Last month I discussed industry specific audit targets and focused on event planners.

Another industry specific audit target is rental companies.

The rule seems simple – when companies rent tangible property (other than mobile transportation equipment which has a different set of rules) they have a choice, either pay tax on the cost when it’s purchased, or pay tax forever on the rental receipts.

Seems simple and obviously the state gets a lot more tax when the Lessor buys the property without tax and reports on the lease income. If tax is paid on the cost of the property, no tax is due on the rental receipts. In real life, however sooner or later, some property is usually acquired without tax. This happens because of an out of state purchase, an occasional sale, or a lease of property that ‘s re-rented. Once the tax paid rental inventory is commingled with ex-tax inventory it becomes tainted. Seldom does the Lessor identify which property is being rented, which presents a problem in determining what portion of lease receipts are taxable. The following example illustrates this problem:

A bicycle rental company acquired 100 bikes and paid tax on the cost. As the business grew, and more bikes were acquired, some were purchased from individuals (with no tax) and some were purchased from out of state. Eventually the bike inventory tripled and business was booming. No tax was ever reported on the lease receipts.

The company was audited by the Board of Equalization and of course, the auditor wanted to see all the purchases to check if tax was paid. As a side note, keep in mind that if the lease income is treated as exempt, it is up to the Lessor to prove tax was paid on the cost of the rental inventory notwithstanding any statute of limitations as to when the purchase was made. In other words, if the purchase occurred 10 years ago and if that property is still in rental inventory, keep the invoice showing tax was paid.

To continue with the war story, the auditor discovered that the rental inventory was commingled and asked the impossible question , “Which bikes are being rented from tax paid inventory and which bikes are being rented from ex-tax inventory?” Of course the business owner (Lessor) was certain that they only rent tax paid inventory and all the bikes acquired without tax were marked with a big “Red X” so no one would ever rent them. Not seeing the “Red X”, the auditor didn’t buy that explanation. In this case, the percent of tax paid inventory to total inventory was computed and that percent applied to total rental receipts to determine the exempt portion.

So if a rental company has commingled tax paid and ex-tax inventory, is there a way they can just pay tax on the cost and not have to pay it on the lease income? Unfortunately, Regulation (1660) requires that an election to pay tax on the cost must be made timely. If an item is purchased ex-tax, it must be reported (on Line 2) of the Sales Use Tax Return in the reporting period that it was purchased.

What if the inventory was sold to a new company and tax was charged? Does this solve the problem? Could a company with commingled inventory start a new company and sell the entire inventory, add tax on the sale to that company and start over?

This is addressed in a couple annotations. The first annotation 330.2022 indicates that if a rental company had originally acquired its property ex-tax and later decides that reporting on rental income is undesirable, it can sell the inventory to Company B, add tax and effectively place the entire inventory in the new company on a tax paid basis.

Annotation 330.2112 (five years later) however, takes the same basic set of facts and concludes that “A Taxpayer may carry out its business transaction in a fashion calculated to minimize the tax liability so long as the transfer has business substance and is not a mere sham.” In this case it was determined that under the Lessor’s proposal, there was no business substance and the sole purpose was to subvert the tax law and therefore it is a sham and should not be given any effect for sales and use tax purposes. Note that in both cases, the property was sold at fair market value.

Obviously the annotations seem to be in contradiction with each other, but the safe approach (until I can get further clarification) is to make sure the transaction has economic substance.