As the economy continues to recover and construction contractors once again look to increase investment in capital equipment, they should carefully consider using a captive leasing company as a vehicle to invest. In general, leasing can offer several advantages over a traditional purchase: lower upfront cost, less risk on residual value and flexibility in the face of functional or technological obsolescence. In addition, contractors may have the opportunity to defer or reduce sales tax by using a captive leasing company strategy.
A captive leasing company is set up to facilitate the purchase and subsequent lease of equipment to a construction operating company. While each situation is different, most of these companies are organized as disregarded entities for income tax purposes. However, for sales tax purposes, these entities are regarded as separate and distinct from their owners in a majority of states. Therefore, a captive leasing structure can offer the opportunity to defer and reduce sales tax obligations through several means.
In most states, a purchase of equipment for lease is not a taxable sale to the lessor; sales tax will be charged to the lessee on its lease payments. A captive leasing structure allows a contractor to act as the lessor and defer sales tax on the purchase of equipment by charging it over the useful life of the equipment.
The first major benefit of a captive leasing company strategy is the time value of savings associated with sales tax on lease payments. For example, if a contractor purchases a piece of equipment for $120,000 at a sales tax rate of 8 percent, sales tax would be $9,600 for a total capital expenditure of $129,600. A captive leasing company could purchase the equipment free of sales tax and lease the equipment to a contractor for 10 years at a payment of $12,000 per year, plus sales tax of $960 per year. The present value of the sales tax, at an interest rate of 8 percent, would be $6,957, meaning sales tax savings on the lease would be $2,643.
Another benefit of a captive leasing company strategy is the ability to reduce sales tax by including a residual value in the formula. The residual value will lower the contractor’s lease payments. In the previous example, a residual value of 20 percent would cut the lease payments by $2,400 per year, which would reduce annual sales tax to $768. As such, the present value of the overall sales tax savings would grow to $4,034.
The captive leasing company strategy also permits a contractor to pay sales tax only on the actual use of the equipment. As previously discussed, when a contractor purchases equipment, it pays tax on the full price regardless of whether the equipment obsolesces before the end of its estimated life. Therefore, if a contractor purchases equipment with an estimated life of 10 years, the contractor has essentially paid unnecessary tax if the equipment deteriorates after five years. A contractor can limit the sales tax paid to the actual useful life of the equipment by leasing from a captive leasing company.
In a captive leasing arrangement, a contractor also may be able to eliminate sales tax on exempt projects in certain situations. A contractor that has purchased equipment has paid sales tax upfront whether the equipment is used for taxable or exempt projects. However, a contractor leasing equipment may not be required to pay sales tax on payments associated with an exempt project.
Finally, under some circumstances, a captive leasing company may be able to eliminate sales tax on equipment repair or maintenance; these costs will generally take the character of the underlying equipment. Because the equipment is nontaxable, repairs and maintenance on the equipment also may be nontaxable. Most contractors would see significant tax savings from eliminating sales tax on costly repairs over the life of equipment.
Contractors should consider potential sales tax benefits from a captive leasing company strategy before investing in new equipment. The opportunity to defer or reduce sales tax may offer substantial advantages over an outright purchase. There are, however, many complexities to consider. Ultimately, any contractor using a captive leasing structure will still need to have an exit strategy at the point it has achieved the highest possible tax savings.
For more information on the sales tax implications of captive leasing company strategies, contact your BKD advisor.