Lessors of hard goods are constantly buying and selling assets to meet the needs of their client base. In many states, lessors incur no sales or use-tax liabilities on these transactions, because tax is primarily due on the lease payment made by the lessee. Thus, the lessor is merely a collector/remitter on behalf of the taxing authority.

The balance of the states typically view the purchase by the lessor as the taxable event and require payment of sales tax by the lessor based on the purchase price. From an economic perspective, lessors recover this cost through the lease stream by building the cost into the lease base. However, because lessors in these “upfront” states are treated as consumers, they are able to avail themselves of credits contained in certain states’ statutes and regulations.

The Illinois Trade-In Model
Having lived in Chicago my entire life, I think I can safely say that no other jurisdiction has as complex a sales/use/rental-tax scheme as Illinois and Chicago when it comes to leasing activities. (Texas would be a close second, however).

Between the state and the city, lessees indirectly (at the state level) and directly (at the city of Chicago level) bear a combined tax burden that ranges from 12.25% to 14.75%. These rates increased by 2% effective January 1, 2008. Illinois is an upfront state requiring payment of sales tax by lessors upon purchase. Sales tax rates in Illinois currently range from 6.25% to 8.75%. Chicago is a “stream” jurisdiction, which collects its 6% rental tax on rental payments made by lessees. The city rate increased to 8% on January 1, 2008.

Illinois allows a reduction of “Gross Receipts” by “… the value of, or credit given for, traded-in tangible personal property where the item that is traded-in is of like kind and character as that which is being sold…”¹ If that were as far as Illinois went, it would be a fairly straightforward exercise for a lessor to dispose of one asset with the same dealer who is selling a new one. Such is not the case in Illinois.

In addition to providing a relatively simple trade-in credit, Illinois, to borrow a phrase from Emeril, “kicks it up a notch.” For trade-in vehicles, Illinois provides for “advance trade-ins.” The state defines this term as “…a trade in credit earned as the result of the trade-in of a vehicle on the future purchase of a vehicle where the purchaser is contractually obligated to make a purchase within nine months after the advance trade.”² The regulation also allows a lessor to trade in a vehicle “owned by a prospective lessee” where that party authorizes the trade-in, in writing, for the benefit of the lessor. (Not available in conjunction with advance trade-ins).

The advance trade-in regulation also allows multiple trade-in transactions and split trade-in transactions. A multiple trade-in allows the lessor to combine more than one vehicle as trades against the purchase of a single vehicle. A split trade-in allows a single trade-in value to be applied to more than one vehicle purchase. Trade-in credit cannot be earned after the purchase of a new vehicle and applied retroactively.³

Okay, so what do all these provisions add up to in real life? Well, basically, a lessor with a continuing, high-volume relationship with an Illinois dealer can dramatically reduce the amount of sales tax paid. The lessor can set up a program with the Illinois dealer whereby the lessor channels disposals through the dealer on a continuing basis. Each disposal through the dealer creates an advance trade-in credit, good for up to nine months, which can be aggregated with other such disposal/trade-ins to collectively reduce or eliminate the sales tax due on new purchases. Of course, the benefit is a function of the volume of trade-ins and the volume of purchases. Given that trade-ins are worth less than new vehicles, a greater flow of disposals is necessary to equal the purchase price of new vehicles.

Another intriguing aspect of the Illinois trade-in credit model is contained in an obscure letter ruling issued by the state in 1998. In that ruling the state agreed that out-of-state vehicles could be used as trade-ins against Illinois purchases.⁴ From a practical perspective, this allows a lessor to take vehicles currently being disposed of in other states without generation of trade-in credit, and, to redirect those vehicles through an Illinois dealer, thereby creating Illinois trade-in credit. The vehicles need not be physically moved to Illinois in order to obtain the trade-in credit.

Clearly, to maximize generation of Illinois credit, a strong relationship with an Illinois dealer is necessary. A program structure must be implemented, requiring, among other things, complete transaction documentation and secure financial arrangements. Assuming these steps can be taken, the sales tax benefit can be quite nice indeed.

