Was a computer company's close-out sale occasional because it claimed the assets belonged mainly to its custom-programming service activity?

Plain-English summary

A corporation holding a seller's permit sold computer hardware and software and provided computer services. It later made an unreported close-out sale of business assets to its major customer while the parties were developing a programming partnership. The corporation argued that most of the assets belonged solely to its custom-programming or consulting activity.

The hearing officer did not decide whether programming was the company's main activity. Even assuming it was, the company had made a series of computer-hardware sales, and the final transfer of computer hardware and software was another step in that series. Used rather than new equipment and liquidation did not supply a sufficient distinction.

The close-out sale therefore did not qualify as occasional. On his own motion, the hearing officer also rejected a section 6010.9 exclusion for the existing custom-software library under Touche Ross. He recommended redetermination without adjustment to the tax; the PDF supplies no final Board action.

Audit history, conflicting figures, authorities, and source limits

Hearing Officer James E. Mahler heard the redacted corporation's petition on February 6, 1991 in San Diego. The protested period was April 1, 1985 through December 31, 1986, and the protested item was an unreported fixed-asset sale measured by $33,857. Senior Tax Auditor James M. Stillwell appeared for the Sales and Use Tax Department; the appearance line for petitioner is blank, although the narrative says the corporation's president and principal shareholder spoke.

The corporation obtained a seller's permit in April 1984 for computer hardware and software; computer services. Its October 1985 through October 1986 returns reported $94,905.22 of total receipts excluding tax, divided into $20,154.77 of labor and $75,750.45 of tangible personal property, with zero receipts in unlisted months. Later, however, the analysis calls the October 1985–October 1986 hardware series $74,750.45. The source does not resolve the $1,000 difference.

Audit comments placed the close-out on October 31, 1986 but said it was backdated to January 2, 1986. The corporation's 1986 federal return reportedly allocated a $33,857 price among $23,760 of computer hardware and software, $1,155 of office furniture, and 1984 and 1985 computer equipment of $7,842 and $1,100.

An original Schedule 12A-3 said the hardware and software was used exclusively in customized programming and therefore qualified as occasional, yet still subjected the full $33,857 to tax. Its listed $1,380, $21,759, and $14,931 components did not add to $33,857. A supervisor ordered a rewrite. Final Schedule 12A-1 instead said the fixed assets of the claimed programming and hardware businesses were commingled and allocated $1,155 to furniture and $32,702 to hardware, software, and manuals. The petitioner received the original schedule but not the revision.

The president said hardware sales initially financed programming equipment and later were often at cost for programming customers. Customer C made up most reported sales from October 1985 through October 1986, including one $69,649.05 hardware purchase at cost in October 1986. Before a proposed entertainment-programming partnership was formally created, the corporation charged C half its normal programming rate and retained half the ownership rights. The close-out allegedly funded more program development.

A post-hearing letter reported $280,369.40 of 1986 consulting or programming income, about three times reported hardware-and-labor receipts. The petitioner conceded tax on $5,416 of the close-out. That passage prints a $33,357 total and a $28,441 disputed balance, while the earlier total is $33,857 and $5,416 plus $28,441 equals $33,857. The analysis later prints $28,411. The source does not choose among these figures.

Sections 6367 and 6006.5(a), together with Regulation 1595(a)(4), supplied the occasional-sale and series rules. The officer assumed without deciding that programming was the main activity but treated the final hardware-and-software sale as another step in the prior hardware series. Regulation 1595(a)(5)'s hospital and hotel examples did not change that conclusion because their final equipment sales could be distinct from prior pharmacy, restaurant, or bar sales, while this company's final assets matched its prior hardware-and-software activity.

Section 6051 supplied the new-or-used proposition. Sutter Packing Co. v. State Board of Equalization, 139 Cal. App. 2d 889, rejected liquidation alone as a sufficient distinction. Ontario Community Foundation, Inc. v. State Board of Equalization, 35 Cal. 3d 811, involved a single hospital-asset sale rather than a series, and Hotel Del Coronado Corp. v. State Board of Equalization, 15 Cal. App. 3d 612, treated a hotel close-out as part of prior hotel-asset sales. The printed citations resolve to the named cases.

The section 6010.9 software-library issue had not been raised in the petition or at hearing. Reviewing it on his own motion, Mahler relied on Touche Ross & Co. v. State Board of Equalization, 203 Cal. App. 3d 1057, to deny an exclusion for an existing custom-program library. That printed citation also resolves to the named case.

