Structuring Out-of-State Leasing Companies for Tax Arbitrage

Does your company have a significant amount of machinery, equipment, or vehicles? For many manufacturing and construction business owners, their assets are a valuable component of their operations. This makes it important to find the right strategies to protect your assets while still minimizing your tax burden.  

In this article, we'll cover the fundamentals of out-of-state leasing companies for tax arbitrage, including when this strategy can be used, the advantages, the disadvantages, how to set up a leasing company, and additional considerations before getting started. Since this is a complex tax strategy, it's best to consult with a qualified accountant before pursuing an out-of-state leasing company.  

Out-of-state leasing is a tax strategy that exploits state tax differences to reduce financing costs and leverage depreciation. The overall goal of establishing an out-of-state leasing company is to lower your taxable income, which eventually gets passed down to the lessee in the form of reduced financing or lease costs.   

Establishing out-of-state leasing companies can be challenging from a legal standpoint and subject to IRS scrutiny. For these reasons, companies with business operations in multiple states generally take advantage of this tax strategy. It's much more difficult to prove the authenticity of an out-of-state leasing company when your business has no sales or physical presence in the state.  

Using out-of-state leasing companies can have a variety of tax benefits. Let's explore some of these advantages in more detail.  

Sales Tax 

Each state has a different sales tax percentage that applies to equipment or machinery purchases. For example, states like Delaware and Oregon have no state sales tax, while states like California have a 7.25% state sales tax rate. Operating a leasing company in a state with no or low state sales tax can help you save a significant amount of money on your purchase.  

Let's say that you are purchasing a new piece of machinery for your construction company that costs $100,000. If you were to purchase the machine in California, you could pay $7,250 in state sales tax. In addition, you could be subject to a local sales tax depending on where you buy the machinery. Leveraging an out-of-state leasing company can help you reduce the upfront sales tax cost, resulting in a lower financing cost.  

Personal Property Tax  

Some states also have an annual personal property tax. While some states have provisions that exempt machinery from tangible personal property, others apply a blanket tax rate each year on the value of your equipment. For example, Delaware exempts business machinery and equipment from personal property taxes, while Alabama imposes a tax rate based on the carrying value of the equipment (purchase price minus depreciation).  

Depreciation  

States also have depreciation differences, which can influence your tax bill. While most states conform to federal tax treatment and allow Section 179, some states disallow bonus depreciation. As a reminder, bonus depreciation was phasing out under the 2017 Tax Cuts and Jobs Act. However, the One Big Beautiful Bill restored bonus depreciation to 100% for purchases on and after January 19, 2025. 

Since the $2,500,000 Section 179 limit does not phase out until over $4,000,000 of assets are placed in service, many companies will have no problem taking advantage of immediate expensing. However, if your company is in a growth phase and expects to purchase machinery and equipment in excess of $4,000,000, using an out-of-state leasing company may be beneficial to leverage bonus depreciation.  

Legal Liability  

Another advantage of establishing an out-of-state leasing company is the legal liability separation. Let's say that you use an out-of-state leasing company to purchase and hold all business equipment. You have an unhappy customer who decides to sue your construction company. Since the equipment is titled under a separate company, those assets are safeguarded from the lawsuit.  

Having an extra layer of legal protection between your business and business equipment can protect your assets and your company from a total loss. While specific procedures and processes do need to be followed to preserve your liability protection, using an out-of-state leasing company can properly protect your investments.  

Before opening an out-of-state leasing company, it's important to be aware of the potential challenges. Let's cover a few of the top concerns when trying to leverage this tax arbitrage strategy.  

Contract Law 

One of the main challenges of using an out-of-state leasing company is the differences in contract law between states. Each state has a different set of laws surrounding commercial contracts and equipment leasing. While contract law should not be an issue if your business is the only entity using the equipment and machinery, problems can arise if you rent property to other parties.  

Licensing  

Many states require licensing and registration in the state of use. Even though the title to the equipment is located in one state, you may need to pay and file registration documents in the state where the machinery and equipment are being used, which potentially adds to your costs. For example, some states require registration fees based on the estimated miles driven, while others assess registration fees based on the specific weight of the vehicle.  

