IRS Position Paper – Part 2Written By: GARRY BARTECKI
Article Date: 11-01-2005
Copyright(C) 2008 Associated Equipment Distributors. All Rights Reserved.
How my books would look if I were the CFO of a dealership.
Last month I introduced you to the IRS Position Paper about rent-tosell transactions. As I am sure all of you know, the Position Paper basically states that you cannot write down inventory unless you pass a series of tests, which you could never pass even it you kept items as rental units for three years. This is a case of mistaken identity. In most cases, rental units are not inventory, we just call them that. Some dealers rent virtually every unit before it is sold. It might be on rent six months or 36 months to various lessees. It might be sold to the first lessee or the tenth. You never know in this business.
Dealers use rent-to-sell as a merchandising tool to allow customers to try a specific machine to see if it meets their needs, earn the higher profits associated with rentals, give customers flexible financing terms because they have built equity in the machine through rental payments, and/or bring down the book value of a machine to make future sales quotes more competitive.
But, no matter how you look at it, dealers are primarily in a rent first and eventually sell business where rental equipment suffers a diminished value because of the type of rental asset it is and an accounting and tax standpoint. Rental assets are rental assets, and they should be treated as such. The problem is an out-of-date practice that has dealers classifying rental assets as inventory. If you ever want to wave a red flag at an IRS agent, all you have to do is suggest any type of write down related to inventory.
It's time to get off this merry-go-round. To properly classify your equipment, think about what you have:
The new units are inventory and are subject to all inventory rules including restrictions related to write downs. Used units could be inventory or rental units, but in this example, they have not been rented by the company that now owns them. Until they are, they're inventory, subject to the same rules.
- New units available for sale and not rented
- Used units available for sale and or rent.
- Rental units.
Rental units are just that. They are not inventory; they are business assets subject to MACRS depreciation rules. These units may have been purchased for the rental fleet or transferred in from new or used inventory. And, once it is determined they no longer are required in the rental fleet, they can be sold out of the rental fleet or transferred back to used inventory.
On the balance sheet, the new and used equipment is listed as inventory and the rental fleet is listed as a business asset. On a classified balance sheet, rental assets would be classified along with fixed assets, below the current asset line.
The problem with the IRS stems from the fact that equipment dealers improperly account for rental units, when what they are doing is no different than, say, a lift truck dealer.
Lift truck dealers carry what they call a short-term rental fleet. Time and dollar utilization vary by type of unit, the economy, demand, and the region. They buy units for this short-term rental fleet and depreciate them even if they have zero or low rental hours accumulated. If fleet profitability suffers, they sell units or transfer them into used inventory. The only difference I can see is they might keep them a little longer.
What you can do:
Rental has become a core part of the business, and we are not handling it properly. We are in the rental business and these are business assets, not inventory!
- Rewrite your accounting manual concerning how you account for sales of new and used equipment and how you account for rental assets. As part of this, consider a minimum hour usage for a new unit and use this as a guideline for booking a machine as a sale, as opposed to sale of a rental asset.
- Reposition assets to a more realistic presentation. Change the balance sheet and footnote presentation.
- Make changes in the general ledger and annual financial statements (re-state last year's to be consistent).
What would I put on my balance sheet?
- An inventory account that contains new, used, parts and work-in-progress.
- A business asset account for rental assets.
- An accounting policy footnote to explain how we earn our profits and how assets may move from one account to another.
- An income statement presentation with rentals in a separate category.
- Consistent application.
I'm sick of trying to explain to the IRS that we rent this "inventory," when what we did was transfer a unit from inventory to the rental fleet.
No tax advice here, just commentary, and an example of how my books would look if I were the CFO of a dealership.
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