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comment on leases and taxes

July 23, 2021
comment on leases from article on July 17, 2021
            I have been reading the questions and answers regarding leases, especially the question from our old friend Anon, on July 17, 2021.   In addition to the numerous operational and legal issues that you discuss, it is important for companies who become Lessors, to consult with their accountants so that they can properly structure and document the transactions for tax purposes.
            Many states tax sales of alarm equipment but do not tax monitoring.  When the customer pays up front for the system this is fairly straight- forward, but what happens when the price of the equipment is rolled into the monitoring, or when the customer actually signs a lease?  If the lease properly segregates the lease and monitoring, and the allocation is reasonable, there shouldn’t be a problem.  
            But, what happens when things aren’t so clear or rational.  We recently ran across a case in which a company sold a “free” system for a $95 “initiation fee” and $80 a month for 72 months.  The system consisted of an 8 zone burglar alarm, a thermostat control, six cameras and a DVR.  The Company treated the entire $80 monthly charge as monitoring.            Monitoring isn’t taxable in that state so the Company didn’t charge the customer sales tax.  The State (and rightly so) determined that the transaction was actually an installment sale (this is another reason that you should have the word “lease” in this type of an agreement, you don’t want to blunder into the world of installment sales) and assessed tax on the entire amount ($5,855) at the time of sale. Both parties ended up in Court and it wasn’t pretty.  The Court allowed the Company to allocate some of the monthly payments to monitoring, but, in doing so, they accepted the State’s argument that a 100% markup on the wholesale monitoring cost of $3.75 was reasonable and determined that the remaining $72.50 of the monthly charge was an installment sale. I am not sure what happened next but I wouldn’t want to go back to a customer looking for sales tax on $5,220.
            I see these cases all of the time and they remind me of the Pennzoil commercial where the guy said “pay me now or pay me later.” Leases can be a good thing, but, before you put on your pioneer hat, give Ken a call.  Call your accountant or call us.  Ken and I are like the mechanics who do oil changes and also rebuild engines.  Let us do the oil change, you don’t want to rebuild the engine.
Mitch Reitman
Reitman Consulting Group
Fort Worth, TX
            Mitch, I don't like to disagree with you but I have to take exception to comparing us with mechanics.  I see us our role as "here to service the rich".  I hope that includes all the alarm guys reading this.  And if you're not sure, remember what Jackie Mason said: "I've got all the money I need, as long as I don't spend any".
            Now that we got that out of the way I want to make it clear that accounting and taxes is Mitch's department; he's right that you should have a great accountant and tax advisor on your team or at least available to you.  If you don't you'd be foolish not to engage Mitch. 
            I am sure Mitch can elaborate on this, but I think there are [at least] two considerations when it comes to taxes. As Mitch comments sales tax may apply to parts of your service and not others.  Monitoring may not be subject to sales tax [in your jurisdiction - not sure it that's a nationwide rule] but repair service or installation may be taxable for sales tax. 
            We know that alarm contracts often conflict with tax laws and how you treat the transaction.  That's because there are other issues in life besides taxes. Protecting against liability is one of them.  For example, there are laws that prohibit exculpatory clauses in connection with the repair and maintenance of real property.  So how come when you install an alarm system, and let's use an example on the extreme end, fire alarm, sprinkler alarm or maybe access control, can you take the position that your equipment is not and doesn't become part of the real property, but remains personalty and is therefore not subject to the laws affecting real property?  Answer:  The contract says so, and generally the equipment falls into a grey area where it may, or may not, be considered fixtures appurtenant to the real property, so the contract provision characterizing the equipment governs or is at least persuasive.
            When subscriber don't want to pay sales tax, and you haven't been successful extracting cash, they will argue that the installation is a capital improvement; you get them to sign a form to that effect.  The capital improvement however contradicts the contract provision that clearly states that the installation does not constitute an improvement to real property.  So can you accept a Capital Improvement Certificate from your customer and later claim that the equipment is personalty and your contract provisions are enforceable? That is my position, though tax advisors may have a different perspective and opinion.
            Sales tax is only one type of tax you need to be concerned with.  Some states have "use" taxes or may call it something else, or it may something else, and you get taxes on your ownership of assets, so the continued ownership of the equipment continues to get taxed.  Mitch, is that right?
            Mitch mentions another thorny issue and it comes up frequently.  I shut it down quickly, but clients are very inventive after they get off the phone and decide to change contract provisions on their own.  Client wants to lease the system and permit a buy-out at end for nominal amount.  This is indeed an "Installment Sale" which went out of style about the time I graduated from law school, almost 50 years ago.  Right, that's how long this sticky issue has been around and we can't seem to bury it for good.  Installment Sales were replaced by a sale secured by collateral [which requires a Security Agreement], usually whatever was sold and installed, perfected by a UCC-1 filing of a Financial Statement, which is the infamous UCC-1.  The Standard Form Agreement actually acts as the Security Agreement and you can file the UCC-1 to secure the subscriber's obligation for payment, but you won't.  When you have a disguised security interest transaction because you used Installment Sale language, and you don't follow it up with a Security Agreement and UCC-1 filing, you have no security, you don't have a lease and you don't have the transaction you thought you had.  Lease it and keep it; sell it and the subscriber owns it when installed.  The after-install services are the same for lease or sale. 
            Mitch mentions a case where the lease was challenged and it sounds like the reason was it was designed as an installment Sale, not a lease.  If it's a lease you probably can have one charge that includes the lease of the equipment and after-install charges.  Sales tax won't care and will argue that the RMR is taxable for sales tax as a lease, again depending on your state tax laws.  I am not aware of any federal sales tax so it's always the state you have to deal with.
            I'll conclude with this.  You want to lease, then get the Standard Leases.  You want to sell, then get the Standard All in One agreements.  Don't try to combine them.  Worried about tax issues, call Mitch. 

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Ken Kirschenbaum,Esq
Kirschenbaum & Kirschenbaum PC
Attorneys at Law
200 Garden City Plaza
Garden City, NY 11530
516 747 6700 x 301