UCC Liens  

Uniform Commercial Code liens are in place to protect the lessor's claim on the collateral. These liens can differ by state. Many states require the lessor to refile a lien in the state where the equipment, vehicle, or machinery is physically located. Neglecting to follow UCC lien regulations can cause challenges, especially if the asset is stolen, lost, or damaged.  

Sales Tax Nuances  

One of the advantages of out-of-state leasing companies is the ability to save on sales tax. However, some states shift the sales tax requirement from the lessor to the lessee. This means that the lessee will pay state sales tax in the state where the asset is located. Similarly, some states also impose a double tax on sale-leaseback transactions. If not carefully understood, sales tax could cost your business additional money instead of resulting in tax savings.   

IRS Disallowance  

IRS disallowance is another concern when establishing an out-of-state leasing company. Instead of recognizing two separate companies, the IRS may see your main business and your leasing company as one, disallowing transactions as intercompany and requiring the filing of a consolidated return. Keeping transactions at arm's length with clear documentation is important to avoid your leasing company being treated as a sham entity.  

If the potential benefits outweigh the risks, you may decide to set up an out-of-state leasing company for tax arbitrage. Since the process requires numerous steps, it can be beneficial to work with an expert who has completed the process before. Nevertheless, here is a brief outline of how to structure your out-of-state leasing company.  

1) Research Tax-Advantaged States 

The first step will be to complete due diligence on the state with the most advantageous tax laws. For example, if you are trying to minimize state sales tax, you might want to choose a state with no state sales tax, like Delaware. It's also important to research the lease requirements, personal property tax regulations, and depreciation rules in the state.  

If your business operates in multiple states, choosing a location where you can establish a physical presence will help substantiate your business operations. If you incorporate in a state that you've never set foot in, you may have difficulty proving the legitimacy of your business.  

2) Form a Separate Business Entity 

Once you've identified the state your leasing company will operate in, you will need to form a separate business entity. The state you form your business in doesn't always need to be the state you operate out of, but it can be helpful to legitimize your business. Many business owners use an LLC or corporation structure.  

3) Apply for Licensing 

Certain states require leasing companies to have specialized licenses, especially for large pieces of machinery and equipment. Check the requirements of the state you are operating in and apply for the necessary licenses.  

4) Purchase or Transfer Machinery 

Next, purchase or transfer machinery into your leasing company. This will involve titling the machinery, equipment, or vehicles in the new business name. It's also important that your insurance policies list the new leasing company as the owner. The more documentation you have to support your leasing transactions, the better.  

5) Create Leases  

Even if you are only leasing to your primary company, it's important to have formal leases in place. These leases should state all relevant terms, such as the lease term, the cost, and the conditions. If the IRS requests supporting documentation, they will be analyzing your leases to ensure they are at arm's length.  

6) Manage Ongoing Filings 

If your leasing company operates in a state with sales or personal property tax, it's important that you continue to manage ongoing filings. For example, many personal property tax forms require an annual filing. You may also need to complete additional filings to keep your licenses and business entity active.  

An important advantage of using an out-of-state leasing company is enhanced asset protection. These assets are often separated from your core business operations, adding another layer of security in the event of a lawsuit. Here are three strategies for ensuring the assets in your leasing company are properly protected.  

Prioritize Documentation  

One of the best ways to enhance asset protection and the legality of your out-of-state leases is to prioritize documentation. All documentation should have the proper company on it. For example, your vehicle shouldn't be titled in one company and have an insurance policy run through another. All relevant documentation should match the leasing company. Any comingling of documents could cause the IRS to classify the leasing company as a subsidiary.  

Strengthen Lease Agreements 

Lease agreements are an essential document that outlines the details of the transaction. Each piece of machinery or equipment rented should have an attached lease agreement. Even though you may own both companies, adhering to the lease agreements is important. A well-drafted lease will be the first substantiating document that will be requested in an inquiry.  

Perfect Security Interest 

A perfected lien establishes a clear claim to the leased asset, which protects it from creditors if the lessee (your company) defaults or is facing a lawsuit. Perfecting your security interest can be done by following UCC regulations, carefully tracking your fleet of equipment, and maintaining all relevant documents.  

Utilizing an out-of-state leasing company might be what your business is looking for to save on taxes and increase your asset protection. However, tax laws can quickly become complex when crossing state borders. If you're considering opening an out-of-state leasing company for tax arbitrage, it's important to work with a professional.