Classification and valuation issues affecting the ad valorem taxation of business tangible personal property.

Diversity in state laws makes compliance with the self-reported taxation of business tangible personal property difficult. Nevertheless, taxpayers can challenge assessors' classification and fair market value (FMV) of property and often achieve significant reductions in personal property tax liability.

Classification

Classification issues become increasingly important to taxpayers in jurisdictions that limit the taxation of business tangible personal property or have different tax rates for personally and realty. In determining whether property should be classified as personal or real, traditional definitions of personal property provide that "personal property is everything that is the subject of ownership that is not real property and not permanently affixed to real property." Personal property includes inventory, machinery and equipment, furniture and intangibles. The classification of property as personally or realty is conventionally determined using the following three-pronged approach:

1. Actual annexation, according to the nature and use of the article.

2. The property's appropriation or adaptation to the use for which it was annexed.

3. The intention of the party making the annexation.

Even property affixed to real property for long periods of time can be classified as personal. For example, the New Hampshire Supreme Court recently held that certain communications equipment was personal property and, therefore, not subject to property tax (New England Telephone & Telegraph v. City of Franklin, 685 A.2d 913 (1996)). The equipment in question included telephone poles, underground conduits, frames and switches. The court held that the equipment was readily removable and transportable, and capable of performing its intended functions elsewhere. Further, removal would not render the realty unfit for use. The fact that the poles had a life expectancy of over 40 years was not relevant to their classification as personal property.

Another controversial area involves the proper classification of automatic teller machines (ATMs). Financial institutions in California pay a higher franchise tax (a "bank tax") to the state in lieu of property tax on personal property. Several California banks convinced the Board of Equalization to revise its regulations to treat ATMs as personal property rather than as permanent fixtures taxable as real property. The revised regulation states that "an ATM is personal property and shall be classified as such if it can be removed or relocated for use at another location without material damage to the ATM or the realty with which it is being used." According to bank representatives, most ATMs are not bolted to the floor and can be installed or removed without harm to the realty in a short period of time. The banks further argued that treatment of ATMs as personal property is consistent with the treatment of computers and other data | processing equipment.

Valuation Issues

Tangible personal property is often reported at cost. State-established depreciation rates are used to adjust the cost to reflect approximate FMV. Often, however, taxpayers can prove that the FMV is lower than the amount I determined using the standard rates, by presenting to the assessor appropriate comparable sales data and details quantifying obsolescence for the subject property.

Typically, a taxpayer bears the burden of establishing that the assessor has overassessed its property. This burden may be difficult to meet and the amount of evidence necessary is not always clear. In a recent case, Xerox Corp. v. Hartford, Conn. Sup. Ct., 3/18/97, a manufacturer and lessor of office equipment provided a personal property tax list to the assessor in which the FMV of its equipment had been determined by applying an average weighted discount obtained from an effective price study. The taxpayer provided the assessor with a summary of the study, which described the methodology the taxpayer used to compute the values and included charts that listed national averages on sales of the equipment during the year. The assessor did not accept the taxpayer's valuation of the equipment, and the superior court denied the taxpayer's appeal on the grounds that the taxpayer had failed to provide sufficient information to the assessor. The Connecticut Supreme Court overrode the dismissal, holding that the taxpayer satisfied its burden of "providing the facts upon which valuations may be based." According to the court, the taxpayer was entitled to a hearing to consider the relative merits of its evidence of value and methodology and that used by the assessor.

In a key unpublished decision of California's Second District Court of Appeals, Treasure Chest Advertising v County of Los Angeles, the court held that assessors are required to take economic obsolescence into account when valuing property. Economic obsolescence, also called external obsolescence, is defined as "a loss in value caused by factors outside a property." Economic obsolescence can be attributable to such influences as political and social factors, insufficient demand, changing technology, costs attributed to governmental regulations and negative economic conditions. In Treasure Chest, the company owned printing presses that had become obsolete due to technological changes in printing press widths. These changes significantly reduced the presses' FMV. The court held that the assessor was required to consider the effects of economic obsolescence, even though the equipment continued to function in its intended use.

Effect on High-Technology Equipment

Almost every industry is affected by current changes in technology. Fixed assets are rapidly being replaced with a genre of assets that do it cleaner, faster and more efficiently Rapid technological obsolescence results in actual market values for these assets that are much lower than the values determined using standard depreciation tables.

High-technology equipment (e.g., computers and related peripherals, medical equipment, etc.) has been plagued by unusually rapid obsolescence, resulting in opportunities to obtain reductions in property value in accordance with FMV standards. Over the last few years, owners of computer equipment have prevailed in a number of states in establishing that general depreciation tax tables failed to consider the fast-paced technological changes in computer equipment; see, e.g., County of Jefferson v. IBM Credit Corp., 888 P. 2d 250 (solo. 1995).

Depreciation factors often establish a residual-value standard, or floor, that does not reflect the FMV (or lack thereof) of obsolete technology. Several states have recognized the need for lowered residual values for computer hardware and related peripherals; for example, Michigan lowered the residual value for computers to 10% (down from 30%). In response to litigation and market recognition of shorter lives, states also have begun to shorten the lives of computer equipment; Maryland recently amended the personal property depreciation rate regulation to allow for mainframe computers costing $500,000 or more to be depreciated at 20% per year and certain data processing equipment and software to be depreciated at 30% per year.

Conclusion

Dynamic and frequent changes to state statutes and case law should be anticipated, as the need to accommodate changing technology increases. Such changes should be monitored closely to minimize personal property tax burdens.

From Deborah A. Davis, CPA, Washington, D.C.