Sales Tax & Bad Debts: Win at Indiana Tax Court Follows Federal

The BR State + Local Tax Spotlight

By Mitchell A. Newmark

Financed transactions can result in states asserting "heads I win, tails you lose" by taking the tax at the time of sale but not accepting pain when the installment sale is busted. When a sale of tangible personal property occurs, sales tax is typically due at the time of the sale on the entire purchase price. If the purchase is financed with installment payments, it is possible that the purchase price will not be recovered if the debt turns uncollectible.

A travesty of justice, aside from the advanced collection timing, is when sales tax is remitted on the full purchase price, but the full amount of the purchase price is not received. The Indiana Tax Court correctly ruled for the taxpayer’s refund in such a scenario. Indiana Finance Financial Corp. v. Indiana Department of State Revenue, Case No. 20T-TA-00017 (Ind. Tax Ct. January 4, 2024).

Facts: Automobile dealership Oak Motors, Inc. (“Oak”) executed installment sale agreements with auto-buying customers and, as required by Indiana law, paid Indiana sales tax on the full amount of the sales price. Oak sold the installment agreements to related party Indiana Finance Financial Corp. (“Financial”) without recourse for approximately 70 percent of the amount financed (that is, Financial purchased the agreements at approximately 30 percent discount). For federal and Indiana income tax purposes, Financial treated the installment sales under the federal market discount rules for gain/loss (Internal Revenue Code (“IRC”) Section 1276) by increasing basis in the agreements by the market discount included in its gross income and decreasing basis by each installment payment made.

When customers defaulted, Financial repossessed the autos and sold them at auction or to Oak. For fair market value of post-repossession proceeds, Financial used the auction proceeds (for sales at auction) or a respected vehicle pricing guide (for sales to Oak), plus third-party receipts related to insurance and warranty claims.

On its federal and Indiana income tax returns to address the uncollectible receivable, Financial treated the value of repossessed vehicles using the same market discount rules and claimed bad debt deductions under IRC 166. It filed sales tax refund claims deducting the Indiana sales tax on the bad-debt-related value that had been included in amounts that Oak had previously paid to Indiana on the full purchase prices.

The Department denied Financial’s sales tax refunds to the extent the market discount rules applied to the value of the repossessed vehicles. The Department asserted that Financial was required to reduce its unpaid installment agreement balances by 100 percent of the values of the repossessed vehicles—that Financial should not follow the federal market discount rules for the bad debt deduction. The Department recalculated Financial’s adjusted basis by reducing unpaid balances by the full value of the repossessed property (not reducing unpaid balances by the amount that was not market discount income).

Decision: Indiana requires that the full amount of sales tax on installment sales is due at the time of the sale. Ind. Code 6-2.5-6-7. Indiana allows a sales tax deduction to the extent of amounts “which were written off as an uncollectible debt for federal tax purposes under Section 166 of the Internal Revenue Code ….” Ind. Code 6-2.5-6-9(a). IRC Section 166 refers to the federal basis rules. Indiana case law requires that the mathematics of IRC Section 166 be followed and that use of the market discount rules to calculate the Indiana bad debt deductions for sales tax purposes prevents writing off more than was actually paid for the uncollectible receivables. Indiana DOR v. 1 Stop Auto Sales, Inc., 810 N.E.2d 686, 686-88 (Ind. 2004); SAC Finance, Inc. v. Indiana DOR, 24 N.E.3d 541, 547 (Ind. Tax Ct. 2014), review denied.

The Tax Court analyzed the above-mentioned case law. It declined the Department’s request to revisit the Tax Court’s prior decision in SAC Finance (it had been decided by the same judge that was ruling on Financing’s refund claim). The Tax Court reasoned that Indiana law requires that the Indiana sales tax deduction computation follow the federal bad debt deduction under IRC Section 166. The Tax Court held that Financial was entitled to its claimed refund based on its bad debt deduction that followed the calculation under IRC Section 166 by excluding only the portion of the repossessed autos that was not market discount income. Words matter. Justice prevailed!

This update is one in a series of updates written for the January 2024 edition of The BR State + Local Tax Spotlight.

© 2024 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.