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.
The choice of business entity should include a matrix of decision topics. Primary topics include the entity’s operating characteristics, short-term and long-term strategies, owner characteristics, liability profiles and tax issues. Although the following discussion focuses primarily on tax considerations, it is assumed that the entity warrants liability protection, therefore eliminating the sole proprietorship and general partnership as viable choices of entity. All of the entities mentioned below, if properly structured, limit liability to protect the owners.
It is common for a dealership to operate as a C corporation, S corporation or Limited Liability Company (“LLC”). The taxable income or loss of an S corporation and LLC passes through to the owners and thereby skips the federal tax at the entity level. Consequently, S corporations and LLC’s (along with partnerships) are known as pass-through entities.
California does assess entity level taxes and fees. S corporations and LLC’s both have a minimum annual $800 tax. An S corporation pays the greater of this $800 or 1.5% of its taxable income. A LLC pays an additional annual fee based on the chart below. “Total Income Level” is based on a gross income formula. To simplify matters, consider this LLC tax, and the chart below, to be based on total entity revenue.
|R&TC §17942 sets the annual LLC fee.|
|Total Gross Income Level||Years Beginning in 2001 and 2002|
|$250,000 or more, but less than $500,000||$900|
|$500,000 or more, but less than $1,000,000||$2,500|
|$1,000,000 or more, but less than $5,000,000||$6,000|
|$5,000,000 or more||$11,790|
Except for these state taxes and fees, pass-through entities pay a single level tax (at the owner level only), whereas the C corporation can pay a tax at the entity level and the owner will pay tax again based on any profits (dividends) distributed to the owner from the C corporation. These dividends result in a double tax on the same C corporation earnings. Therefore, most closely held C corporations rarely pay out dividends to the individual stockholders.
Retained Earnings and Excessive Compensation Issues
Since most closely held C corporations rarely pay dividends, the IRS may look for excessive accumulated earnings and excessive compensation to stockholders.
Excessive Accumulated Earnings Tax (AET): The AET does not apply to a pass-through entity. The aim of the accumulated earnings tax is to prevent a C corporation from accumulating income in order to shelter its stockholders from the individual income taxes that they would have to pay if the corporation’s income were distributed to them as dividends. The IRS imposes an additional tax on C corporate earnings and profits that are accumulated in excess of reasonable business needs. For tax years beginning after December 31, 2002 the rate has been reduced from 38.6% to 15%. Some accumulation is allowed without the risk of additional tax liability, but amounts in excess of $250,000 ($150,000 for service-type corporations) may be examined by the IRS.
Consequently, the IRS must pass judgment on numerous business reasons to accumulate earnings. However, one of the most common acceptable reasons is to provide capital for planned expansion for internal growth or via franchise acquisitions. Recently, the courts have started to focus on liquidity as they now realize that accumulated earnings are only the starting point. Moreover, the real issue is whether or not the C corporation had the requisite liquidity available to have made a dividend distribution.
Excessive Compensation: Significant salaries can be paid to stockholders and deducted by a dealership if they are reasonable. Just what constitutes “reasonable” compensation is based on the facts and circumstances of each situation. After years of disagreements brought to trial, the IRS and the courts have yet to develop a bright line test for determining what is reasonable, although rules governing public companies prohibit deduction of an employee’s compensation in excess of $1,000,000.
In any case, you should ask your attorneys or tax accountants for a brief synopsis of your potential for excess compensation and the accumulated earnings tax (if you operate the dealership as a C corporation).
Although the disadvantages of a C corporation include the possibilities of the double tax and accumulated earnings tax, the C Corporate form does offer several advantages: 1) C corporations can have any person or entity as a stockholder. S corporations make certain persons ineligible as stockholders. For example, partnerships and certain trusts cannot be stockholders in an S corporation; 2) An S corporation is limited to 75 stockholders. A C corporation has no such limitation; 3) C corporations are used in parent – subsidiary groups. These groups typically involve numerous commonly controlled companies that most likely file one consolidated tax return; 4) C corporations generally allow the deductibility of the owners’ fringe benefits without taxability to the owners. On the other hand, pass-through entities disallow the deductibility for owners’ fringe benefits such as life, medical, and long-term care insurance, and access to a section 125 cafeteria plan; and 5) the income retained or distributed from a C or S corporation is not subject to self-employment tax. As discussed below, the income of a LLC may be subject to self-employment tax.
