Will cash method soon be a choice for BHPH dealerships?

HOUSTON - 

So you have heard over the years that independent dealers cannot use the cash method of accounting and must use the accrual method, which is correct. You have been told about the benefits of a related finance company and how having one can mitigate much of the tax due to the revenue recognition under the accrual method that makes it difficult to operate a buy-here, pay-here dealership. This is all centered on the fact that an inventory is necessary to clearly show income when the purchase or sale of merchandise is an income producing factor. Therefore under the current tax code you must use the accrual method of accounting for your purchases and sales for tax purposes. 

Did you know that in the Tax Cuts and Jobs Act Bill (H.R.1) released on Nov. 2 by Congress contains a Small Business Relief provision that would indeed allow inventory to be counted as “non-incidental materials and supplies” for companies with revenue less than $25million. Most BHPH operations have gross receipts less than $25 million. This bill has the potential to help countless BHPH dealers. However, it is uncertain whether the bill will be passed into law.

How would it help? Current law requires dealers to use the accrual method of accounting. So every vehicle sold is taxed on income that has not been received yet by the dealer. Let’s take the following examples of XYZ Auto Sales.

In late December XYZ purchased the vehicle from auction for $4,000 and had $1,000 reconditioning and incidental costs. XYZ sold the vehicle to a customer for $11,000 in exchange for a $1,000 down payment and a retail installment sales contract for the remaining $10,000. The Fair Market Value of the Note is estimated to be $6,300. At the end of the year, XYZ has their taxes properly prepared and shows the following:

Sales Finance Transaction Accrual Basis
 Gross Sales Price  $11,000
 Cost of Goods Sold  ($4,000)
 Reconditioning Cost  ($1,000)
 Taxable Income  $6,000
 40% Tax Rate  $2,400
Cash Position
 Down Payment  $1,000
 Cost of Goods Sold  ($4,000)
 Reconditioning Costs  ($1,000)
 Total Cash Deficit  ($4,000)

 

As you can see, XYZ is going to be taxed on a transaction that even though they have not received much cash. We refer to it as “phantom income.” The cash method has the potential to mitigate this problem, and only tax the dealer on the estimated fair market value of the contract what was actually received less expenses.

Sales Finance Transaction Cash Basis
 FMV of Installment Contract  $6,300
 Down Payment  $1,000
 Cost of Goods Sold  ($4,000)
 Reconditioning Cost  ($1,000)
 Taxable Income  $2,300
 40% Tax Rate  $920

 

But wait! What does fair market value have to do with the cash basis of accounting? Well, the issue is that an installment sales contract is a deferred-payment obligation which is readily marketable and immediately convertible to cash. Therefore even under the cash method you still must recognize the FMV of the contract into income. And to do so, you need to be able to estimate your losses using static pool performance to assign a fair market value that can withstand IRS Scrutiny. But this is still a significant tax savings, in this example a 61.7 percent decrease in tax! Talk with your CPA on how this could impact your own operation.

As always there are many hurdles before the Tax Cuts and Jobs Act Bill becomes law and it is also a question of how the IRS will implement the new law, but this could be positive news for BHPH Dealers. In the interim, if you are currently on the cash method for tax reporting, we suggest that you consider changing to the accrual method using the automatic change provisions. Talk with your CPA about why this is desirable. That way you will be protected even if the tax law does not change.

John Donaldson is the president and chief financial officer of Ace Motor Acceptance Corp. Ken Shilson is the president of the National Alliance of Buy-Here, Pay-Here Dealers and Subprime Analytics.