Tax Deferral Improves Dealer Cash Flow - Best Practices
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Tax Deferral Improves Dealer Cash Flow

By Mary Seaman

Article Date: 04-01-2004
Copyright (C) 2004 Associated Equipment Distributors. All Rights Reserved.


Michael M. Sill II of Road Machinery & Supplies Co. says “Every profitable dealer should consider using this strategy.”

Finding a way to provide funds for the purchase of new rental equipment, while at the same time deferring taxes and improving cash flow, may seem an impossible task. However, with Section 1031 of the Internal Revenue Code, it’s possible. Several years ago, Michael M. Sill II, president and CEO of Road Machinery & Supplies Co. (RMS) began using Section 1031’s “like-kind exchange rules” to account for his rental assets after a local accounting firm approached him with the idea. Section 1031 is a tax provision that has been around for decades. It allows equipment rental businesses to defer the recognition of taxable gain on the sale of rental equipment where those assets are replaced with “like-kind” rental assets. “Every dealer with consistent taxable income should consider using this strategy,” says Sill. How it works In general, taxable gain must be recognized on the sale of any property. However, Section 1031 of the Internal Revenue Code provides an exception to the general rule where property held for productive use in a trade business is exchanged for property of a like kind. The like-kind exchange exception only applies to the current recognition of gain. Gain is deferred until the replacement property is disposed of in a later taxable transaction. However, the gain is only potentially taxable. Gain can be deferred as long as the taxpayer continues to reinvest subsequent disposition proceeds in successive exchanges of like-kind replacement property. The rationale for gain deferral was Congress’ desire not to impose a tax on a theoretical gain where the taxpayer continued its investment in like-kind assets. This rationale is also based on congressional concern that taxpayers would not have sufficient cash to pay the tax if an exchange triggered recognition of gain. Like-kind exchanges are tax-deferred, not tax-free. When qualifying equipment is sold without replacement, the original deferred gain and any additional gain is subject to tax. Also, like-kind exchanges require the use of a qualified intermediary to complete the exchange. When the taxpayer uses a qualified intermediary, the firm holds sales proceeds for the taxpayer until the taxpayer wishes to acquire like-kind replacement property. In this scenario, the IRS does not consider the taxpayer to be in receipt of sales proceeds from the property or equipment sold. Instead, proceeds go directly to the intermediary, who holds the funds until they are needed to acquire the replacement property or equipment, or to retire debt related to the sold assets. The intermediary then delivers the funds directly to the supplier of the taxpayer’s replacement property who transfers ownership of the property or equipment directly to the taxpayer. Without a qualified intermediary, the IRS would consider the taxpayer to be in receipt of property that was not “like-kind” to the property being exchanged, making the transactions ineligible for tax-deferred status. Lower your cost of capital Like-kind exchange can help dealers save thousands of dollars in income taxes when replacing old rental equipment with new. “We treat our rental fleet as qualifying property and that allows us to defer the gain on the sale of a piece of properly identified rental equipment into the replacement piece,” says Sill. Normally, a construction equipment dealer would pay federal income tax on the gain related to the sale of a piece of rental equipment. However, with the like-kind exchange rules, dealers can defer all federal income taxes on the sale of the old equipment when they buy a similar piece of equipment as a replacement. The biggest benefit is the interest saved on the tax deferral, according to Bill Holte, CFO for RMS. For example, he says, RMS purchased a piece of equipment as a rental asset for $100,000 in 2003. The equipment is eligible for bonus depreciation, which means the asset would depreciate by $60,000. For tax purposes, the company has a net book value $40,000. If the company sells the equipment in 2004 for $80,000, they defer the taxes related to the $40,000 gain and use the funds to purchase another piece of equipment. The tax deferral in this case could total up to $18,400. “The ultimate goal is to get the tax base of your rental fleet down to a low number,” says Holte. “The goal is to create a permanent deferral like LIFO inventory costing, with this deferral growing each year.” Deferring the gain is like receiving an interest-free loan from the government. Although the company will have to pay the tax eventually, the company keeps the interest savings, says Holte. Collectively, 1031 exchanges allow Sill to generate a significant tax deferral. “Because the rental fleet is a big part of what we do as a company, it allows us to offset most of our income,” says Sill. “It doesn’t mean we don’t have to pay taxes, but the gain deferral allows us to utilize money we would have paid in taxes and put it to work in our company.” Dealers who have significant amounts of capital tied up in their rental fleets should also find a benefit from the 1031 strategy, according to Sill. Using the strategy has enhanced RMS’ leverage. “One of the real threats our industry faces is the highly leveraged nature of equipment dealers,” says Sill. “The strategy can significantly improve the balance sheet if used properly.” The strategy must be implemented with the assistance of experts, which can be expensive, says Sill. The process can also be time-consuming, but Sill says, it’s worth it. RMS works with PricewaterhouseCoopers and their intermediary, North Star Deferred Exchange of Chicago. “Every profitable dealer should consider using this strategy,” says Sill. “Tax accountants exist to find new ways to best use tax laws. If you are profitable and if you have a defined rental fleet, I think you should be using the 1031 strategy.” RMS is a multi-line dealer covering sales, rental, parts and service of new and used equipment with 11 locations, primarily in Minnesota and Iowa. Sill is the third generation working for the company.
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