The PDF omits the petition, determination, returns, audit report and workpapers, both schedules, federal return, close-out agreement, invoices, asset list, ownership and use records, backdating evidence, partnership proposal and formation record, programming contracts, post-hearing letter, transcript, exhibits, briefs, tax calculation, Board submission and decision, payment, refund claim, appeal, and later outcome.

The live annotation preserves the corporation's hardware, software and service activities, its main-programming claim, close-out, related-asset and sales-series reasoning, and June 6, 1991 date. It omits the hearing and audit provenance; dates, amounts, allocations and internal conflicts; original and rewritten schedules; unprovided revision; permit and return history; proposed partnership and post-hearing income; statutes, regulation details and all four cases; software-library ruling; recommendation language; missing records; final-outcome gap; and reliance status.

What this means for you

Service businesses that also sell products

Under this historical recommendation, describing an enterprise as primarily a service business did not protect a final asset sale that matched its prior tangible-property sales.

Accountants and tax professionals

Compare the final assets with prior sales and reconcile returns, workpapers, contracts, and asset allocations before applying the series rule. New-versus-used status and liquidation labels did not decide this record.

Common questions

Q: Did the recommendation decide whether the company was essentially a service enterprise?
A: No. It assumed that point in the company's favor and still found the close-out sale taxable.

Q: Why did the final sale belong to the prior sales series?
A: The company had repeatedly sold computer hardware, and the close-out transaction also transferred computer hardware and software.

Q: Did selling used rather than new equipment matter?
A: No. Sales tax applies to tangible personal property whether new or used.

Q: Was the existing custom-software library excluded?
A: No. The recommendation said an existing library of custom programs did not qualify for the section 6010.9 exclusion under the cited appellate decision.

Q: When did the close-out occur?

A: Audit comments said October 31, 1986 but backdated to January 2, 1986. The underlying records are missing.

Q: How much was the close-out?

A: Most passages and the allocation use $33,857. One passage prints $33,357, and the source does not resolve the conflict.

Q: Did the source consistently state the prior hardware-sales total?

A: No. The returns chart totals tangible personal property at $75,750.45, while the analysis states $74,750.45.

Q: Was the petitioner's disputed portion clear?

A: No. The source prints both $28,441 and $28,411 after stating a $5,416 concession.

Q: Was this the final Board decision?

A: No final Board action is supplied. The document is a hearing officer's decision and recommendation to redetermine without adjusting the tax.

Citations and references

• California Revenue and Taxation Code §§ 6006.5(a), 6010.9, 6051, and 6367
• California Sales and Use Tax Regulation 1595(a)(4) and (a)(5)
• Sutter Packing Co. v. State Board of Equalization, 139 Cal. App. 2d 889, 896
• Ontario Community Foundation, Inc. v. State Board of Equalization, 35 Cal. 3d 811, 815
• Hotel Del Coronado Corp. v. State Board of Equalization, 15 Cal. App. 3d 612
• Touche Ross & Co. v. State Board of Equalization, 203 Cal. App. 3d 1057
• Returns, audit and schedules, federal return, sale and partnership records, post-hearing letter, Board decision, and outcome — described or implicated but not included

Verbatim support

From the official June 6, 1991 Appeals Division recommendation:

According to the audit comments, the sale to (C) occurred on October 31, 1986, but was backdated to January 2, 1986.

Whether petitioner's business was or was not "essentially a service enterprise" is certainly an intriguing philosophical question, but we find it unnecessary to decide the point.

Petitioner made a series of sales of computer hardware from October 1985 through October 1986 which totalled $74,750.45, a series sufficient in number, scope and character to require the holding of a seller's permit.

The fact alone that the last sale was made in liquidation of a business is apparently not such a distinction in the nature of the sale as to warrant an exemption if it would otherwise have been considered part of a series of sales sufficient in number, scope and character to constitute an activity requiring a seller's permit and subjecting it to the tax.

The California Court of Appeal has recently held that the sale of an existing software library consisting of custom computer programs does not qualify for exclusion under Section 6010.9.

Redetermine without adjustment to the tax.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 395.0673
• Original supporting opinion: 395.0673 PDF

Original ruling text

STATE OF CALIFORNIA
BOARD OF EQUALIZATION
APPEALS DIVISION
In the Matter of the Petition
for Redetermination Under the
Sales and Use Tax Laws:

Petitioner

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395.0673

DECISION AND RECOMMENDATION
No. ----

The above-referenced matter came on regularly for hearing before Hearing Officer James E. Mahler on February 6, 1991, in San Diego, California.

