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May 22, 2018

Illinois’ Unique Treatment of Leases and Traps for the Unwary Lessor

Authored by David Machemer

 in State & Local Tax (SALT)

Illinois' treatment of leases is an anomaly when compared to almost all other jurisdictions.[1] While most jurisdictions impose sales tax on the lease receipts collected from the lessee, the user of the equipment, Illinois differs by treating the lessor as the user of the equipment.  As such, the lessor is subject to Illinois use tax.  86 Ill. Admin. 130.2010; GIL 16-0067 (12/27/2016).  Illinois' unique treatment presents many challenges for lessors.  First and foremost, Illinois' places the imposition of tax on the entity that does not have the day-to-day control over the equipment.  This is particularly challenging in the context of mobile property.  Additionally, in the context of exemptions, the question of whether a lessee's exemption "flows through" to the lessor is often presented.  This post provides an overview of the retailer's occupation tax (i.e. sales tax) and use tax consequences of leasing equipment in Illinois.

What is a lease?

Under Illinois law, "true leases" and "conditional sales", often referred to as "$1 outs" are subject to different tax treatment. GIL 16-0067 (12/27/2016).  A conditional sale is traditionally characterized by a nominal or dollar purchase option at the end of the term.  Essentially, conditional sales are finance or "loan" transactions disguised as a "sale."  This finance product is subject to Illinois Retailers' Occupation Tax (i.e. sales tax).  Conversely, a "true lease" does not have an automatic buy-out provision at the end of term, and if one does exist, the buyout must be for fair market value.  Under Illinois law, lessors are deemed to be the end users of the property being leased and are subject to Illinois Use Tax on the acquisition cost of the property.  86 Ill. Admin Code 130.220.

However, the general rule that lessors are subject to a use tax on purchases of property they intend to lease is not without exception.  For example, automobiles which are rented for less than one year are subject to Automobile Renting Occupation and Use Tax ("AROT")[2], certain leased passenger motor vehicles are subject to different rules and compliance requirements, including paying tax on "post lease" charges which I wrote about here [3], and consumer rent-to-own equipment are all examples of scenarios that do not follow Illinois' general treatment of equipment leases outlined in this post.[4] Thus, the analysis which follows applies to the general rule that lessors incur use tax on property purchased for lease. 

Ramifications of the Illinois Lessor's Use Tax

Lessors should not provide a resale certificate to the seller.

In jurisdictions where the tax is imposed on the lessee, the lessor should habitually provide a resale certificate to the seller of the equipment to be leased.  This is because most jurisdictions impose tax on the lessee and grant a "resale" exemption to property acquired for the purposes of leasing or renting to an end user.  Conversely, in Illinois, a lessor should never provide the vendor or manufacturer with a resale certificate in a true lease.  86 Ill. Admin Code 130.220.  Rather, the lessor should pay the applicable use charged by the seller, or alternatively, if the vendor otherwise fails to charge tax, the lessor must self-assess and remit Use Tax on its Illinois return.  Id.

As lessor, is the lessor's use tax just a cost of doing business that I cannot recover?          

No.  Despite Illinois' imposition of use tax on the lessor, and that lessees are not subject to tax on the lease receipts, a lessor can recoup its tax costs through private reimbursement with its lessee.  86 Ill. Admin. Code 150.305(d); ST 15-0018 GIL (3/18/2015).  Lessors often accomplish this by drafting a tax reimbursement provision in the lease agreement.  So long as an agreement exists, lessees are obligated to fulfill the terms of the private contract. 

What if my lessee claims its entity status qualifies for an exemption?

The short answer is that a lessee's "exempt" status does not always flow through to the lessor and exempt the lease transaction.  In my prior experience working in-house for a large leasing company, this was one of the most common issues that caused friction between the lessor and its lessees.  Often, charitable and religious institutions, who are generally exempt from their purchases and leases in most jurisdictions, unexpectedly find a "reimbursement for use tax paid" on its invoice. See Private Letter Ruling ST 92-0688 (12/21/1992).  These entities often attempt to rely on the rule that lease receipts are not subject to tax, but fail to understand their lease agreement with the lessor requires it to reimburse the lessor for its use tax obligations.  If lessors seek to collect this reimbursement from its lessees, specific "reimbursement" language should be used. 

