To charge sales tax or not to charge sales tax?

Pros and Cons or mostly Cons

In many states a portable storage operator can select to pay sales or use tax at the time he enters a container into his rental fleet and avoid the obligation of charging sales tax to his rental customer. The benefit of making this selection is that the operator can either offer a lower total cost of rental to his customer or charge the same rate as if sales tax was included but keep the additional revenue for himself. The selection may or may not be the best way to optimize profits and here are some views of the pros and cons of the different methods.

The main argument I hear from those companies that have chosen to take the use tax route is that they can offer lower rates to their customers. I have even seen companies advertise the benefit that they don’t charge sales tax. Obviously, the rate is a component of the cost and theoretically, it should be a competitive advantage not charging sales tax. However, one can argue that the amount is often insignificant and the typical quote is more or less always given without sales tax. Therefore, the buyer of rental service probably doesn’t pay much attention to the fact that there is no sales tax charged. The flip side of offering the lower rates is to be able to charge the same rates as the competition does including sales tax. In other words, in an environment with an average sales tax of 8%, the company that selects the use tax method would obtain 8% more revenue than the competition with the same cost to the customer. However, in this case one is likely to have more challenges if the rental customer is shopping for good rates and compares one company over the other. The quote from a rental company that charges sales tax would be, for example, $80 per rental period and the quote from the company that doesn’t charge sales tax would be $86:40 per rental period. Unless the customer asks the former of the two for the cost including sales tax will he understand the difference and the use tax operator alternative looks like it is more expensive.

There are also practical and financial considerations. On the practical side the use tax operator has to keep track of sales and use taxes not only for the container itself but for other materials used to improve or upfit the container. It is easy to pay use tax on the purchase cost of the container, which most often is purchased from a trading or container leasing company excluding sales tax. What is more complex is keeping track of taxes paid on tools and materials that he may or may not be able to acquire with the exemption of sales tax. This maybe off set by the operator not having to file is monthly or quarterly sales tax returns which in some states is tedious process. Secondly, if a container for which use tax is paid is sold, sales tax still applies unless the buyer is a reseller of containers. In other words, to handle the use tax method correctly, there are a lot of administrative tasks, involved.

The financial consideration is that paying use tax ties up capital and one should make a serious cost benefit analysis comparing the cost of capital for each of the two methods. It doesn’t seem like paying $160 in use tax on $2,000 container is a big deal but if one has a large fleet, say for instance 500 units, then the amount is $80,000 which then is equal to investing in an additional 40 containers. Or explained another way, for the use tax model to be beneficial the operator has to either be able to increase his fleet by more than 8% as a result of offering a rate without sales tax or charge the same rate as his competition does, including sales tax, for an initial period that is 8% longer than the average rental term. A third way to look at the cost of the use tax selection is to think in terms of the number of rental periods it takes to recover the use tax. If the rental rate is $80 per rental period the sales tax one doesn’t have to charge is $6:40 and if the use tax paid is $160 the recovery period is 25 rental periods. Furthermore, taking in consideration a utilization of 85% the rental recovery period is 29 rental periods, or two and half years and this is provided the operator can charge his rate at the same level as if the customer was paying sales tax.

Market Rental Rate – $80
Market Rental Rate including Sales Tax – $86:40
Container Purchase Cost – $2000
Use Tax Paid – $160
Monthly Sales tax not being charged – $6:40
Recovery Time in number of Rental Periods – ($160/$6:40) 25

Finally, and from my prospective, the largest negative of selecting the use tax model is what happens when the portable storage operator is looking to sell his business. In my previous article “Acquiring a fleet of portable storage containers on hire, NPSA Dec 2011”, I discussed the different valuation models of a rental fleet. One of the methods that is used for fleet and company evaluations is the “Return on Investment Method”. This methods looks at the cash flow stream of a rental fleet and depending on the buyers criteria for return on investment, he can establish a value of the fleet or business to be acquired. If the seller has selected the use tax model, the buyer is faced with the situation of either paying sales tax on the fleet he acquires and maintain the current status of the rental agreements; in other words, to continue to not charge sales tax, or buy the fleet selecting the traditional sales tax model. If he chooses the traditional sales tax model he is faced with rental agreements that are now subject to sales tax and it is very difficult to maintain utilization, customer loyalty and goodwill if one has to start charging sales tax and make the customers pay more by changing the rental agreements he acquires. Therefore, his best choice is to back in the sales tax in the current rates and only charge sales tax for new rental agreements post purchase. However, being faced with this situation the buyer is going to require a discount from the seller that compensates him for the lower rates. This discount is obviously related to size of the sales tax but can still be a considerable amount.

Here is an example:
Annual Rental Revenue – $884
Buyer ROI Requirement – 25%
Sale Price Per Unit – $3536
Use tax discount – 8% -$283
Discounted Sale Price – $3274
Monthly Sales tax not being charged – $6:40
Recovery Time in number of Rental Periods – ($283/$6:40) 44

We can also look at this from the perspective of how many rental periods it takes to recover the discount the seller’s selection of the use tax method. In the example above that period amounts to forty four rental periods which is about three and a half years.

Conclusion

A portable storage operator can select to pay use tax for his container and thereby not have to charge his customers for sales tax. The challenges with selecting this method are:

• The customers are used to quotes being made exclusive of sales tax and therefore tend to overlook the benefit of the method
• The operator will have a competitive disadvantage if his quotes are made at the same price as a competitor using the traditional sales tax method including sales tax
• The administration of add on expenses and capital improvements to the containers can be complex
• The use tax is a cash layout that has to be recovered over an extended period of time; either by higher rates, longer rental periods or increased number of customers
• The use tax method has negative impact on the valuation of a rental fleet and a seller of such a fleet cannot expect the same price as if the traditional sales tax method was used.

Given my observation of this use tax method, I recommend that if you are using this model; take a look at the benefits of converting to a sales tax model, especially if you are looking to sell your business within the next few years. Secondly, do very detailed calculations if you are considering this method. Obviously, all markets aren’t the same; rates and sales tax rates may differ and therefore the choice of method can be more or less beneficial.