One unexpected consequence of today’s hot collector car market has been that many SCMers have been buying and selling more cars more quickly than ever before. They — and their accountants — have wondered if they have crossed the line from a collector to a dealer, which would carry some significant tax and legal consequences. The importance of specialist insurance was a lesson learned early on in my career in the motor trade industry.
All states require car dealers to be licensed. The most obvious consequence of dealer licensing is the cost. Not only do you have to file an application and pay a licensing fee, but you need to carry appropriate insurance, post a bond and meet a host of other requirements. A friend recently went through the process and, while trying to keep it as cheap as possible, ended up spending about $8,000.
But the licensing costs are probably not your most significant legal exposure. As a dealer, you are now subject to all sorts of legal regulation. You must collect sales tax on all your sales. You are subject to any mandatory disclosures about the condition of the cars you sell, and any mandatory warranty provisions that your state may require dealers to extend. You are exposed to lemon-law liability. You are exposed to liability under your state’s consumer-protection laws, as each of your sales is now a commercial sale to a consumer. Remember, in the eyes of the law, judges and juries, used-car dealers are right down there on the popularity scale a rung or two below lawyers.
Favorable tax consequences
The most immediate tax benefit is that your cars don’t have to be registered, but they can be driven with dealer plates. That means you don’t have to pay sales or use tax when you buy them.
Dealer status also offers the ability to deduct all of your dealer business expenses on your income tax returns. These can be substantial — travel to check out possible purchases, travel to and registration at collector car auctions, your SCM subscription, and so on. Those savings can certainly add up.
However, there are many reasons why dealer status is a short-sighted approach that can cost you even more in the long run. One reason is that claiming to be a dealer when you really aren’t can land you in legal hot water. You can be fined or charged criminally for failing to properly license your personal cars and for filing false licensing applications. Another reason is that the income tax deductions aren’t automatic. Dealer licensing is a matter of state regulatory law. To be able to deduct your “dealer” expenses, you have to actually be engaged in the business of being a car dealer. If you aren’t, but deduct your expenses, you can be subject to substantial tax penalties — and even criminal tax charges in egregious cases.
You can also say goodbye to the low insurance rates you’ve been getting from your collector car specialty insurance company, as they don’t insure dealer cars.
For the other reasons why it’s a bad idea, keep reading.
Unfavorable tax consequences
As a dealer, your collector cars are now inventory — not investments. As such, all of your profits on sales are now taxed as ordinary income, with federal rates running as high as 39.6% today. If you were not a dealer, the profit would be taxed as a capital gain — at a maximum federal rate of 20% if the car was held at least a year. That’s a pretty big spread, and your state’s income tax rules will affect the spread in either direction.
As a dealer, you are not eligible to use like-kind exchanges to defer your gain on a sale. Collectors commonly use that technique these days. By using an exchange accommodator to reinvest sale proceeds in other collector cars, the collector can avoid paying tax until ultimately cashing in. And, if the cars are retained until death, your heirs will avoid the income taxes altogether.
Dealers, on the other hand, are required to pay income taxes on their gains every time they sell a car — even if they reinvest in other cars. That erodes their invested principal and their rates of return.
Crossing the line
So the question arises — when do you cross the line and become a dealer even when you don’t want to be one? Unfortunately, the answer is not clear-cut.
Many states’ licensing statutes look at the number of sales within a single year — most often five. But the number of sales is not determinative — it is just a legal presumption. Think of that as a burden-of-proof principle. Once you exceed the stated number of sales in any given year, the law assumes that you are a dealer unless you can establish that you are not. Below that number, you are assumed not to be a dealer unless the government can establish that you are. Thus, you can be a dealer with fewer sales in a year, and still be a collector even with a higher number of sales.
Character, not number
To be a dealer, you must be selling cars in the ordinary course of business. That is a bit of a self-defining term. A car is sold in the course of business when you are in the business. You are in the business when you routinely buy cars for the purpose of immediately finding someone to buy them. An investor buys them to hold until something happens that makes it worth selling. If that something just happens to happen quickly, then it’s still an investment.
The question is completely subjective — did you buy the car with the intent of selling it in the ordinary course of business? Since only you know your true intent, the inquiry necessarily focuses on your actions and other circumstantial evidence. The more cars you sell in a year, the more it looks like you are a dealer, that’s all.
That is a pretty big factor for an auditor because it is easy to understand. However, the number of sales is not as important as the way in which you go about selling the cars. Here are some factors that would point to you being considered a dealer:
For example, if you have a showroom or car lot, that’s an easy one. Being licensed as a dealer is a bad fact. How you advertise is a factor. Slick magazine ads and multiple cars listed in the same ad are detrimental. An eBay store would be bad. Using a business name or a business entity, rather than your own name, would be a negative. How long you own a car before you start trying to sell it is another factor. Looking for a buyer as soon as you buy a car, or perhaps even before buying it, makes you look like a dealer.
Still, numbers can matter. In isolation, every one of your car sales can be defended as an investment, but the market moved so quickly, and offers started coming so fast, that you had little practical choice but to take the money. However, when they accumulate into a fairly large number over a fairly short period of time, it starts to establish a pattern. Plus, it draws attention to your tax return.
We don’t have a Tax Court case dealing with collector cars, but we do have a recent one dealing with real estate that is illustrative. In Garrison v. Comm., a mortgage banker and his wife bought distressed properties, renovated them and then resold them in relatively short periods of time. The taxpayers made at least 15 sales over three years, with most of them occurring within four months of purchase.
None of properties were rented out, and only one was held for more than one year before being sold. The real estate activities had become more substantial than the husband’s mortgage brokerage activities.
The Tax Court found that the overall purpose of acquiring the properties was to benefit from the immediate financial gains in selling them as quickly as possible. The conclusion was that the real estate was held primarily for sale to customers in the ordinary course of the taxpayers’ real estate renovation and resale business, and not for investment.
Preserving investor status
If you’re going to be selling a lot of cars, you need to be holding a lot of cars for an extended time. You have to avoid the buy-fix-flip cycle. Exceptions are no problem, but patterns make a lot of difference.
You also have to be consistent. You can’t claim to be a dealer to avoid sales tax, and at the same time claim to be an investor to get favorable income-tax treatment. Your licensing status will be used against you as an admission.
After all, you wouldn’t have lied to your state government to defraud them out of their sales tax, would you? And if you lied to them, we’re supposed to believe you’re telling us the truth now? ♦
John Draneas is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney. He can be reached through www.draneaslaw.com.