However, some entities' status will flow through to the lessor and exempt the lease transaction.  For example, certain purchases of tangible personal property by persons who are leasing property to qualifying persons who have been issued an "E" number by the Illinois Department of Revenue are exempt from use tax. See 35 ILCS 105/3-5(22), (23), (31).  These persons are limited to governmental bodies and exempt hospitals.  86 Ill. Admin. Code 130.2011 & 130.2012.  In the context of hospitals, only certain purchases will qualify - namely computers and communications equipment utilized for hospital purpose and equipment that are used to diagnose, analyze, or treat hospital patients. Id.; See also  General Information Letter Ruling ST 15-0018 IL (3/18/2015).

Rolling Stock: A common exemption that "flows through"[5]

Another common exemption which flows through for the lessor's benefit on its purchase of equipment is the rolling stock exemption.  The term "rolling stock" includes the transportation vehicles of any kind of interstate company for hire (railroad, bus, airline, trucking, etc).  Effective August 24, 2017, to qualify for the exemption, the motor vehicle or trailer must be used to transport persons or property for hire, the purchaser must certify that the motor vehicle or trailer will be utilized by an interstate carrier for hire who holds an active USDOT number with the carrier operation identified as "interstate" and the operation classification as "authorized for hire," "exempt for hire," or both, and for motor vehicles, the gross vehicle weight rating must exceed 16,000 pounds.  P.A. 100-321 (eff. Aug. 24, 2017).  Prior to this amendment, the lessor was required to certify that the vehicles were utilized more than 50% of its miles or trips outside Illinois. See 35 ILCS 115/2d.

Notably, this exemption cannot be claimed by a purely intrastate carrier for hire.  However, a lessor can claim this exemption if the vehicle is used by an interstate carrier for hire, even if just between points in Illinois, if in transporting, for hire, the persons or property being transported originate or terminate outside Illinois on other carriers.  86 Ill. Admin. Code 130.340(d).

By requiring the lessor to certify as to the lessee's status, this exemption places the lessor in an uncomfortable position.  Notably, the Illinois form used to claim this exemption requires the lessor to sign and certify as to the lessee's interstate carrier status.  Fortunately, the recent law change has lessened this burden by eliminating the actual mileage/trip usage.  Moreover, there are ways that a lessor can verify a lessee's carrier status by visiting the U.S. Department of Transportation, Federal Motor Carrier Safety Administration's "Safety and Fitness Electronic Records (SAFER) System."

Conclusion

An equipment lessor leasing property in Illinois must be aware of Illinois' unique treatment of leases or it will undoubtedly find itself with unforeseen tax liability. Additionally, lessors leasing property within the City of Chicago must also be aware of the Personal Property Lease Transaction.  My colleague, Samantha K. Breslow recently wrote about this tax.  Unlike the treatment of Illinois leases, the lease transaction tax is a tax on lease receipts.  Thus, lessees in Chicago are subject to the Chicago lease transaction tax and, most likely, reimbursement of the lessor's use tax. 



[1]See California in the context of Mobile Transportation equipment and Maine generally for other jurisdictions that treat leases similarly to Illinois unique treatment.  Cal. Code Regs. 18 § 1661; M.R.S. 36 § 1811, Maine Instructional Bulletin No. 20

[2]See 35 ILCS 155/1 et seq. ("AROT")

[3]See 35 ILCS 105/2 for vehicles subject to an alternative "selling price" under the Illinois Use Tax

[4]See P.A. 100-437, effective January 1, 2018

[5] Although not discussed in this article, two other common exemptions that flow through to the lessor's purchase of equipment for lease are the Graphic Arts Machinery and Equipment and the Manufacturing Machinery and Equipment exemptions. See 86 Ill. Admin Code. 130.325, 86 Ill. Admin Code 130.330

This Blog/Web Site is made available by the lawyer or law firm publisher for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand that there is no attorney client relationship between you and the Blog/Web Site publisher. The Blog/Web Site should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.

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