Some Disadvantages of Pass-Through Entities
1) As mentioned above C corporations are the best entity for deducting the owner’s fringe benefits without resulting in taxable income to the owner. It is likely that the same fringe benefits provided to the owner of pass-through entities will be taxable to the owner. However, any health insurance premiums taxable to an individual owner will be 100% deductible from adjusted gross income on the individual’s tax return (form 1040).
2) The remaining profits in C and S corporations (after the payment of wages to the owners) are not subject to self-employment tax. However, if you are an active or managing member in a LLC, your business income from the LLC (not including portfolio or rental income) will be subject to self-employment tax.
For example, assume your share of LLC business income is $500,000 and this represents all of your income from all sources. The self-employment tax for 2003 will be 15.3% of the first $87,000 and 2.9% of the remaining 413,000, which totals $25,288 of self-employment tax. In addition, assume the LLC’s total revenue resulted in the highest LLC entity level fee of $11,790 plus the $800 minimum tax. Altogether, this results in $37,878 in taxes and fees.
If the above involved an S corporation, the self-employment tax would be $13,311 (assuming wages paid to the owner of $87,000). The California entity level tax would then be $413,000 times 1.5% or $6,195.
The above S corporation’s tax cost is $19,506 versus $37,878 for the LLC. The major difference in incremental tax cost between a highly profitable S corporation and LLC results from the fact that all business income from a LLC will be subject to the aforementioned unlimited Medicare tax at the 2.9% rate, which exceeds the 1.5% S corporation tax rate. The self employment tax hit faced by LLC members is somewhat mitigated by the fact that individuals can deduct 50% of their self-employment tax from adjusted gross income on their individual tax return (form 1040).
Most likely, if you are not a passive member of a highly profitable dealership, you will likely be subject to self-employment tax, which also includes the 2.9% unlimited Medicare tax. In this case, it will be more expensive to operate as a LLC than an S corporation. Further, there is no guaranty that the state of California will not continue to raise the LLC fees on total revenue.
3) If your dealership has high total revenue and low net income you should consider (from a tax expense perspective) an S corporation to avoid the LLC fee based on total revenue.
Pass-Through Entities Mitigate the Tax on Disposition
Consider you invest $200,000 in both a C corporation and a pass-through entity. In addition, assume for the following nine years each entity’s taxable income is $200,000 per year. Also, during the same time no dividends or distributions are paid by either entity. At this point we will assume your individual tax liability was equal to the C corporation’s entity level taxes.
Now you sell your stock in each entity for $2,000,000. Your sale of stock in the C corporation results in a $1,800,000 long-term capital gain and an approximate federal tax liability on your individual tax return of $270,000. On the other hand, your sale of the pass-through ownership has zero gain. Your pass-through $200,000 investment (tax basis) was increased by the pass-through income ($1,800,000), which results in a tax basis of $2,000,000, and zero gain on the sale.
As evident from the above, despite some advantages of a C corporation and disadvantages of a pass-through entity, family or closely held businesses should most likely be a pass-through entity. This general statement results from several common themes. First, the double tax – if it does not kick-in with the taxation of current dividends, it can carry a nasty tax bite when you sell your ownership in a C corporation. This is due to differences in the “at risk” calculations between C corporations versus pass-through entities, which are discussed below. And, despite the possibility of a higher self-employment tax for LLC members, we cannot rule out LLCs as a viable and attractive entity. LLC’s offer flexibility in the allocation of income and loss, and qualified LLC debt may be allocated to members when calculating their amount “at risk” from which to take any net losses generated by the LLC. The “at risk” concept is discussed under the “Allocation of Debt” section below.