The Texas Trade-In Model
Unlike Illinois, Texas generally imposes sales tax on lease payments received by lessors. However, with regard to motor vehicles, there is a lot of similarity between the two states. In this respect, Texas is an upfront state, like Illinois.

Texas also is generous in its approach to trade-in credits for vehicles. In fact, in some ways, the Texas model is more generous than the Illinois model although in other ways less so. Let’s examine the differences.

Texas allows advance trade-ins, just like Illinois. Texas, however, allows advance trade-ins up to 18 months before the subsequent purchases — twice as long as Illinois.⁵ Texas also allows “deferred trade-ins,” which are vehicles “offered for sale” on the date of the purchase of the replacement that can be used to reduce the taxable base of the new purchase. In such a case, the fair market value on the owner’s books at the date of replacement purchase is the amount of the trade-in credit.⁶

Texas allows multiple trade-ins to reduce the taxable base of a purchase of a new vehicle, but does not allow split trade-in transactions.⁷

By far, the most attractive feature of the Texas trade-in credit model is that a trade-in credit can be earned by a sale to one dealer and used on the purchase from another dealer.⁸ Texas requires vehicle lessors to be licensed by the Department of Transportation. Therefore, when the lessor sells a vehicle to Texas dealer “A,” the sales amount becomes a portable trade-in credit, which can be claimed up to 18 months later in conjunction with a purchase from Texas dealer “B.” Records are maintained by the lessor, and trade-ins are claimed at the time the new vehicle is registered at the county tax assessor/collector’s office.

One limitation in the Texas model, not found in Illinois, is that only vehicles titled and used in Texas may be used to earn Texas trade-in credits.⁹

Interplay With Like-Kind Exchange Programs
Lessors may have in place a like-kind exchange (LKE) program intended to improve their federal and state income tax position. The question has arisen as to whether an LKE program and a sales tax trade-in credit program can exist harmoniously. The short answer is yes.

LKE programs utilize the services of a qualified intermediary (QI) to effectuate transactions. In an LKE program, a taxpayer assigns his rights to the sales proceeds to the QI. The issue is whether the deemed sale by the QI earns a trade-in credit, which can be utilized by the lessor. Most states, (Illinois notably)¹⁰ have rules that as long as the QI is acting as the agent for a disclosed principal (the lessor), then the acts of the agent will be attributed to the lessor. This, in effect, makes the deemed disposition by the QI, a disposition by the lessor.

Another issue involves the LKE rule, which allows subsequent purchase of replacement property. Many states require that trade-ins occur simultaneously with the purchase of new property. Illinois and Texas, as noted previously, both allow advance trade-ins and both have advance trade-in periods in excess of that specified in the LKE rules.

In conclusion, state specific trade-in credit programs can co-exist with LKE programs, and can produce impressive savings of sales tax expense. It is also important to note that the majority of information needed to administer a trade-in credit program is also required to administer an LKE program. Therefore, once an LKE program is implemented, layering a trade-in credit program on top is relatively straightforward and benefits dramatically from the automation that is generally required for LKEs.

Larry Fee is a partner in the Chicago office, State and Local Tax Services Group at PricewaterhouseCoopers. His practice focuses on providing transaction tax consulting services to Fortune 500 companies. He has worked extensively with clients to identify overpayments of sales/use tax, as well as assisting clients in reducing audit liabilities, negotiating compliance agreements, and implementing automated sales tax billing solutions.

Fee obtained his J.D. and L.L.M. in Taxation from John Marshall Law School, and his B.A. from the University of Illinois at Chicago. He is an adjunct professor for DePaul University’s Masters of Science in Taxation program. He is also a featured speaker at numerous state tax forums, and has authored a portfolio for Tax Management’s Multistate Tax Service, entitled Sales and Use Taxes: Services. His professional affiliations include the Chicago Bar Association, State & Local Tax Committee Member, Institute for Professionals in Taxation, and the Taxpayer’s Federation of Illinois.