It is a true conundrum: to depreciate or inventory? A dental equipment manufacturer or dealer purchasing equipment for use in the business or held for rental can depreciate it, plus it qualifies for like-kind exchange treatment under our tax rules. If however, that same equipment is held out for sale, under our tax rules it is considered inventory and cannot be either depreciated or exchanged.
With many dental dealers engaged in both selling and renting new and used equipment, as well as servicing such equipment, a recently published memorandum from the Office of the Internal Revenue Service's chief counsel may answer some confusing questions: Can a dental equipment business claim depreciation deductions or qualify for like-kind exchange treatment for equipment that is both "held for sale" and designated as rental equipment?
The tax laws
The tax laws are clear: a dental dealer can claim a depreciation deduction for the exhaustion and wear and tear of property used in a trade or business or for the production of income. However, those same laws also deny depreciation deductions for inventories or stock in trade.
Another area of the tax laws allows a manufacturer or dealer to ignore gain or loss on the exchange of business property if the property is exchanged solely for property of like kind. Restrictions deny this non-recognition treatment for an exchange of property that is stock in trade or other property held primarily for sale.
The real world
Equipment rentals have increased in recent years because of the relatively high cost of new equipment, which has become increasingly more sophisticated. Many potential customers for equipment are small practices and businesses that cannot afford to purchase new equipment. Consequently, many of these practices and businesses rent or purchase equipment after it has been rented for a significant period of time and the purchase price has been substantially reduced.
Some dental dealers have a separate rental operation where equipment items are dedicated to rental. More commonly, however, a dental dealer or business will hold equipment for either sale or rental. This is usually labeled as "dual use" property.
Looking back while looking forward
In 2005, the Internal Revenue Service acknowledged that so-called "dual use" property could arise in several different situations. For example, a business can hold equipment items for sale or rent, automobile dealers can use certain cars as demonstrators, and department stores can use articles of clothing for display purposes.
Unfortunately, the IRS failed to realize that there are important differences among industries. Demonstrators and display merchandise do not generally generate separate revenue for a taxpayer engaged in the business of selling merchandise. In contrast, equipment that is rented generates rental income for the dental dealer in addition to revenue from the sale of equipment. The existence of this separate revenue stream is, at least to some dealers, an indication that they are engaged in a rental business in addition to a merchandising business.
The IRS's position remains vague. The IRS has indicated that an important factor in determining whether property is used in a taxpayer's trade or business is whether the property generates separate revenue. In a 1989 Revenue Ruling, for instance, the IRS held that houses used as models or sales offices for a small fraction of their expected useful lives, which never generate any rental income, remain inventory property and therefore cannot be depreciated.
In a 2002 memo, the IRS stated that a taxpayer's leased equipment qualified as property used in a trade or business because the taxpayer "had a bona fide, ongoing leasing operation, and was using the equipment in that operation." The taxpayer usually sold its leased equipment for substantially less than its original cost and only recovered a portion of its cost through sales revenue. What's more, most of the taxpayer's equipment was leased multiple times and was offered to customers for lease for a substantial period of time. Thus, in this situation, the IRS believed the taxpayer's leased equipment was also held for sale and did not have to be treated as inventory.
Other IRS "advice" involved leased equipment that was temporarily used in the taxpayer's business where the taxpayer at all times could withdraw the dental supplies from lease, and the average term equipment was leased was only six months before being sold.
In a 1989 Revenue Ruling, the IRS held that equipment was not temporarily withdrawn from inventory where the equipment, once leased, was re-leased multiple times, the taxpayer derived substantial income from its leasing activities, and the equipment leased was usually owned two to four years before being sold by the taxpayer.
As far back as 1998, the IRS stated that, "{I]f an asset can function as both merchandise held for sale and as an asset used in a trade or business, the taxpayer's primary purpose for holding that asset determines whether the asset is inventoriable."
On balance, the courts and the IRS seem to indicate that if property is withdrawn from inventory and used in a taxpayer's business for longer than one year, the property will not generally be considered "temporarily" withdrawn from inventory.
