In Kansas, can property a business rents out still qualify for the merchant's inventory property-tax exemption, or does depreciating it for federal taxes disqualify it?

Plain-English summary

Kansas exempts merchant's and manufacturer's inventory from property tax, under Article 11, Section 1(b) of the Kansas Constitution and K.S.A. 79-201m. The hard question this directive answers is what happens when a business both rents and sells the same goods -- and depreciates them on its federal return.

The statute seemed to say depreciation was fatal: as amended in 1989, it provided that "[a] capital asset subject to depreciation or cost recovery accounting for federal income tax purposes shall not be classified as inventory." But in Board of Sedgwick County Comm'rs v. Action Rent to Own, Inc., 266 Kan. 293 (1998), the Kansas Supreme Court held that "a capital asset subject to depreciation for federal income tax purposes may still be considered inventory."

The dividing line is what the property is primarily held for:

• Primarily held for sale in the ordinary course of business → can qualify for exemption.
• Primarily rented in the ordinary course of business → not exempt.

The statute helps by treating light rental use as harmless: an "incidental use, including but not limited to the rental or lease of any such property, shall not be deemed to be an intervening use." Legislative history showed the legislature meant to protect large equipment "occasionally leased for demonstration purposes before it is sold," while expressly declining "to exempt the inventory of a regular rental business, such as a video or car rental business."

Rent-to-own sat between those poles, and the Court put it on the exempt side: it "viewed 'rent-to-own' business inventory as something other than the inventory of a regular rental business."

What this means for you

Rent-to-own and lease-to-own businesses

Your goods are not disqualified merely because you depreciate them. But exemption is not automatic either -- "[w]hether or not inventory is primarily held for sale is a question of fact generally determined by the county appraiser or the Kansas Board of Tax Appeals." The three factors the Board of Tax Appeals actually weighed are your roadmap for documentation:

1. The economics of the agreement. The rent agreements were "in substance sales finance agreements given their relatively short length (typically 12 months) and nominal purchase price ($0) at the end of the agreement."
2. Age and eventual disposition. Assets held for sale or under contract were "fairly new; typically just twelve months old or less," and "[v]irtually all the assets were eventually sold without modification or intervening use other than the incidental lease use."
3. Turnover before sale. "On average, the assets were rented slightly more than two times and less than two years before being acquired by the customer," with some evidence of direct cash sales as well.

Keep records that speak to these: contract length, end-of-term purchase price, average age at sale, number of rentals per unit, and your mix of outright sales.

Regular rental businesses

If you rent as your business -- the directive's own examples are video and car rental -- your rental fleet is not exempt inventory, even though you may sell units at the end of their life. Note the separate statutory bar: a depreciable capital asset "that is retired from regular use by its owner and held for sale or as standby or surplus equipment by such owner shall not be classified as inventory." Retiring a rental unit and putting it up for sale does not convert it into exempt inventory.

Equipment dealers who demo before selling

This is the case the legislature had in mind. Occasional demonstration leasing of large equipment held for sale is the paradigm of an "incidental use" that is not an intervening use, so it should not cost you the exemption.

Accountants and tax professionals

Two practical points. First, the federal-depreciation treatment is not controlling for the Kansas property-tax exemption, so do not concede exemption merely because an asset is on a depreciation schedule. Second, note the tie-break rule at the end: if the county appraiser is in doubt, "he or she should construe in favor of taxation and assist the taxpayer in filing an application for exemption (Directive 92-025)." Doubt resolves against exemption at the county level, which means the burden of building the factual record is effectively yours -- and the directive contemplates that "[a]ll relevant facts should be presented to the Board to allow them to make a proper determination."

Common questions

Q: Does depreciating property for federal taxes kill the Kansas inventory exemption?
A: No, not by itself. The Kansas Supreme Court held that a capital asset subject to depreciation for federal income tax purposes may still be considered inventory, so long as it is primarily held for sale in the ordinary course of business.

Q: What is the actual test?
A: Whether the property is primarily held for sale, versus primarily rented, in the ordinary course of business. "Assets that are primarily rented in the ordinary course of business are not exempt."