Appearing for Petitioner:

Appearing for the Sales and Use Tax Department:

James M. Stillwell
Senior Tax Auditor

Protested Item
The protested tax liability for the period April 1, 1985, through December 31, 1986, is measured by:

Item

State, Local and County

Unreported sale of fixed assets

$33,857

Petitioner's Contention
Petitioner was engaged primarily in the business of performing nontaxable computer programming services, and tax does not apply to the sale of assets held or used in that business. Summary The petitioner corporation obtained a seller's permit in April 1984 to engage in the business of selling "computer hardware and software; computer services." From October 1985 through October 1986, petitioner filed monthly sales and use tax returns reporting sales as shown in the following charts (For the months not shown on the chart, petitioner filed returns showing zero receipts.)

October ’85
December ’85
January ’86
February ’86
September ’86
October ’86

Total Receipts (ex tax)

Labor

$18,674.87
250.00
2,875.20
659.50
2,411.60
70,034.05
$94,905.22

$17,325.67
-0-032.50
2,411.60
385.00
$20,154.77

Tangible Personal Property
$1,349.20
250.00
2,875.20
627.00
-069,649.05
$75,750.45

The audit found that petitioner had made a close-out sale of its business assets to an entity called (C) , which was not reported on petitioner's sales and use tax returns. The audit asserted tax on this sale and petitioner protests. According to the audit comments, the sale to (C) occurred on October 31, 1986, but was backdated to January 2, 1986. The total selling price as shown on petitioner's 1986 federal income tax return was $33,857, allocated as follows: Computer hardware & software Office furniture Computer equipment (1984) Computer equipment (1985)

$23,760
1,155
7,842
1,100
$33,857

The auditor originally prepared a Schedule 12A-3 stating that the computer hardware and software was "used exclusively in conjunction with the T/P's customized programming business, therefore qualifying it as an occasional sale." Despite this comment, the schedule showed the entire $33,857 selling price as subject to tax. (The schedule also broke down the selling price between furniture, $1,380; computer hardware, $21,759; and computer software and manuals,
$14,931, which does not add up.)
Subsequently, the auditor's supervisor ordered the auditor to rewrite this schedule. As incorporated into the final audit workpapers, the schedule is retitled Schedule 12A-1 and comments that the occasional sale exemption is not available to petitioner because: "Although the TIP contends he was operating two separate and distinct businesses, the development of customized software, and the sale of computer hardware, the fixed assets of the business were commingled." (The revised schedule breaks down the $33,857 selling price between furniture,
$1,155; and computer hardware, software and software manuals, $32,702.) A copy of the original Schedule 12A-3 was provided to petitioner. No copy of the revised Schedule 12A-l was provided to petitioner. At the appeal hearing, Mr. --- petitioner's president and principle shareholder, explained that he had always been primarily interested in computer programming. Hardware sales were initially intended only as a way to finance the acquisition of equipment for use in the programming business. Over the years, the amount of hardware sales decreased as the income from programming increased. In fact, in later years hardware was often sold at cost as an accommodation to programming customers.

By 1985, (C) was petitioner's major customer, and most of the reported sales between October 1985 and October 1986 were to that company. For example, the $69,649.05 reported sale in October 1986 was from a single sale of hardware to (C) at cost. (C) had proposed to form a partnership with petitioner to engage in the business of writing computer programs for the entertainment industry. Early in 1986, although the partnership had not as vet been officially formed, petitioner began charging (C) only one-half of the normal hourly charge for programming work, and in return kept one-half of the ownership rights in the programming. The close-out sale in question was a step in the formation of the partnership with (C). The transaction was structured as a sale of business assets solely to provide funds to petitioner to finance additional program development. Mr. --- also stated that the amounts reported as "labor" on petitioner's sales and use tax returns were mostly for the labor of installing hardware sold. Receipts from programming services were not reported on the returns. After the hearing, Mr. --- advised the Hearing Officer by letter that "consulting" or programming income for the calendar year 1986 was $280,369.40, about three times the reported receipts from hardware sales and labor. Petitioner concedes that $5,416 of the $33,357 close-out selling price was for computer hardware and office furniture used in all aspects of the business. Petitioner admits that tax applies to that amount. As for the remaining $28,441, petitioner contends that it was for computer hardware and software used solely in "the consulting or programming business. Petitioner argues that such assets were not held or used in an activity requiring a seller's permit, so that the sale of those assets qualifies as an exempt occasional sale. Analysis and Conclusions Revenue and Taxation Code Section 6367 provides that tax does not apply to "occasional sales". In relevant part, the term "occasional sale" is defined in Section 6006.5(a) of the Code to include the: "… sale of property not held or used by a seller in the course of activities for which he or she is required to hold a seller's permit... provided the sale is not one of a series of sales sufficient in number, scope, and character to constitute an activity for which he or she is required to hold a seller's permit…" Petitioner contends that assets sold for $28,411 were held or used in the business of consulting or custom computer programming, an activity which in itself would not require the holding of a seller's permit. Petitioner concludes that the sale of these assets therefore qualifies as an exempt occasional sale. In support, petitioner relies on the provisions of Sales and Use Tax Regulation 1595(a)(5)(A) dealing with the occasional sale exemption as applied to operators of "service enterprises". The audit staff responds that all of the assets sold to (C)were held or used in a single business, a business which included hardware sales as well as computer programming, and that a seller's permit was required for the business. The staff accordingly concludes that the close-out sale was not an occasional sale. The staff apparently relies on Sales and Use Tax Regulation 1595(a)(5)(B), which discusses the occasional sale exemption as applied to any business which is not "essentially a service enterprise."

