The Tax Consequences of VW Class Action Settlement Payments to VW Dealers

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1 Crowe Horwath LLP Independent Member Crowe Horwath International 401 East Jackson Street, Suite 2900 Tampa, Florida Tel Fax The Tax Consequences of VW Class Action Settlement Payments to VW Dealers Robert C. Zwiers and Joseph A. Magyar Crowe Horwath LLP Most U.S. VW dealers will be receiving settlement checks from the class action lawsuit that resulted from VW s installation of defeat device software on certain VWs. While the total of the proposed settlement is $1,208,000,000, each of the 652 VW dealers would receive about $1,850,000 on average. The obvious question in the minds of these dealers is Is this taxable? Starting with the basics, the initial answer is Yes, it is taxable. But, are there any exceptions or special provisions that provide for a different treatment? This is where it gets complicated. Due to these complications and remaining uncertainties about the settlement, this article is intended as general guidance for dealers on this topic recognizing that individual dealer circumstances may vary and future developments in this litigation may produce different outcomes. It is primarily intended to assist VW dealers in understanding options and reporting responsibilities related to their 2016 tax returns. The first issue that needs to be answered is What are the payments meant to replace?, which in turn raises the question What is the nature of the complaint? The class action complaint states that VW dealers have been harmed in their business in the form of reduced sales, lost profits, cars sitting on their lots which cannot be sold, and investments in dealerships that are worth substantially less than their purchase, investment and carrying costs The goodwill and franchise/going concern value of all Plaintiffs has been devalued.. Loss of customer goodwill. Loss of value of their VW franchise. The proposed settlement for VW dealers contains both cash and non-cash benefits. VW will pay a cash benefit of $1,208,000,000 for the alleged loss in dealership value as a result of the emission issues surrounding the VW 2.0 and 3.0 liter TDI vehicles. The non-cash benefits include: incentive and other support payments; standstill of capital investment obligations; and treatment of dealer inventory of VW diesel vehicles. The loss in dealership value refers to the Blue Sky value of a dealership. When settlement payments are reimbursement for lost income or increased expenses, the payments are generally taxable as ordinary income. However, when the payments are designated for a decrease in Blue Sky, other possibilities exist, including reduction in basis, capital gains, and the provision that a transfer of a franchise - when the transferor retains significant power - will not be treated as a sale of a capital asset. Frequently, the nature of lawsuit settlement payments is not clear because the case involves claims that could relate to both lost income and damage to capital assets. In this case, the proposed settlement clearly indicates that the cash benefit relates to the diminution of goodwill and the non-cash benefits relate to lost profits. Even so, the IRS may not entirely agree with how a dealer characterizes the cash payments. While it is generally a good idea to ask the IRS for its opinion regarding the character of the payments, the IRS is never bound by informal advice. Only formal advice can be relied on and, so far, the IRS has not issued any public or private rulings concerning this matter. So, while the proposed settlement documents say one thing, the IRS could take a completely opposite position.

2 To complicate things a little more, all of the facts are not yet finalized in this matter. A fairness hearing in district court is scheduled for January 18, 2017 when additional evidence and arguments can be presented. The judge could then approve and finalize the proposed settlement or determine that the settlement needs to change. Either way, the decision could be appealed. If the appeal is denied, the trial judge s ruling would become the final decision. If the appeal is allowed, there would be additional court proceedings. While subsequent court action will not affect the payment amount received by dealers who have executed a release with VW Group of America, the factual record developed in connection with such court proceedings could nonetheless inform the ultimate tax treatment of those payments. On this issue, dealers will need to determine whether the payments are, in fact, for the decrease in value of Blue Sky? Let s assume that the answer is Yes. For tax purposes, Blue Sky is considered to be an intangible asset which is generally a capital asset unless it was acquired as part of a business acquisition after August 10, In this case, the Blue Sky is considered to be an Amortizable Section 197 Asset treated as property used in a trade or business. The general principle is that lawsuit settlement payments for goodwill first reduce the basis of the goodwill and, if the payments exceed the basis of the asset, the excess is gain. How the gain would be taxed depends on whether the goodwill was acquired after August 10, 1993 (or July 25, 1991 if a dealer properly elected this date under Section 197 of the Internal Revenue Code). It gets more complicated. The amount the dealers will receive will be paid in installments. One-half of the total will be paid shortly after VW receives the release from a dealer or after the settlement is finalized. The remaining half will be paid over 18 months starting within 30 days of the initial payment. Because payments will be received in two or more tax years, any capital gain is reported under the installment method. However, dealers could elect out of the installment method. Under the installment method, any ordinary gain that is recaptured is fully taxed in the year of disposition. The reported recapture income then increases the installment sale basis in determining the gross profit that is reported on the installment basis. Also, under the installment rules, a portion of the payments would be allocable to unstated interest. The Appendix provides six distinct hypothetical factual scenarios that walk through these considerations. When is the transaction reportable? Dealers who do not opt-out For tax purposes, transactions like these lawsuit settlement payments are reportable when the amount to be received is fixed and determinable. In this case, the Court issued the proposed settlement on September 30, While this is an offer by VW to settle the lawsuit, the offer was open to options by the dealers. They could (i) opt-out of the settlement, (ii) not opt-out but still object to its terms, or (iii) sign a release to accept the settlement. When the dealer signs and mails the release form, the settlement is fixed and determinable. For dealers who signed and mailed the release form in 2016, the transaction is reportable in 2016 even though payments might not start until For dealers who do not sign the release form in 2016, the transaction would be reportable the earlier of when they sign and mail the release form or when the decision in the lawsuit becomes final. Dealers who opt-out The dealers who opt-out will probably file their own lawsuits and should report their settlements when they sign a release or an agreement or when the decision in their case is final, whichever is earlier. The January 18, 2017 Hearing On January 18, 2017, the district court will conduct a fairness hearing to determine whether the method used in the settlement agreement to determine the portion of the total settlement amount allocable to each dealer is reasonable. Dealers who object to the proposed settlement must show that the method used is unreasonable and not simply that other reasonable methods exist.