Q: My business both rents and sells the same goods. How is that decided?
A: It is a question of fact for the county appraiser or the Board of Tax Appeals, decided on evidence like the substance of your agreements, the age of assets when sold, how many times a unit rents before a customer acquires it, and whether virtually all units are ultimately sold.

Q: Is a video store's or car rental company's fleet exempt?
A: No. The legislative history the Court relied on expressly declined to exempt the inventory of a regular rental business, naming video and car rental businesses.

Q: What happens to a rental unit I retire and put up for sale?
A: The statute quoted in the directive says a depreciable capital asset retired from regular use and held for sale, or as standby or surplus equipment, "shall not be classified as inventory."

Q: What was Directive 92-026?
A: The Division's earlier "Rent to Own" Property directive. This directive states that it "is hereby rescinded," and supersedes it to reflect the Supreme Court's December 11, 1998 decision.

Citations and references

Kansas constitution and statutes:

• Kan. Const. art. 11, § 1(b) (merchant's and manufacturer's inventory exemption)
• K.S.A. 79-201m (definitions of "merchant," "manufacturer," and "inventory"; incidental rental use; retired/standby/surplus equipment)
• K.S.A. 79-505 (authority for the directive)
• L. 1989, ch. 289, § 1 (the 1989 amendments the Court construed)

Case and administrative decisions cited:

• Board of Sedgwick County Comm'rs v. Action Rent to Own, Inc., 266 Kan. 293 (1998), at 300, 302, 303-04 (decided December 11, 1998)
• Kansas Board of Tax Appeals Docket No. 93-4695-TG, Original Order paragraphs 49, 50, 51; Order on Remand paragraphs 5, 9

Related directives: rescinds and supersedes Directive No. 92-026 ("Rent to Own" Property); cross-references Directive 92-025 on construing doubt in favor of taxation and assisting with exemption applications.

Source

• Landing page: Kansas Property Tax Directives
• Original PDF: PVD Directive 99-037

Original ruling text

STATE OF KANSAS DEPARTMENT OF REVENUE
%LOOUDYHVRYHUQRU .DUOD3LHUFH6HFUHWDU\

Mark S. Beck, Director (785) 296-2365
Kansas Department of Revenue FAX (785) 296-2320
915 SW Harrison St. Hearing Impaired TTY (785) 296-3909
Topeka, KS 66612-1585 Internet Address: www.ink.org/public/kdor

                                  Division of Property Valuation

                                        DIRECTIVE #99-037

   TO:                     County Appraisers


   SUBJECT:                Merchant’s and Manufacturer’s Inventory Exemption
                           This Directive Supersedes Directive No. 92-026


   This directive is adopted pursuant to the provisions of K.S.A. 79-505, and reflects the law of
   Kansas due to a published Kansas Supreme Court decision issued on December 11, 1998.

   Directive No. 92-026 entitled “Rent to Own” Property is hereby rescinded.

   Summary

   Article 11, Section 1 (b) of the Kansas Constitution and K.S.A. 79-201m provide a property tax
   exemption for merchant’s and manufacturer’s inventory. The terms “merchant,” “manufacturer,”
   and “inventory” are defined in K.S.A. 79-201m. The Kansas Supreme Court issued a decision
   that helps define merchant’s inventory. (Board of Sedgwick County Comm’rs v. Action Rent to
   Own, Inc., 266 Kan. 293 (1998)(hereinafter Rent to Own, Inc.)) The court held that leased
   property subject to depreciation for federal income tax purposes may still qualify for exemption
   if it is primarily held for sale in the ordinary course of business.

   Kansas Supreme Court: leased and depreciated property may be inventory

   In Rent to Own, Inc., the Kansas Supreme Court held that for purposes of K.S.A. 79-201m, a
   capital asset subject to depreciation for federal income tax purposes may still be considered
   inventory. (Rent to Own, Inc. at 303-4). However, the property tax exemption extends only to
   capital assets that are primarily held for sale in the ordinary course of business. Assets that are
   primarily rented in the ordinary course of business are not exempt. (Rent to Own, Inc., at 304).

