaining popularity
Until recently, there were generally three basic forms of organizations normally used for automobile dealerships, i.e., corporation, limited partnership, and general partnership. A few dealers also operate as a sole proprietor.
But now with the passage of LLC statutes, a LLC which is properly organized according to state law combines the liability protection of a corporation with the flexibility and tax benefits of a partnership. The owners of an LLC are called “members,” rather than partners of a partnership or shareholders of a corporation.
One of the primary benefits of an LLC is that, like a corporation, the LLC provides the owners (members) limited liability. The owners will have no personal liability for the liabilities and obligations of the LLC. This contrasts with a partnership, which does not protect from personal liability either general partners or limited partners who participate in management.
LLCs may be treated as partnerships for federal tax purposes. Thus, unlike a C corporation, the LLCs income is not subject to double taxation. Instead, the income or loss from the LLC entity passes through to the LLC members, who pay tax only once at their individual tax rates.
Although an S corporation provides a similar escape from double taxation, there are numerous restrictions on the number and types of owners permitted and with regard to the allocation and distribution of profit and loss. An LLC is not subject to these same restrictions. As a result, an LLC can provide much greater flexibility in creating an economic structure that meets its owners’ objectives.
Characteristics of an LLC
An LLC can elect to be taxed as a corporation, or as either a disregarded entity or a partnership. The determination depends on the number of owners. If an LLC is formed with a single member, it is a disregarded entity. If an LLC has two or more members, it can elect to be taxed as a partnership or a corporation.
Internal Revenue Code Section 754 Election
Whenever a member’s interest in an LLC is transferred by death or sale, Internal Revenue Code Section 754, dealing with partnership taxation, allows a partnership, or an LLC, to value the underlying assets (inventories, depreciable assets, etc.) which are attributable to the incoming member’s interest, at a value equal to the purchase price allocated to the assets if a sale, or fair market value if transferred by death. The election in effect authorizes the transferee of the LLC interest to make a special basis adjustment, placing the transferee in roughly the same position as if he or she had purchased the assets directly.
Effect of Election on Buyer of a Member’s Interest
The buyer of a member’s interest in an LLC receives a new basis on the assets of the LLC which are attributable to the member’s interest. If the interest is 80%, the new member will have a stepped-up basis in 80% of the LLC’s assets. This stepped-up basis will help the buyer shelter some of the income from the LLC because of greater depreciation deductions available to the buyer.
Effect of Election on the LLC
The LLC will have to keep track of the various basis and depreciation schedules. Some LLC agreements provide that any additional administrative costs are to be borne by the member benefiting from the election.
Effect of Election on the Seller
The seller still has to pay a capital gains tax on the gain over the seller’s basis with regard to the interest being sold. Because of the favorable consequences for the buyer, however, the seller may be able to receive a higher price for sale of the seller’s interest in the LLC.
Effect of Election on Death of a Member
If a 754 election is made upon the transfer of a member’s interest by reason of a member’s death, the buyer, or heir of the interest, has the same benefits as are set forth above when a member’s interest is sold.
Effect of Election on LIFO Reserve
During the past three decades, there has been an increase in the use of the LIFO inventory method of accounting by automobile dealerships. Many dealers are now contemplating their retirement and eventual divestiture of their interest in the dealership. The owner thus faces the income tax consequences of the LIFO reserve.
Terminating the LIFO method of inventory accounting will usually generate large income taxes. If the corporation’s stock is sold, the owner may be forced to reduce the selling price because of the LIFO reserve. If the owner sells the dealership’s assets, the corporation will recapture LIFO at the time of sale. If the 754 Election is made, the inventory values attributable to the new member’s interest are increased to reflect the purchase price paid, or their fair market value in the event of death. Thus, there would be no LIFO recapture, and a new inventory cost basis is established for the new member equal to that portion of the purchase price allocated to the inventory. The following is an example of the effect of the 754 election on an LLCs balance sheet. Remember, this balance sheet would be valid only as to the new member:
|Assets||Before Transfer||After Transfer||Adjustment|
|Inventory @ LIFO||5000||7000||2000|
|Liabilities & Equity|
|Total Liabilities and Equity||6,750||9,550|
The book value of the company in the example will be increased by $2,800 without paying income taxes on the assets whose value has been stepped-up to fair market value, and the buyer will recognize the full benefit of the stepped-up value because of a higher depreciation basis.
The above are just some of the considerations in analyzing whether a dealership should be organized as an LLC. Competent professional advice must be sought in this area because these types of elections have many ramifications that must be examined, and they may place the partners in conflicting positions. It should be pointed out that with regard to existing S and C corporations; there may be disadvantageous tax results if these entities are converted to an LLC.
This article was written in 1996 and updated in 2012
This article was written in 1996.