3 The district court could decide on the 18 th whether the evidence is sufficient to show the present method to be unreasonable or whether the proposed settlement should be made final. If the district court rules that the present method is unreasonable, the parties will have to get together and propose a different allocation method. If the district court approves the present method, there could be appeals filed. If an appeal is granted, there would be additional court proceedings. If all appeals are denied, the proposed settlement would become final and VW would begin making payments to the remaining dealers. IRS advice In the past, the IRS and NADA have worked together to resolve significant controversial tax issues such as those involving Demos, LIFO, and UNICAP. There are several ways to engage the IRS and one of the best ways has been through the Industry Issue Resolution Program (IIRP). The IIRP is preferred because it is intended to result in a public ruling that is applicable to a group of taxpayers rather than a single taxpayer. The IIRP also can produce guidance on a number of different situations (such as the hypothetical scenarios set forth in the appendix) and could consider the unique facts that exist in this lawsuit. While initial informal contact has been made with the IRS, any official request for consideration should be delayed until after the class action litigation has been finalized since the IRS is unlikely to accept the issue prior to that time. Further, it should be recognized that if the IRS were to accept a subsequent request to clarify the tax status of VW payments to dealers pursuant to the class action settlement, it would likely take many months (and perhaps years) before the IRS would issue a clarification on the matter (and there is no guarantee that the IRS would address the full range of issues related to it). What are the risks? Until some guidance is received from the IRS, it is not certain that dealers would be able to treat the cash settlement as a reduction in the basis of Blue Sky and any balance as either capital gain or 1231 gain. Additionally, it is not entirely clear that the provision that denies capital gain treatment to the sale of a franchise when the taxpayer retains significant power does not apply. The law in this area is a combination of statute and court cases. There is no single authority that specifically addresses all of the issues in this case. The IRS could decide that the settlement amount is payment for lost profits taxable as ordinary income or that a different statute calls for ordinary income treatment. Also, the IRS could challenge the date when the settlement should be reported and decide that the transaction should be reported when the proposed settlement was issued. Keep in mind that, when an IRS challenge includes an additional tax assessment, interest is always added and often penalties are also assessed that may include a 20% accuracy related penalty when there is a substantial understatement of tax. What should dealers do? Unless a dealer has a severe cash shortage, the dealer may want to consider delaying the signing of the release in 2016 in order to potentially defer any gain to report for 2016 or any tax to pay on the settlement. Also, it is possible that tax rates may decrease as early as If this were to occur, it would result in a lower tax on settlement payments that were initially reported in 2017 rather than If a dealer likes the current offer from VW, signing and mailing the release form early in January 2017 will probably mean that the payments would start soon since they will be made by electronic transfer (and the amount received by the dealer would not be affected by the fairness hearing). If a dealer waits until after the fairness hearing, it is uncertain whether the current offer would be available if the district court decides to change the allocation method. Above all, dealers should discuss all aspects of the VW settlement with their professional tax advisor and legal counsel. The information provided herein is educational in nature, is based on authorities that are subject to change, and is not intended as legal or accounting advice. You should contact your tax adviser and legal counsel regarding application of the information provided to your specific facts and circumstances.