   In Rent to Own, Inc., the property at issue was furniture. Some of the furniture was sold outright
   for cash, but the vast majority of it was leased. These lease agreements allowed the lessee to
   acquire the furniture by renewing the lease for a specified number of consecutive periods. No
   additional payment was required at the end of the lease for title to transfer. The Board of Tax
   Appeals determined that these lease agreements were in substance finance agreements. (Rent to
   Own, Inc., at 300; Board of Tax Appeals Original Order No. 93-4695-TG, paragraph 49).

Page 2

Directive #99-037
Page 2

From a legal perspective, the court focused on K.S.A. 79-201m (a) and (c) as these paragraphs
were amended in 1989. The relevant provisions follow:

   (a) “Merchant” means and includes every person, company or corporation who shall
       own or hold, subject to their control, any tangible personal property within this state
       which shall have been purchased primarily for resale without modification or
       change in form or substance, and without any intervening use in the ordinary course
       of business without modification or change in form or substance and without any
       intervening use, except that, an incidental use, including but not limited to the
       rental or lease of any such property, shall not be deemed to be an intervening use.
       …
   (b) “inventory” means and includes those items of tangible personal property that: (1)
       Are primarily held for sale in the ordinary course of business (finished goods ); (2)
       are in process of production for such sale (work in process); or (3) are to be
       consumed either directly or indirectly in the production of finished goods (raw
       materials and supplies). Assets A capital asset subject to depreciation or cost
       recovery accounting for federal income tax purposes shall not be classified as
       inventory. A depreciable asset that is retired from regular use by its owner and held
       for sale as standby or as surplus equipment by such owner shall not be classified as
       inventory. L. 1989, ch. 289 Sec. 1, Rent-to-Own, Inc. at 302.

Legislative History

Finding this language somewhat ambiguous, the Kansas Supreme Court turned to documented
legislative history. The court found that the legislature intended to exempt large equipment that is
occasionally leased for demonstration purposes before it is sold. However, the legislature
expressly stated that it did not intend to go so far as to exempt the inventory of a regular rental
business, such as a video or car rental business.

Kansas Supreme Court: a “rent to own” business differs from a “regular rental business”

The court viewed “rent-to-own” business inventory as something other than the inventory of a
regular rental business. (Rent to Own, Inc., at 303). Therefore, the court held that “rent-to-own”
business inventory can qualify for exemption if the inventory is primarily held for sale in the
ordinary course of business. Whether or not inventory is primarily held for sale is a question of
fact generally determined by the county appraiser or the Kansas Board of Tax Appeals.

Factors used to determine whether “rent to own” property is held primarily for sale

In Rent to Own, Inc., the Board of Tax Appeals considered the following factors when it
determined that the property was primarily held for sale rather than rent:

   1.      The rent agreements were in substance sales finance agreements given their
           relatively short length (typically 12 months) and nominal purchase price ($0) at
           the end of the agreement. (Docket No. 93-4695-TG, Original Order, paragraphs
           49, 50).

Page 3

Directive #99-037
Page 3

   2.      The assets that were held for sale or under contract for sale were fairly new;
           typically just twelve months old or less. (Id., paragraph 50). Virtually all the
           assets were eventually sold without modification or intervening use other than the
           incidental lease use. (Order on Remand, paragraph 9).

   3.      On average, the assets were rented slightly more than two times and less than two
           years before being acquired by the customer. (Original Order, paragraphs 50, 51).
           There was also evidence of some direct sales. (Order on Remand, paragraph 5).

Property held for sale in the ordinary course of business

Depreciable property that is held for sale by its owner but not in the ordinary course of the
owner’s business does not qualify for the inventory exemption. The last sentence in K.S.A. 79-
201(m)(c) states:

   “. . . A capital asset subject to depreciation or cost recovery accounting for federal
   income tax purposes that is retired from regular use by its owner and held for sale
   or as standby or surplus equipment by such owner shall not be classified as
   inventory.”

Conclusion

If a county appraiser is in doubt as to whether rent-to-own property is held primarily for sale or
for rent in the ordinary course of business, he or she should construe in favor of taxation and
assist the taxpayer in filing an application for exemption (Directive 92-025). All relevant facts
should be presented to the Board to allow them to make a proper determination.

Approved: February 24, 2000 ______
Mark S. Beck
Director of Property Valuation