Is LKE a Case of The Tail Wagging the Dog?By Brent Abrahm
Article Date: 09-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.
A strong tax strategy is critical to the company’s overall operational success.
In recent months I’ve heard a number of people suggesting that tax issues simply aren’t a part of their strategic financial thinking. There are several variations on this theme, like these:
- “We leave all our tax strategies until the end of the year.”
- “We only have one person worrying about tax issues.”
- “We’re not going to let tax strategy determine how we run our business. That’s the tail wagging the dog.”
It’s hard to imagine a competent, responsible CEO opting to jettison valuable assets, discard powerful incentives and erode cash flow, especially now, when cash is more important than it has ever been. But it is happening.
Hi-Lo Equipment: A Case Study
To illustrate the issue, let’s examine a brief case study, one that’s built around the portfolio of an actual dealership – we’ll use the fictitious name Hi-Lo Machinery. Every day, Hi-Lo’s sales team, which is probably a lot like most dealer sales groups around the country, is encouraged to not only identify new business, but also to sell, sell, sell. When the economy tightens, the heavy equipment industry is notorious for selling anything that isn’t nailed to the floor, whether it’s new, used or from the rental fleet. “If we can make a sale, regardless from which fleet, we will make it,” is Hi-Lo’s philosophy.
But does this always make sound economic sense? What if a Hi-Lo sales guy just sold a motor grader that has participated in several rounds of like-kind exchanges? Say this motor grader was similar to several others on the lot, all of which are 2006 and 2007 models. The 2006 motor grader he just sold may have a remaining tax basis that’s a small fraction of the original cost. The remaining assets were purchased at approximately the same time but were not qualifying replacement assets for LKE purposes, and therefore maintained a high tax basis with little or no tax depreciation.
For a detailed look at the choices facing the Hi-Lo salesman, have a look at this table, which outlines the tax implications for several similar assets on the lot.
Selected Hi-Lo Equipment Inventory
||Year Placed in Service
||Tax Acquisition Cost
||Projected End-of-Year Adjusted Basis if Sold
||Gain if Sale Price is $213,000
||Tax on Gain at 40%
Compare Assets 5 and 6, for instance. These two motor graders may be sitting side by side on the lot. They have roughly the same number of hours in use, and even upon close inspection the prospective buyer can’t see much difference. The sale price is about the same. So the Hi-Lo salesman sells asset No. 6.
Did this sale help the bottom line? No, it didn’t.
The books may show that this transaction was profitable on paper, but this narrow view ignores the all-important cash impact. Hi-Lo banked $213,000 in either case, and since both assets had comparable acquisition costs the profit may seem identical. However, the dealership owes the IRS more than $80,000 instead of $20,729.
We all appreciate that revenue is revenue. But if Hi-Lo couldn’t match the sold asset with a qualifying piece of heavy equipment, for some reason, they’ve now incurred a tremendous tax gain and associated tax bill. Had the sales guy instead sold motor grader No. 5, their tax gain would have been minimized, they’d have moved a nonproducing piece of equipment, and they would have improved their financial metrics. By providing extra incentives to the sales team to move high-basis assets, Hi-Lo Equipment could have saved themselves $60,000 in tax gain.
It’s true that cash is always king, and in our current economy very few businesses can afford to turn their noses up at that kind of money.
Tax is an Essential Component of Any Sound Financial and Operational Strategy
That last bullet in the introduction – the one about the “tail wagging the dog” – is especially troubling, because it makes clear that this person still hasn’t grasped how fundamental a strong tax strategy is to the company’s overall operational success. Tax deferral opportunities like bonus depreciation (which is slated to expire at the end of the year) and 1031 like-kind exchange (LKE) programs, especially, can be powerful strategic drivers in times when operating cash is extremely hard to come by. It’s a basic truism that if you must pay a tax bill, you’d rather pay it in the future than today, when you can put the money to work strengthening your business.
Joseph C. Lane, the vice chairman of Sinter Capital and the former CEO of GATX Capital, IBM Credit Corp. and
GE Technology Finance, recently explained: “Deferring the tax today by replacing the sold asset with a like-kind asset through a 1031 exchange generates a higher financial return.”
Cash You Can Use Today
Regardless of the amount of deferral, any amount not paid in current taxes is, effectively, another source of cash. At a time of tight credit, widening spreads, and increasingly burdensome covenants and conditions characterizing the capital markets, a careful cost-of-capital analysis will illustrate another real benefit of a like-kind exchange.
Some owners measure the value of their LKE not as a tax deferral, but by its impact on their real cost of funds – the avoided cost of issuing debt or equity is significant, and by preserving the cash that otherwise leaves the company in the form of taxes paid, owners can redeploy that cash to acquire replacement assets at a lower effective cost. Lower effective cost of assets then translates into greater operating efficiencies, which improves margins and profitability or makes the enterprise more competitive in the market. Either way, tapping the cash “hidden” in assets being sold and replaced is by all measures a good thing. (http://accruit.com/now-is-the-time-to-think-about-1031-exchanges/)
Since 2001, dozens of heavy equipment dealers have implemented 1031 exchange programs. During the downturn in 2002 and through three rounds of bonus depreciation, LKE programs continued to flourish, driving literally hundreds of millions of dollars in increased cash flow through the industry. Nevertheless, some of these companies, now faced with difficult new financial realities associated with the recession, are contemplating discontinuing these programs.
We believe this is the wrong answer for several reasons.
As dealers find themselves facing shocking new bank covenants, it’s critical to maximize every source of available cash flow. For those already deferring gains (and possibly in a net operating loss environment), now is the time to really start managing their existing LKE programs, a point the Hi-Lo case powerfully illustrates.
If your challenges during the current economic down cycle include increasing cash flow – or more accurately, preserving your cash – then don’t sell your low basis assets if you have a choice. Remember that all gains (sales price minus tax basis) are taxed at approximately 40 percent. Instead:
- Evaluate your entire fleet
- When your sales team finds a qualified buyer and you decide to sell an asset, take these kinds of critical tax and cash flow factors into consideration as you’re prioritizing which assets to move
- Provide extra incentives for your sales team to dispose of high-basis assets if you believe finding replacement equipment is going to be a challenge
Meanwhile, here’s hoping that you’re fortunate enough to be in competition with businesses that see effective cash management as the “tail wagging the dog.”
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