4 APPENDIX The following scenarios are intended to illustrate how the tax provisions discussed above could possibly apply to VW dealers in six different hypothetical situations. It is important to note that the IRS has not issued a determination on the assumptions that apply to these scenarios, including whether cash payments made to VW dealers pursuant to the proposed settlement agreement may be treated as a reduction in the basis of Blue Sky. Dealers should discuss these issues with their tax advisor and legal counsel. Scenario 1: Dealer was awarded an original store and no basis in Blue Sky. VW dealer 1 was awarded a VW franchise in 1990 by VW of America as an original store. Nothing was paid for the Blue Sky. In 2016, the dealer receives $1,000,000 of a $2,000,000 VW settlement. Because this was an original VW store, Dealer 1 has no basis in Blue Sky. Therefore, since there is no basis to deduct from the gain, the entire $2,000,000 is considered to be gain from the sale of a long-term capital asset and is taxable as long-term capital gain. Under the installment sale rules, the gain reportable in 2016 is $1,000,000 Scenario 2: Dealer acquired store before August 11, 1993, no amortization. VW dealer 2 acquired a VW store in 1990 and paid $300,000 for the Blue Sky. In 2016, the dealer receives $1,000,000 of a $2,000,000 VW settlement. The dealer s basis in the Blue Sky is $300,000 and the gain is $1,700,000. The entire gain of $1,700,000 is considered to be gain from the sale of a long-term capital asset and is taxable as long-term capital gain. Under the installment sale rules, the reportable gain in 2016 is $850,000. Scenario 3: Dealer acquired store after August 10, 1993, fully amortized. VW dealer 3 acquired a VW store in 1995 and paid $300,000 for the Blue Sky. In 2016, the dealer receives $1,000,000 of a $2,000,000 VW settlement. Since the acquisition was after July 24, 1991, the Blue Sky qualified as an Amortizable Section 197 Intangible Asset and is considered to be both property used in a trade or business (Section 1231 property) and Section 1245 property because the basis in the Blue Sky was subject to amortization. Amortization of $20,000 was deducted for 15 years. Amortization deductions totaled $300,000. The dealer s basis in the Blue Sky is the original $300,000 less amortization of $300,000 or zero. The dealer s gain is $2,000,000 and $300,000 of the gain is taxable as ordinary income (amortization recapture) and the balance of $1,700,000 is taxed as a Section 1231 gain. This could be treated as long-term capital gain if there were no Section 1231 losses for the year. Under the installment sale rules, all of the ordinary 1245 gain is reportable in 2016 and the balance of the gain is reported as the payments are received. Under the installment sale rules, the reportable gain in 2016 is $300,000 as ordinary income (1245 gain) and $850,000 as Section 1231 gain. Scenario 4: Dealer acquired store after August 10, 1993, partially amortized. VW dealer 4 acquired a VW store in 2010 and paid $300,000 for the Blue Sky. In 2016, the dealer receives $1,000,000 of a $2,000,000 VW settlement. Since the acquisition was after July 24, 1991, the Blue Sky qualified as an Amortizable Section 197 Intangible Asset and is considered to be both property used in a trade or business (Section 1231 property) and Section 1245 property because the basis in the Blue Sky was subject to amortization. Amortization of $20,000 was deducted for 6 years. Amortization deductions totaled $120,000. The dealer s basis in the Blue Sky is the original $300,000 less amortization of $120,000 or $180,000. The dealer s gain is $1,820,000 and $120,000 of the gain is taxable as ordinary income (depreciation recapture) and the balance of $1,820,000 is taxed as a Section 1231 gain. This could be treated as long-term capital gain if there were no Section 1231 losses for the year. Under the installment sales rules, the reportable gain in 2016 is $120,000, reportable as ordinary income (1245 gain) and $850,000 as Section 1231 gain.

5 Scenario 5: Dealer acquired store after August 10, 1993, gain is all ordinary income. VW dealer 5 acquired a VW store in 2010 and paid $2,000,000 for the Blue Sky. In 2016, the dealer receives $1,000,000 of a $2,000,000 VW settlement. Since the acquisition was after July 24, 1991, the Blue Sky qualified as an Amortizable Section 197 Intangible Asset and is considered to be both property used in a trade or business (Section 1231 property) and Section 1245 property because the basis in the Blue Sky was subject to amortization. Amortization of $20,000 was deducted for 6 years. Amortization deductions totaled $120,000. The dealer s basis in the Blue Sky is the original $2,000,000 less amortization of $120,000 or $1,880,000. The dealer s gain is $120,000 and the entire gain of $120,000 is taxable as ordinary income (depreciation recapture). Under the installment sales rules, the reportable gain in 2016 is $120,000 as ordinary income. Scenario 6: Dealer acquired store after August 10, 1993, no gain. VW dealer 6 acquired a VW store in 2013 and paid $3,000,000 for the Blue Sky. In 2016, the dealer received $2,000,000 from the lawsuit settlement. Since the acquisition was after July 24, 1991, the Blue Sky qualified as an Amortizable Section 197 Intangible Asset and is considered to be both property used in a trade or business (Section 1231 property) and Section 1245 property because the basis in the Blue Sky was subject to amortization. Amortization of $200,000 was deducted for 4 years. Amortization deductions totaled $800,000. The dealer s basis in the Blue Sky is the original $3,000,000 less amortization of $800,000 or $2,200,000. The dealer reduces the basis in the Blue Sky by $2,000,000 and the remaining basis is $200,000 which is deductible as amortization in * * *