The owners of a construction business have set-up a separate legal entity to buy new equipment to rent on a monthly basis exclusively to the operating legal entity. A similar structure was used by these owners in a previous investment about 10+ plus years ago. They do not recall the exact arrangement. One benefit appears to the time value of money by spreading the sales tax paid over the rental period/useful life instead of paying sales tax at the purchase date. Does anyone have experience with this type of arrangement? Are there other benefits? What are the potential pitfalls to avoid? Any suggestions on how to structure the arrangement and set the monthly rental rate?
Optimal structure for equipment leasing to another company
Answers
Off the top of my head I can think of the following:
Liability, bankruptcy and selling of the business advantages: Similar to owning buildings
Downside is possible transfer pricing issues if you can't show the lease is FMV.
I've had 40+ years in the corporate equipment leasing business but have seen few of these. What do your owners want to achieve? The typical reason people create this kind of arrangement is to capture the financial benefits of equipment ownership in the new entity instead of the operating company. I assume Newco will retain ownership of the equipment, which should entitle it to investment credit, depreciation and rental income. Leases of this nature usually have either a fair market value purchase option or no purchase option at all. Avoid arrangements that offer "rental credits" or other discounts if Opco chooses to buy some item of equipment at the end of the lease. Those indicate a secured financing arrangement or so-called finance lease, neither of which entitle Newco to ownership benefits.
The one area significantly changed in the decade since the owners last did this is accounting rules. Things are tighter now that lease accounting has moved toward conformance with IFRS. To avoid the transfer pricing issue, the hourly/daily/monthly rate for equipment leased by Newco to Opco generally should be in line with competitive market rates for similar equipment. Determine those rates by periodically surveying rental operations in the area and recording the responses. That will be helpful if the IRS or accountants ever ask. If leases are at market rates, that will limit the owners' ability to substantially inflate Newco's cost of money in order to boost margins from financing activity.
Use an attorney knowledgeable about short-term equipment rental/leasing to set up Newco (or review what has been done already). Create a good, professional, arms-length lease agreement between Newco and Opco. The option to pay up front sales tax versus use tax over time is state specific and may not be as simple as you indicate. Spreading sales or use tax over some undefined "useful life" has never been an option. Government bodies want their money sooner, not later. Understand sales tax requirements for the state where Newco is based but don't get locked in on the financial impact of this issue. Sales tax represents roughly 6-8% of the value in the transaction. The present value impact/benefit of that modest stream isn't a terribly significant part of the whole picture.
Three final thoughts: a) secure periodic consulting help from a leasing-knowledgeable individual to organize Newco so it looks and operates like a business; b) have someone (perhaps the consultant) dedicated to manage this business, even if only for a few hours a week or month; and c) consider using leasing software to help with lease pricing, asset management, accounting and financial reporting.
Have used this often. Beware of sales tax issues on anything they're doing that needs licence plates on them. DMV probably will want sales tax upfront (upon registration) to get the plates.