Subprime Automotive and the Growing Lease Here – Pay Here Model

The buy here – pay here (BHPH) industry is relatively well-known and mature, but in recent years the lesser-known lease here – pay here (LHPH) industry has grown in momentum. Why have some BHPH operators explored, and even switched to, an LHPH model? And what are some of the accounting and operational implications?

What Are the Benefits of an LHPH Model?

One of the largest benefits of an LHPH model is improved cash flow and liquidity through the deferral of sales tax payments. Generally, in a BHPH model, sales tax is remitted for the entire sales price up front. But, in most states, sales tax related to a lease is only assessed on the payment stream from the customer as it is received. Additionally, initial customer payments can be collected as non-taxable, refundable security deposits.

LHPH owners can benefit from deferred federal and state income taxes by deferring the gross profit realized on a traditional sale and finance transaction. BHPH transactions typically result in the sale of a vehicle from the dealership at significant gross margin. BHPH operators frequently offset the gross profit by selling the installment contract – at a discount – to a related finance company (RFC). Because LHPH transactions typically do not generate a sales transaction, there is no gain to be recognized. Without the need to sell contracts to the RFC, LHPH models can also eliminate the need for the two-company structure, which simplifies financial reporting. Furthermore, with an LHPH model, vehicles remain the property of the dealership and are often depreciated at 100% in the year of purchase due to tax reform’s enhanced bonus depreciation program. This results in a significant reduction of initial tax liability.

Many LHPH operators enjoy additional benefits, such as better bankruptcy protections and regulations that are somewhat less restrictive. But the questions remain: Why have some BHPH operators made the switch while others have not, and how is the discussion changing?

The Challenges

The most consistently voiced concerns regarding the switch from BHPH to LHPH are identifying a willing lender and identifying a document management system (DMS) capable of administering and reporting the program. While each of these concerns certainly warrant careful consideration, they aren’t as restrictive as they once were.

Lending has certainly tightened in recent years, so both BHPH and LHPH dealers generally meet cautious lenders. LHPH dealers have had luck in educating traditional banks on their model and have been successful with lenders who extend credit specifically to their marketplace.

Furthermore, software companies are beginning to react to the increasing demand for LHPH functionality in their DMS, which has created software packages that simply didn’t exist a few years ago.

Accounting and Operational Implications

It is important to note that the lease terms established will determine the appropriate accounting methods used for sales tax, income tax, and financial statement reporting. Variables, such as the age and value of the vehicle at the time of sale, the number of lease payments, the amount of each payment, and any residual payments due at the end of the lease, will all factor into determining the accounting method used. Certain leases may be treated as a sale for tax and financial reporting purposes, which will negate significant tax advantages achieved by the LHPH model. Careful planning up front is necessary to ensure that the desired outcomes – and the benefits of the LHPH model – are achieved.