The IRS's chief counsel recently rendered an opinion, citing the situation of a taxpayer in the business of selling, renting, servicing, and financing equipment that the taxpayer classified as "held for rental" (investment), "or held for sale" (inventory). As with many similar businesses, rental equipment that was initially classified as held for rental (investment) when purchased was often subsequently sold to a renter or other purchaser later.
There are usually no prior purchases, sale agreements, or other contracts in place with the renters stating how much of the rental payments, if any, will be applied toward the purchase price of the rental equipment. The price is negotiated at the time that the renter decides to acquire the rental equipment.
Further complicating matters, the taxpayer in the IRS's example has been structuring like-kind, Section 1031 tax deferred exchanges on the sales and dispositions of rental dental instruments when sold to the renters and other buyers.
Although on rare occasions the taxpayer arranged a sale or lease before acquiring the equipment, most of the new equipment acquired was available to customers for either sale or lease. The taxpayer's ultimate goal was to sell all its equipment; however, because of the nature of its business and its competitive business environment, the taxpayer often leased its equipment prior to selling it.
While using equipment during a lease caused its value to decrease, the taxpayer received income from its leases that benefited its business. The taxpayer normally reacquired the leased equipment upon the early termination or expiration of the lease and would hold it for varying periods of time before selling or re-leasing it. The taxpayer never scrapped any equipment and eventually sold all of it. The title to all equipment remained with the seller until it was sold.
Initially, the taxpayer treated the equipment as "inventory" unless the equipment had already been subject to an existing lease when the taxpayer acquired it. This treatment was not challenged.
Swaps, trade-ins, and exchanges
The business cited by the IRS's chief counsel structured its sales of "rental property" equipment as exchanges. It entered into a Master Exchange Agreement and named a qualified intermediary (QI) and a trustee, neither of which was related to the business. The business negotiates sales with customers and assigns the sales contracts to the QI.
The business routinely ordered replacement property from the manufacturer and assigned its rights to acquire the equipment to the QI. The trustee collected the proceeds from the sale of the relinquished property and made disbursements for purchases of the replacement property on behalf of the business. The replacement property was assigned an order number and entered into the business's fixed asset depreciation system. The business routinely sent a monthly statement to the QI and the manufacturer informed them of the replacement property and included the statement, "Under IRC# 1031, [Business] has assigned its rights to acquire this equipment to [QI]."
An analysis of the business's annual results showed 91% of its income was generated from "sales," while 9% was generated from its rental operation. What's more, the IRS found that a substantial amount of the equipment designated as rental equipment was sold by the business prior to the equipment generating any rental income.
The IRS speaketh
The IRS's chief counsel concluded that the rental equipment that had been classified as held for rental (investment) was not actually held for rental purposes, but was actually held as inventory in the business and was, therefore, held for sale and not investment. Temporarily withdrawing the equipment from inventory held for sale does not convert the equipment from inventory held for sale into equipment held as rental property, at least according to the IRS.
The IRS's position is that, given these or similar facts and circumstances, a business may not depreciate the equipment and cannot qualify for like-kind exchange treatment. Will your dental equipment business be affected by this latest IRS opinion? Professional advice is certainly advised for every dental equipment manufacturer and dealer.