Danger Areas in buying/selling operating assets

Floyd Clem

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. 

This article is intended to alert potential buyers and sellers of automobile dealerships of danger areas in these transactions, particularly in the area of buying and selling operating assets. [We will leave questions about buying and selling (or leasing) physical facilities for another column.]

At first glance the valuation of these assets would appear relatively straightforward and easy to determine. But there are several problem areas both buyers and sellers need to watch:

VALUING NEW VEHICLE INVENTORIES: New, current model year vehicles are usually priced at the factory invoice cost. Buyers Beware! This can be a trap … because the factory invoice may include charges above the cost of the actual vehicle-such as dealer holdback, advertising association charges, finance participation, new vehicle prep and conditioning and other miscellaneous items. Many of these items may have already been received by the selling dealer. Therefore, a buyer agreeing to acquire new vehicle inventory at dealer invoice may, in fact, be paying substantial costs for which he will receive no benefit. I recommend that the buy-sell agreements specify that new vehicle inventories will be acquired at the net vehicle invoice cost, excluding items that have been paid to the selling dealer or that have no future value.

VALUING USED VEHICLE INVENTORIES: The value of used vehicle inventory is usually determined by a wholesale appraisal, prepared by someone independent of either the buyer or the seller. In lieu of such appraisal the typical buy-sell agreement should provide that the buyer does not have to acquire any used vehicles which he believes are overvalued. The larger problem in the transfer of used vehicles is in the legal disclosure area. Appropriate warranties should be obtained with respect to used vehicle inventories, certifying the correctness of all odometer readings, and disclosure of previous accidents and repairs. Buyers should inspect the titles on all used vehicles because titles that are not clear or from out-of-state can later cause unnecessary and costly delays in the resale of these vehicles.

VALUING PARTS INVENTORIES: The value of a parts inventory is usually determined by pricing the inventory at current replacement cost based on factory parts catalog. The actual amount of inventory is based on the findings of an independent inventory service as of the date of close. But this method does not take into consideration obsolete and slow-moving parts inventory, non-returnable parts, and the salability and value of non-factory parts or accessories. Buyers Beware! Agreements that remain silent on the valuation of these parts of inventory generally benefit the seller.

VALUING FIXED ASSETS: Valuing furniture, fixtures, machinery and shop equipment is the most difficult area of a buy-sell agreement. The transfer of fixed assets is subject to sales tax. If the buy-sell agreement is silent with respect to the party responsible for the payment of such sales tax, the selling dealer will ultimately pay the sales tax. Also, I recommend that a purchasing dealer either insist upon an independent appraisal of the fixed assets or, at a minimum, obtain a detailed listing of the assets being acquired and perform his own inspection to determine that all assets being acquired are physically on the premises and in operating condition.

VALUING BLUE SKY: This is the valuation of everything beyond the hard assets. Some call it “goodwill,” “franchise value” and/or “blue sky.” The allocation of this negotiated amount is especially important to both the buyer and the seller. The seller will typically want to allocate this cost to some form of asset that will create a capital gain. The buyer will typically want to allocate this value in a manner that will obtain the lowest tax consequences. Since the Tax Reform Act of 1986, when the tax rates on capital gains and ordinary income were the same, it has been fairly typical for “blue sky” to be allocated to a covenant not to compete, and/or to a consulting agreement because either results in tax deductible payments by the buying dealer and in ordinary income to the seller. Since 1990, the marginal top tax rate on capital gains has been 28% and the rate on ordinary income increased to 31% but this difference has been small enough not to create great conflicts between the parties. However, President Clinton’s proposed increases in the tax rate on ordinary income would create an even greater disparity and thus more likelihood of controversy on how “blue sky” is paid.

So I strongly recommend that you keep a keen ear tuned to President Clinton’s proposed tax changes because they may well impact your negotiations. I also recommend strongly that buyer and seller thoroughly review the proposed agreements as to the value and structure of “blue sky” with their attorneys and CPAs in order to ensure that they qualify as you expect them to under Internal Revenue Service Regulations.

We hope to deal in more depth with other specific problems relating to buy-sell agreements in the future, among them the sale of corporate stock versus an asset sale, and step transactions involving buy-sells over an extended period. In the meantime, good buying and selling….

This article was written in 1993.

Floyd Clifford Clem, a partner in the accounting firm of Rogers & Clem, has been giving businessmen in the Inland Empire and Los Angeles basin the guidance they need to fight through red tape and tax regulations and overcome those technical glitches since he graduated from Cal State Long Beach in 1965. As a businessman (an accounting firm is, of course, a business as well), Clem has been greatly successful as well. His firm currently employs about 24 people, including 11 Certified Public Accountants. The company is headquartered in a spacious Covina office building and maintains an office in Upland as well. Mr. Clem is a Covina-based CPA with Rogers, Clem & Co., who focuses his practice on service to the automobile industry. He can be reached at 818-858-5100.