LLCs in the Context of Amounts “At Risk”
the Ability to Deduct Tax Losses
In general, you can deduct tax losses to the extent of your adjusted investment and allocable qualified debt. This is known as the amount that you are “at risk.” In a pass-through entity your amount at risk includes invested capital plus allocated income and qualified liabilities, less allocated losses and distributions. LLC’s and S corporations have different rules for allocating debt. For example, assume you invest $100,000 in a business and the business takes a loan of $200,000 from a bank. At the end of the first year the business has a tax loss of $250,000.
If you operated the business as a LLC your amount at risk may include the $200,000 bank loan and your $100,000 capital investment. Your total loss of $250,000 would be allowed because the amount at risk exceeds the amount of the loss. Your amount at risk carried over into the subsequent year (assuming no principal reduction on the bank loan) would be $50,000. Therefore in the second year, any loss in excess of $50,000 would be suspended until you acquired additional amounts at risk. Alternatively, the excess loss can be held in suspense and used to offset future net income from the pass-through entity.
On the other hand, if you owned the business as an S corporation stockholder your amount at risk is your investment plus funds that you directly loan to the S corporation. The loan from the bank does not count because it was obtained by the corporation. Note that personal guarantees on S corporation borrowings do not add to your amount at risk. Therefore, your amount at risk is limited to your $100,000 capital investment. The allowed loss is $100,000 and the suspended loss is $150,000. However, if you obtained the bank loan personally and then loaned the $200,000 to the S corporation, the loan would increase your amount at risk. In this situation, you would be allowed to deduct the $250,000 loss.
Against the background of the above discussion consider a transaction involving obtaining a new mortgage for a multi-million dollar real estate acquisition. You probably would not consider obtaining the loan personally and then loaning the funds directly to an S corporation in order to increase your amount at risk. From a practical standpoint, the entity would obtain the real estate loan. Therefore, a LLC (or partnership) is the preferred entity to obtain the loan because of the allocation of qualified debt.
LLC’s – Flexibility
LLC’s offers the flexibility of a partnership when it comes to the allocation of income and losses. This differs from an S corporation, which must allocate income, losses and make distributions in exact proportion to the ownership percentages. For example, suppose a LLC with several owners has a significant loss. The owners can agree to allocate the loss without regard to the ownership percentage if the LLC agreement is properly drafted. This could be a tremendous advantage if some owners are in high tax brackets and others are in much lower tax brackets. Or, the owners with insufficient amounts at risk from which to take the losses could have their losses allocated to other owners that possess sufficient amounts at risk and can benefit from deducting the tax loss.
Next, a distribution of property to a stockholder from a C corporation is usually taxed as a dividend based on the property’s fair market value. In many cases property can be distributed to members of a LLC without tax. In general, this is one of the reasons why it is advisable to not hold highly appreciating assets and real estate inside either a C corporation or S corporation.
The flexibility to make property distributions can also be helpful in situations where a multi-point dealership spins off a franchise to a new LLC. This commonly occurs when the franchise has a key manager that is ready for ownership. However, in many cases it makes sense to limit the ownership to the key manager’s franchise. This often makes practical sense because the buy-in of the whole dealership by the key manager is often beyond their financial means.
However, the price of the buy-in to the new LLC is usually significantly less after the franchise and its related assets are separated out of the whole dealership entity and moved into the new LLC. Furthermore, the key manager’s financial success is aligned with the success of the new LLC.
This spin-off technique is also available to corporations. However, corporations have significantly more detailed rules and pitfalls to deal with compared to those of a LLC.
Akin to the spin-off idea, an LLC also can be structured and funded with specific assets to facilitate the estate planning process. LLC’s offer substantially more flexibility than S corporations. As mentioned previously, an S corporation must allocate income, losses and distributions in exact proportion to the ownership percentages. This restriction may inhibit the implementation of the most efficient estate plan.
The Final Choice
As can be seen from the above discussion, many different factors must be taken into consideration when determining the best choice of entity for a business venture and no single article can attempt to cover in detail all choice of entity alternatives. However, the above information is provided as a summary of several mainstream topics that can be amplified by your team of professional advisors when helping you make the right choice of entity decision for your dealership operation.
This article was written in 2003.