Whether petitioner's business was or was not "essentially a service enterprise" is certainly an intriguing philosophical question, but we find it unnecessary to decide the point. Assuming without deciding that custom programming was petitioner's main business activity, the close-out sale to (C)would still be subject to tax. The definition of "occasional sale" in Section 6006.5(a) expressly excludes any sale which is "one of a series of sales sufficient in number, scope, and character to constitute an activity" requiring a seller's permit. Regulation 1595(a) (4) further provides: "When a person not otherwise engaged in an activity requiring the holding of a seller's permit makes a series of sales sufficient in number, scope and character to require the holding of a seller's permit, the gross receipts from all of such sales are subject to tax." Petitioner made a series of sales of computer hardware from October 1985 through October 1986 which totalled $74,750.45, a series sufficient in number, scope and character to require the holding of a seller's permit. The close-out sale in question was merely another step in this series and therefore does not qualify as an occasional sale. The examples listed in Regulation 1595(a)(5)(A) are not to the contrary. The regulation lists enterprises such as hospitals (which might have made taxable sales of non-prescription medicines through a pharmacy) and hotels (which may have made taxable sales through a restaurant or bar). In these situations, a final sale of equipment used in the business could not reasonably be considered part of a series with the prior sales. Here, however, petitioner was engaged in the business of selling computer hardware and software, and the final sale to (C) was also computer hardware and software. We recognize that petitioner's prior sales were new equipment, while the final sale to C was used equipment. However, sales tax applies to all sales of tangible personal property without regard to whether the property is new or used. (See Rev. & Tax. Code § 6051.) There is accordingly no rational basis for treating a final sale of used assets as inherently different from prior sales of new equipment. As the court held in Sutter Packing Co. v. State Bd. of Equal., 139 Cal.App.2d 889 at 896: "The fact alone that the last sale was made in liquidation of a business is apparently not such a distinction in the nature of the sale as to warrant an exemption if it would otherwise have been considered part of a series of sales sufficient in number, scope and character to constitute an activity requiring a seller's permit and subjecting it to the tax." Petitioner also relies on Ontario Community Foundations, Inc. v. State Bd. of Equalization, 35 Cal.3d 811 and Hotel del Coronado Corp. v. State Board of Equalization, 15 Cal.App.3d 612. Neither case supports its position. In Ontario, the court was careful to note that the "single sale" of hospital assets was not “‘one of a series’ of such sales which independently might require a permit under the statute.” (35 Cal.3d at 815.) In Hotel del Coronado, the court concluded that a close-out sale of hotel assets was subject to tax, and was not an exempt occasional sale, because it was part of a series of prior sales of hotel assets.

For these reasons, we conclude that petitioner's close-out sale to (C) does not qualify as an occasional sale.

In discussions with the audit staff prior to the appeal hearing, petitioner apparently contended that the portion of the close-out selling price attributable to its custom software library would qualify for exclusion under Revenue and Taxation Code Section 6010.9. This contention was not raised in the written petition for redetermination or discussed at the appeal hearing, but we have reviewed it on our own motion and conclude that no adjustment to the tax is warranted. The California Court of Appeal has recently held that the sale of an existing software library consisting of custom computer programs does not qualify for exclusion under Section 6010.9. (Touche Ross & Co. v. State Bd. of Equalization, 203 Cal.App.3d 1057.) Recommendation Redetermine without adjustment to the tax.

6/6/91
James E. Mahler, Hearing Officer

Date