An IRS proposal to prohibit the depreciation of dual-purpose equipment that is available for sale or rent has flaws in its foundation and could have serious consequences, according to industry leaders who oppose the measure.
The equipment industry became aware of the situation in late July when the IRS circulated a draft of the coordinated issue paper (CIP) it is developing as an internal guidance document, which would be used by field agents. Equipment distributors said the CIP would make it nearly impossible for them to depreciate machinery they offer for both sale and rental purposes.
"The CIP states that if an equipment distributor tells customers they can rent or buy equipment, they can't depreciate that equipment. They just have to hold it as inventory," said Christian Klein, Washington counsel of the Associated Equipment Distributors (AED) headquartered in Alexandria, VA. "Basically, it means our members can't depreciate their rental fleet. This is a departure from the IRS policy of the past that allowed this equipment to be depreciated so the IRS is doing a 180-degree turn."
Attorney Donald Barnes, who maintains a specialty tax practice in Washington, D.C. and has served as the AED's outside counsel for five years, has a special insight into the issue because he previously served as an assistant to the IRS tax commissioner and worked in the IRS's chief counsel office. He stressed that the CIP is only a proposal and it could be many months before an internal policy is finalized.
"The basic point is very fundamental because when heavy equipment, construction equipment or agricultural equipment is rented to a customer, it suffers wear and tear," said Barnes. "If the person renting the piece of equipment uses it extensively for several months, the owner then has equipment that is less valuable and it can't be sold for as much after it has been used as it could have been if it was still new.
"Most equipment distributors rent a fair percentage of their equipment and the tax law generally permits distributors to claim depreciation for wear and tear," he added. "In fact, many distributors are currently claiming depreciation on this type of equipment. These are usually very expensive pieces of equipment and the depreciation can be quite large."
Barnes and Klein sent a letter dated Aug. 30 to the IRS, recommending that the CIP be withdrawn pending further study. They state the CIP does not accurately set forth the existing law on whether dual-purpose property can be depreciated. Furthermore, they believe the tax treatment of equipment held for rent by distributors should be based on all of the facts and circumstances applicable to their rental business.
AED believes the CIP is a major threat to distributors. Concerns expressed by Klein and Barnes include:
• It could expose equipment distributors to massive tax liability,
• It would undermine the ability of Congress to stimulate equipment sales through tax incentives such as the depreciation bonus,
• It would expose equipment distributors to wild fluctuations in future tax liability,
• It is illogical given the tremendous wear and tear to which rental equipment is exposed, and
• It would harm contractors and other customers who rely on the flexible equipment acquisition deals distributors are able to create through rent-to-own transactions.
Klein strongly suggested the CIP be withdrawn because the IRS wrongly interprets the law, which supports the premise that rent-to-own equipment can be depreciated.
"If it is finalized, there is the risk that it could be applied retroactively against equipment distributors and they would then be subject to retroactive tax liability," said Klein. "We don't know how retroactive it might be, but there is no reason to believe that they wouldn't go back as far as they possibly can. We have already heard from some members against whom the CIP is being threatened."
Klein said contractors are concerned because the IRS proposal would make it difficult to enter into rent-to-own contracts with distributors. Higher rental rates also may be necessary to compensate for higher tax liability sustained by distributors.
"If there is less flexibility in equipment purchases, the cost of projects could start going up, as well," said Klein. "The initial impact will be on distributors, then their customers and it could continue to have repercussions."
AED officials do not believe the matter requires Congressional action at this point, but some members are contacting their friends on Capitol Hill just to ensure they are aware of the proposal in case the situation progresses to the point of legislative intervention.
Other organizations, including the North American Equipment Dealers Association and several major manufacturers, also have expressed their opposition.
The IRS concluded in its CIP that "The decision whether a taxpayer is entitled to depreciate goods under the IRS Code, if those goods are used in the taxpayer's trade or business while simultaneously being held for sale in the normal course of business, is factual."
The IRS stated the factual determination should be based on the following criteria:
• Inventory may not be depreciated,
• Goods are presumed to be inventory provided they are held for sale in the original course of business,
• The taxpayer has the burden to overcome the presumption of inventory, and
• The taxpayer can overcome the presumption by showing that the preponderance of the facts indicates the primary purpose of the goods is for lease.
However, if the gross selling price of the goods is greater than half the gross cost of the goods, the primary purpose is inventory. If the gross lease income is less than the gross sales income of the goods, the primary purpose of the goods is inventory. If the total time the goods are leased is less than half of the economic life of the goods, the primary purpose of the goods is inventory.
Goods may be converted from inventory to business use. However, the goods must not be held for sale while in business use if depreciation is to be taken. Temporary withdrawal of the goods from sale is insufficient to qualify as converted to business use. CEG
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